The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
October 19, 1979 The Fed CrossesThe Rubicon "Using the proverb ... 'The die is cast,' he took the river."-Plutarch Over the October 6 weekend, the Federal Reserve announced that it was taking three steps "that should assure better control over the expansion of money and bank credit, help curb speculative excesses in financial, foreign exchange and commodity markets and thereby serve to dampen inflationary pressures." First, the Fed announced a onepercent increase in the discount rate, the rate at which Reserve banks lend to member commercial banks. Second, it imposed a marginal eight-percent reserve requirement on "managed liabilities" -large time deposits, Eurodollar borrowings, repurchase agreements against U.s. Government and federal-agency securities, and federal-funds borrowing from nonmember institutions. Finally, the Fed announced a greater emphasis, in the day-to-day conduct of monetary policy, on bank reserves-and less emphasis on confirming short-term fluctuations in the federal-funds rate, the rate at which banks borrow reserves from each other and from other institutions. The first two measures have received considerable attention in the financial markets and the press, yet may affect the overall performance of the economy for only a short period of time. But the third measure, while receiving much less attention, may have fundamentally improved the long-run inflation outlook in the United States. By focusing its day-to-day operations on bank reserves, the Federal Reserve may now have found a way to keep growth in the nation's money supply under tighter control. Since high inflation rates cannot persist for long without rapid money growth, substantial progress against inflation may be achieved over the next few years. Operating procedures The Federal Reserve can influence the growth in money in either of two basic ways-with either a reserves operating target or a funds rate target. Both methods operate through the market for bank reserves. Under the Fed's present regu lations, member banks must hold reserves against deposits equal to a certain minimum percentage of those deposits. This means that deposit growth is ultimately constrained by the rate at which bank reserves are expandirig. Thus the banking system must find additional reserves if more deposits are to be issued. The Federal Reserve, of course, has the power to add to or subtract from reserves through open-market operations, in which it either buys financial assets from banks (adds reserves) or sells financial assetsto banks (withdraws reserves). Under the reserves operating target, as apparently adopted on October 6th, the Fed attempts to hit certain target growth rates for the quantityof bank reserves. Once this quantity is expanding at a set rate, the rate at which banks can issue deposits (the main element in the money supply) will be largely determ i ned. Under the funds rate target, as used prior to October 6th, the Fed attempted to influence deposit growth not through the quantity of bank reserves but indirectly through the cost of these reserves. Banks can borrow from other institutions in the federal-funds market. The Fed can affect the interest rate on these reserves (the fed-funds-rate) by injecting or withdrawing A rise in the funds rate, for example, increases the cost of reserves, which in turn leads to increases in other market rates of interest. With higher yields on financial assets like Treasury bills, the public chooses to hold smaller stocks of low-or noninterest-bearing deposits, and money growth declines. A great deal of research has been done on which technique does a better job of controlling money. As a technical matter, the race seems to be a draw: using either the funds rate or reserves as the operating target (except in 1 970 and mid-1973) have not been sufficiently aggressive to keep money growth from following the path of income growth over the business cycle. As a result, monetary policy has generally added to inflationary pressures in cyclical expansions and to unemployment in recessions. produces equally good results. This conclusion, however, leaves out a crucial factor, namely, the cautious way in which the Federal Reserve's monetary policymaking body -the Federal Open Market Committee -has tended to adjust its funds-rate targets in response to deviations of the aggregates from their official longer-run targets. This cautious control has several implications. First, with such an approach, a funds-rate operating instrument