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April 14, 1989

Interest Rate Smoothing
Since late 1982, the Federal Reserve has implemented monetary policy through its control over
the level of borrowed reserves. While not identical, this approach is analytically similar to the
federal funds rate operating procedure the Fed
used in the 1970s. (The fed funds rate is the interest rate on reserves banks lend each other overnight.) Both approaches have had the effect of
smoothing out fluctuations in short-term market
interest rates, as the chart shows. They also are in
sharp contrast to the approach used during the
period from late 1979 through late 1982, when
large movements in market interest rates were

Monthly Fluctuations in
Short-term Interest Rates

(90-day T-BIU Rate)












- 5


The Fed was widely criticized in the 1970s for
not paying enough attention to the longer-run
inflationary consequences of its policy. In view
of the similarities between the fed funds rate procedure followed in the seventies and the current
approach, a number of economists have voiced
concerns that the Fed is again stabilizing shortterm interest rates to the detriment of long-run
price stability. Such an approach to policy, they
argue, is inappropriate because there is an inevitable trade"off between. the goals of short-run
interest rate stability and long-run price stability.
This Letter reviews recent research on the effects
of interest rate smoothing and concludes that

smoothing short-term interest rate fluctuations
can be consistent with achieving long-run price
Policy in the 19705
Most economists share the view that the appropriate ultimate goal of monetary policy is price
stability (that is, zero inflation), or perhaps stable
inflation at some low rate. Under the federal
funds rate procedure it used in the 1970s, the Fed
adjusted its funds rate target only gradually. As
spiraling inflation expectations pushed up market
interest rates in the 1970s, this delayed adjustment in the target produced rapid money growth
and fueled inflation. Based on this experience, it
has become clear that a policy aimed at smoothing short-run interest rate movements is not consistent with long-run price stability unless the
Fed is willing to quickly adjust its interest rate
. target in response to changing economic conditions.

Base drift
Recently, a number of economists have argued
that price stability inevitably will be sacrificed
if the Federal Reserve gives any weight in the
conduct of monetary policy to the objectiveof
smoothing interest rates. For example, Marvin
Goodfriend of the Federal Reserve Bank of Richmond, suggests that to the extent the Fed seeks to
dampen short-run fluctuations in interest rates,
such a policy will preclude it from offsetting
deviations in the level of the money supply from
its long-run target.
If the money supply is above its long-run target,
the goal of price stability requires the Fed to
force the level of the money stock back down.
However, any attempt to do so requires interest
rate adjustments which contravene the goal of
short-run interest-rate smoothing. Thus, if the Fed
is concerned at all about smoothing interest
rates, its response to the·above-target money
stock will be muted. As a consequence, Goodfriend argues, the price level will not be stable,
but will, instead, drift with no tendency to return
to its initial level.

financial disturbances. In this way, such a policy
promotes price stability.
This failure to fully offset past deviations from
target is reflected in the Fed's decision to use the
actual level of the money supply as the base
when establishing new target growth paths each
year. This decision results in what has been
called "base drift." With base drift, the Fed starts
each year "on target," nO.matter hQwlarge the
deviiltionJrom target might have been in the
prior year. Basedrift, according toGoodfri~nd,is
an inevitable outcome of a rate smoothing policy
since a return to the original base requires interest rate adjustments that are not consistent with
rate slTloothing.Suchan approach tends to compound past deviations froOltarget andcompromises the goal of price stability~ .

Are all. sl'110othing policies equal?
The possibility ora tradeoff between short-term
interest rate stabi lity and .long-term price stability
certainly .is cause for concern; particularly since
the Fed's cUrrent operating procedures tendto .'
diminish short-run fluctuationsinmarket interest
rates. HUlda all policies that have the effect of
smoothing interest rateS involve such a tradeoff? base,driftnecessarilyinconsistentwith the
goal of 10l)g-termpricestabiIity? The ansWer to
both questions is no.
Whenever the Fed acts to reduce fluctuations in
market iJ;lterestrates,itis pursuing aJate-smoothing policy. BuUt is the underlying motivation for
the ril!e-slTloothing policy. that determines, in
part,whether thatparti, pqIicyis in conflict
with long-term price stability. In general, one of
twq cancems tendsto.motivate rate-smoothing
policies, First,' policy makers may view OlOVEtments, in interest rateS assignall il)g disturbances
in the economy that require,C).djustlTlents ,in the.
direction of lTlonetCiry ,>order to OlCiintain
such ultimate goals as low inflationandunemployment. Thus, a rise in interest rates due to an
increa~e inmoneydeOland, for eXilmple, would
inducethe.Fedio.e~pandthelTloneysupply .'
sufficiertly tQ off~et theriseinrnarket rates.
In this~~se,'int~restrate .stability implies
cOJTlpleteaccommodation .Qf seasonCiland
temporary fluctuations .in·Olo[)eydemandand
supply. AccoOlmodating such fluctuations can
be interpretedasJulfilling the Fed's mandate to
provide liquidity to the ec;onomy,and. in so
doing, serves tqinsulatethe real economY from

