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September 5, 1 980
In Pursuitof Mon ey
Last October 6, the Federal Reserve made
what was probably the greatest change in
monetary pol icy since the Federal ReserveTreasury Accord of 1951, when the Fed broke
loose from the Treasury dominance which
had characterized the World War II and early
postwar years. On October 6, 1979, the Fed
announced that it was changing the basic
way in which it conducts open-market policies-the buying and selling of Government
securities-in the pursuit of it'smonetary objectives. The Fed described this basic change
to Congress as follows:
"Previously the reserve supply had been
more passively determined by what was
needed to maintain, in any given short-run
period, a level of short-term interest rates, in
particular a level of the Federal-funds rate,
that was considered consistent with longerterm money growth targets. Thus, the new
procedures entail greater freedom for interest
rates to change over the short-run in response
to market forces."
Many economists had argued that under previous operating procedures, monetary policy
tended to amplify movements in real output
(GN P), instead of moderating and stabilizing
such cyclical swings as it should. To these
critics, the policy shift (if successfully pursued) presaged a more stabilizing role for
monetary policy. But the man in the streetand many financial analysts-remain dubious about the outcome of this policy shift.
The greater stability in money-supply growth
(if achieved) may seem too great a price for
the increased variability in interest rates since
last October. For that reason, it might be useful to examine the intellectual background of
monetary-control ru les and operating procedures. This means reviewing the previous
criticism of the Fed's operating procedures, as
well as the rules of thumb that economists
have proposed for appropriate monetary
policy.
Critical legacy
According to the earlier critics, the Federal
Reserve, by "targeting" or attempting to
moderate interest-rate movements, had
, caused "procyclical" monetary growth. In
this view, the Fed's attempts to prevent interest rates from rising too fast in a cyclical
expansion caused the Fed to supply too many
reserves to the banking system, and thus
led to overly rapid money growth. Rapid
money growth then led to unsustainable real
growth-and
in the long run, to greater inflation. Conversely, the Fed's atteinpts during
a cyclical recession to prevent an over-rapid
decline in interest rates generally led the Fed
to expand reserves and money less rapidly
than required to maintain reasonable realoutput growth, and thus tended to worsen
each economic downturn. In critics' eyes,
then, the Fed inadvertently tended to amplify
each business cycle instead of stabilizing it.
Moreover, its mistaken policies eventually
led to more rather than less inflation, and
caused greater and not less peak-to-trough
movements in interest rates.
With its previous interest-rate approach to
control of monetary growth, the Fed attempted to influence the public's demand for
money. Since money demand is inversely related to interest rates, this approach dictated
an increase in interest rates (providing fewer
reserves) when the Fed wanted to reduce
money growth -and dictated a reduction in
rates (maid ng reserves more plentifu I) when
the Fed wanted to stimulate money growth.
Under this approach, then, the supply of reserves to the banking system was determined
residually, as the above quotation suggests.In
other words, the Fed suppl ied whatever level
of reserves that appeared consistent with its
short-run interest-rate'targets.
The Fed in the short run thus determined the
monthly Fed-funds rate target, usually in
terms of a range of about 50 to 100 basis
points (V2 to 1 percentage points), while the
flected the tendency of high interest rates to
discourage the holding of demand deposits
and currency, the components of the narrowly defined (M-1) money supply. Nor did
money growth show much stability this
spring, when the M1 -B money measure declined at a lA-percent annual rate in April but
then grew at a 14V2-percent rate in June.
public's demand for money determined the
supply of reserves. To many Fed critics, the
October 6 policy move did not represent
simply a choice of operating targets, as between the funds rate and bank reserves. Rather, it represented a vindication of their longstanding view that the economy can be better
controlled with a monetary aggregate than
with an interest-rate target.
With the economy subjectto both "real" and
"monetary" shocks, which is the most appropriate monetary-policy response-moneygrowth targeting or interest-rate targeting?
Brown University Professor William Poole,
writing in 1970, argued that if the real shocks
are greater and less predictable than the
monetary shocks, the Fed should respond by
targeting the money supply-and in the reverse case, it should respond by targeting
interest rates. In recent years, real shocks
seem to have had the greater impact. Thus, in
moving explicitly to control monetary growth
via the supply side (bank reserves)rather
via the demand side (interest rates), the Fed is
now in abetter position to respond to shocks
to the economy coming from the real side.