in the past resulted in less control over the monetary aggregates than was either desirable or feasible. Second, the cautiouscontrol approach is now likely to carry over to the new reserves operating target. And third, cautious control of reserves is likely to improve control over the aggregates. Why cautious control? Why hasn't the Federal Reserve moved the funds rate more actively? The Fed is faced with a good deal of uncertainty concerning the cu rrent cond ition of the economy and the precise timing and impact of policy actions. This uncertainty reflects the current state-ofthe-art in the economics profession, and is not likely to be eliminated in the near future. Under these circumstances, the rational policymaker with the best available information shou Id react cautiotJslYln changing the operating target when money growth appears to be off target. Since the impact of potential policy actions is uncertain, the fact that the economy functioned tolerably well last month is important evidence in favor of not substantially changing the operating target this month. In this way, significant swings in policy are quite rationally delayed "until next month". Cautoous fUlf1ldsrate cOlf1ltrol In evaluating the experience underthe previous funds rate target, it is important to recogn ize that growth of the (M 1) money supply is influenced primarily by two factors. First, if the Fed increases the funds rate, for example, M 1 growth tends to fall as banks find it more expensive to borrow reservesand as the public finds non- or low-interestbearing deposits and currency less desirable. Second, as income rises and falls over the business cycle or in concert with inflation, Ml growth will also be pulled up and down as the public's need for transactions balances changes. Several political and bureaucratic constraints on Fed actions also have contributed to cautious control of the funds rate. First, policy is made by a committee (the twelve-member Federal Open-Market Comm ittee) and the Committee's inevitable compromises sometimes lead to only modest changes in the operating targets. Second, the Fed is appropriately sensitive to Congressional and public opinion about the effectiveness of monetary policies. For some reason, public and pol itical attitudes tend to view the risk of doing something to be greater than the risk of the status quo. Since greater blame attaches to mistakes resulting from activist policies, the Fed is influenced in the direction of gradual ist pol icies or the status quo. Third, frequent changes in policy impose high costs on the private sector by forcing it constantly to revise its decisions, and so can be detrimental to aggregate economic perfor- Presumably, in targeting the aggregates the Fed wishes to avoid increases in money growth in recoveries which would "overheat" the economy, and decreases in money growth in recessions which would exacerbate unemployment. Such undesjred procyclical money-supply movements theoretically can be avoided by changing the funds rate fast enough to "fight off" the procycl ical effects of income growth on money. But as the chart indicates, the Fed generally has not done so. The funds rate has moved in the right direction - increasing in recoveries to restrain monetary accelerations, and decreasing in recessions to hold back monetary decelerations. But these actions 2 Annual Change (%) 150 100 50 ·50 ·100 . --_. _-------_. __ _ ___-----_. •....... .. _-_ ..-.- - - _. - ..__...._._----_. _-_. _----_ __-. .. .. _--_. _-- While the Fed can keep interest rates down in the short-run, this is not true in the long-run. Attempts to lower rates in the face of strong money and credit demands result in fast money growth and ultimately inflation. And given the inclusion of an inflation premium in nominal interest rates, attempts to resist interest-rate increases in the short run often cause higher rates in the long run. But now, by emphasizing reserves, the 'Fed may avoid some ofthe public pressure to control interest rates, and thus may promote a more accurate public perception of its actual ability to control rates. mance. Thus, in addition to being concerned with inflation, unemployment, and the foreign exchange value of the dollar, the Fed may qu ite reasonably want to provide a stable policy framework, and in doing so may be cautious in changing the funds rate. hilterest rate variability All of the above considerations regarding the Fed's control of the funds rate apply equally well to any other operating target the Fed might use, includingbank