In this framework, moreover, base drift will not
necessarily be inconsistent with long-run price
stability. If, for example, financial innovation
leads to a permanent shift in the demand for
money, a similar permanent shift in the money
supply is necessary to maintain price stability.
However,to the extent that Olovements in interest
rates do not always signal financial disturbances,
rate smoothing will interfere with the goal of
price stability. For example, a rise in interest
rates associated with a disturbance in the real
economy such as a spurt in investment demand
should not be offset. Similarly, the appropriate
response to a rise in interest rates caused byexpectations of higher future inflation would be to
tighten policy, and that might lead to an even
larger rise in short-term interest rates. Moreover,
to the extent that these disturbances are transitory, an automatic policy of always allowing
complete base drift in setting monetary targets
is unlikely to be consistent with price stability.
A second motivation for rate smoothing is a
concern that rate volatility itself may be destabilizing. Specifically, some argue that rate
movements generate risk to the financial sector
in the form of potential capital losses in the portfolios of financial institutions. To minimize this
risk,they argue, the Fed should act to offset rate
movements even if doing so caused it to sacrifice
some of its other goals. For. example, the Fed
might ease policy in an attempt to minimize a
rise in market rates even ifthe initial rise were
the result of expectations of higher inflation.
Obviously, such a policy is at odds with the goal
()f long-run price stability.
But it also may be at odds with short-run price
stability. Consider the following: Assuming that
assetswith longer maturities embody expectationsconcerningthe level of short-term interest
ratesin the future, investQrsshould be able
to.el iOlinate riskassQciated with forecastable
changes in interest rates by arbitraging across
assets ofdifferentmatljrities. Thus, the risk associated with rate changes should arise only from
changesthatcannot I:>eforeseen. This considerationsuggests that a,more appropriate measure of
risk wouldbe the sizeof interest rate forecast
errqrs, not the magnitude of the fluctuations

However, a policy that seeks to minimize the
forecast errors may do Iittle about interest rate
fluctuations caused by other types of disturbances most economists think the Fed should
offset. Such a policy, for example, would not
require the elimination of movements in interest
rates such as might be caused by (forecastable)
seasonal fluctuations in money demand. This
would seem to violate the Fed's responsibility to
provide liquidity and could reduce short-term
price stability.

Prohibit rate smoothing?
Itappears that both types ofrate-smoothing
policies can pose problems for long-run price
stability. Mistakes in interpreting interest rate
movements tend to contravene the price stability
goal under a policy that treats interest rates as a
signal of macroeconomic developments. And a
policy that has as its objective the reduction of
interest rate volatility, on its face, contradicts the
goal of price stability. However, whether rate
smoothing is desirable depends upon the type
of price objectives the Fed should pursue. A simple example will show that there is a trade off
between long-run price level stability and inflation stability. If the latter is an appropriate goal,
then interest rate smoothing may be desirable.
Because the Fed exercises only imperfect control
over the money supply, monetary control errors
can occur. An above-target deviation of money
from its target for instance, would tend to lower
market interest rates. To maintain a constant
long-run price level under a non-smoothing approach, the Fed would need to lower its future
target growth path in order to return the money
stock back to its original targeted level.
However, such a zero-base-drift policy wi.1I
not prevent the economy from expanding in
response to the initial decline in interest rates. In
addition, the price level initially will tend to rise
as a result of this monetary control error. Slower
money growth eventually will cause the economy to contract, and the price level will fall.
Ultimately, prices will return to their original
level, but only after inflation has fallen below the
long-run inflation goal of the Federal Reserve.
This inflation adjustment process is needed to
bring the price level back on track and generally
will take 18 months to two years, given the lags
between monetary policy and its impact on the
economy. Thus, it appears that while a zero-

base-drift policy can maintain long-run price
stability, it can do so only at the cost of shortrun instability in inflation.
This example suggests that the question whether
rate smoothing is desirable cannot be divorced
from a consideration of the price objectives that
the Fed should pursue. If reducing short-run inflation fluctuations, or maintaining a low average
rate of inflation, are appropriate objectives of
monetary policy, then drift in the level of money
and prices is of no consequence. If, instead,
macroeconomic stability requires that the Fed
should stabilize the long-run price level, then the
Fed should not give independent weight to rate
smoothing objectives, and base drift will be unacceptable, except in the case that there are
persistent shifts in the demand for money.

Summing up
An interest rate smoothing policy that prevents
seasonal and temporary fluctuations in the demand for money and instability in financial markets from affecting the real side of the economy
can be consistent with the stabilization goals
implicit in the Fed's mandate. However, frequent
adjustments in the level around which rates are
stabilized generally would be required to take
account of other types of disturbances that ought
not to be offset.
A monetary policy designed to smooth interest
rate movements sometimes will lead to price
level disturbances that are not reversed, however.
On the other hand, the absence of rate smoothing is not sufficient to insure price stability,
In the final analysis, economists need to provide
policy makers with a better understanding of the
relative costs of inflation versus achieving price
stability. Without such an understanding, one
cannot draw normative conclusions about the
impact of policies designed to smooth interest
rates. Criticism of rate smoothing seems misplaced without clear guidance on the nature of
the price objectives the Fed should pursue.

Carl E. Walsh
Associate Professor
University of California, Santa Cruz
Visiting Scholar
Federal Reserve Bank of San Francisco

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board af Governors of the Federal Reserve System.
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publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
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