reserves. Thus the Fed's recent decision to focus on reserves rather than the fu nds rate cou Id mean that the reserves-operati ng targets wi II now be moved cautiously also. Improved monetary control? As we have seen, a cautious funds-rate strategy can lead to procyclical swings in money and reserves that are larger than desirable. A cautiously controlled reservesoperati ng target wi II work in just the opposite direction - it will tend to resist, rather than accede to, the forces producing procyclical swings in money. With the supply of bank reserves expanding at a relatively stable rate, the maximum rate at which banks can issue deposits will be relatively stable also. Cautious control would of course mean that short- and long-term fluctuations in banks' demand forreserves would (in most cases) not be accommodated. This is likely to cause the federal funds rate to become much more variable than it has been in the past. This possibility has prompted some observers to argue that such funds-rate variability would be unacceptable to the Fed -indeed, would cause the Fed to revert to a funds-rate target, leading again to interest-rate smoothing. Cautious control appl ied to a reserves operating instrument thus is likely to insulate the growth in money more thoroughly from cyclical swings in output and prices. The outcome should be a better record in moderating economic fluctuations and particularly in containing the rate of inflation. Under the old system, inflationary pressures often led to faster money growth and thus even more inflation later. Under the new system, more inflation now is likely to be met by higher nominal interest rates and unchanged money growth, which means that higher rates of inflation cannot be permanently sustained. For this reason, the long-run outlook for inflation control has been improved by the recent Federal Reserve action. These fears could be exaggerated. First, under a reserves target, funds-rate fluctuations probably will not be transmitted to other money-market rates (such as the Treasury-bill or commercial-paper rates) to the same extent that they were under a funds-rate target. Formerly, cu rrent changes in the fu nds rate contained policy information aboutwhat the Fed would do in the future; thus fundsrate changes were almost immediately reflected in other money-market rates. Under a reserves-operating instrument, the essentially random day-to-day and week-to-week changes in the funds rate will convey less information about its future levels, and will have a much smaller impact on other moneymarket rates. Second, under the funds-rate regime, the Fed came to be held publicly responsible for interest rates -and thus came under considerable pressure to keep rates down. JohnP.JuddandJohnl. Scadding 3 l.S!:!II.:! U01 8U!4SEM.4Em • uo8aJO • EpEAaN !!EMt:?H • E'!UJOJ!lE':) E'UOZpV. CD) ZS'l 'ON GIYIlI : J9¥150«1's'n 1I1VWSSYD BANKINGDATA-TWELFTHFEDERAL RESERVE (Dollar amounts in millions) SelectedAssetsandliabilities largeCommercialBanks Loans(gross,adjusted)"and investments* Loans(gross,adjusted)- total# Commercial and industrial Realestate Loansto 'individuals Securitiesloans U.5. Treasurysecurities* Other securities* Demand deposits - total# Demand deposits- adjusted Savingsdeposits - total Time deposits- total# Individuals, part. & corp. (LargenegotiableCD's) WeeklyAverages of Daily Figures MemberBankReserve Position ExcessReserves(+)/Deficiency (-) Borrowings Net free reserves(+ )/Net borrowed(-) Amount Outstanding 10/3/79 135,090 111,970 31,821 40,785 22,711 2,273 7,513 15,607 45,966 31,151 30,364 54,494 46,213 20,269 Weekended 0/3/79 Changefrom yearago@ Dollar Percent Change from 9/26/79 - - - + 16.68 + 20.01 + 15.63 + 19,309 + 18,670 + 4,302 + 8,344 1,359 1,420 148 166 38 54 130 69 3,181 969 286 249 211 272 - + + + - + + + Weekended 9/26/79 NA NA 1,284 1,923 3,654 628 480 7,476 8,619 1,644 - + + + - + + + 25.72 NA NA 14.60 14.05 8.64 2.06 1.56 15.90 22.93 8.83 Comparable year-agoperiod 57 42 99 - 25 96 71 2 15 17 - 514 - 453 243 - 289 77 + 555 - FederalFunds- Sevenlarge Banks Net interbank transactions [Purchases(+ )/Sales(-)] Net, U.5. Securitiesdealer transactions [Loans(+)/Borrowings (-)] * Excludestrading account securities. # Includes items not shown separately. @ Historicaldataarenot strictlycomparable dueto changes in thereportingpanel;however,adjustments havebeenappliedto 1978datato removeasmuchaspossibletheeffectsof thechanges in coverage. In addition,for someitems,historicaldataarenotavailabledueto definitionalchanges. 0 o4EPI E'>lsEIV
@FedFRASER