Choke of target
Such critics thus welcomed the new control
procedures which require Fed control over
the supply of reserves. Finally, they said, the
Fed has learned to let the marketplace determine interest rates. But does this by itself
insure greater stability of the real economy?
Most economists would probably answer
yes. The real economy in recent years has
been hit by a series of unexpected shocksshocks affecting supply and demand conditions for goods and services. These shocks
included the series of oil price increases of
1 973-74 and 1979-80, as well as the sharp
reduction in consumer saving in 1978-79.
These "real shocks" are best absorbed if the
Fed concentrates its efforts on controlling the
nominal quantity of money. If it instead attempts to control interest rates,.the effect on
the economy of these outside shocks could
be amplified.
I mpact on the markets
Since the adoption of the new control ru Ie last
October, U.S. financial markets have been
rocked by unprecedented movements in interest rates. This volatility could be attributed
in part to major shifts in expectations of inflation. But it could also be attributed to the
Fed's desire to let financial markets determine
the interest rates that equate the supply and
demand for money and credit-rather than
have the Fed determine interest rates and
have the markets determine the levels of
money and bank reserves. For example, the
Fed's decision to let interest rates fall as the
economy weakened this spring-instead of
holding them up artificially-tended
to cushion the decline in real output without jeopardizing the Fed's long-run anti-inflationary
policy.
But this is not the entire story; the economy is
also subject to "monetary shocks." In late
1 974, for example, we witnessed a breakdown in the previously stable relationship
between the aggregate demand for money,
on the one hand, and income and interest
rates, on the other. This development came
about in part because of the growth of a
variety of close "money substitutes," such as
money-market mutual funds and thriftinstitution N OW accounts. But it also re-
While greater interest-rate volatility could be
expected on the basis of the change in Fed
operating procedures, no one correctly anti2
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cipated the amountof volatility involved. The
three-month Treasury-bill rate jumped from
about 1 percent in September 1979 to more
than 15 percent in March 1980, then plummeted to less than 8 percent in May, and
finally rose to 1 percent again by late August. Again, these volatile interest-rate movements reflect more than just a change in Fed
operating procedures. Nonetheless, they
lend support to the Business
Weekcontention
that "analysts can no longer be confident that
they know what the central bank is up to
simply by watching the key Federal-funds
rate."
...
restraint program this spring. Economists are
now puzzling over the effect that that program may have had on money demand and
interest rates during the March-June period.
This suggests that policy changes-which are
poorly understood by the public can create as
many problems as they are intended to solve,
and blur our understanding of how the private economy works.
°
°
On this subject, economists are in a new ball
game. At this point, we have only a vague
understanding of how economic behavior
changes in response to the way economic
policy is conducted. State-of-the-art econometric models assume that the private sector
will respond to government stimuli in the
same way it has in the past. But in a recent
paper ("After Keynesian Economics"), Professor Lucas and Minnesota University Professor Thomas Sargent have attacked this
assumption: "There is no reason, in ouropinion, to bel ieve that these (econometric) models have isolated structures which will remain
invariant across the class of interventions that
figure ·in contemporary discussions of economic policy."
There's no dou bt that the change in operati ng
procedures has created an educational problem for the Fed. It must first convince the
public why the change occurred, and explain
that interest rates no longer have the policy
significance they once did. But just as important, it must convince the public that the new
operating procedures can bring about greater
control of the monetary aggregates.
Control rule
The Fed is encouraged to "stick to its guns"
because of the growing perception that the
public's economic behavior is sensitive to the
"control rule" of the monetary authorities. In
contrast, poorly understood changes in policy threaten to add disruptive uncertainty into
the real economy. Indeed, substantial policyrule changes could reduce our understanding
of how the real economy operates, specifically through the mechanism of the econometric models which attempt to forecast and
explain the behavior of our market economy.
University of Chicago Professor Robert Lucas, Jr., has strongly criticized these econometric models, on the grounds that they fai I to
capture the basic changes induced by major
policy changes in the "structure" -the behavioral relationships-of the U.S. economy.
The Fed's policy change of last October thus
may have changed our ability to understand
how certain sectors of the economy will respond to monetary and fiscal stimuli.
The Federal Reserve policy change of last
October 6 could be interpreted as having
altered our understanding of how the private
market economy interacts. For this reason,
the Fed is under pressure to stick to its present
operati ng procedu res -targeti ng money supply rather than interest rates-so as to maximizetheir credibility with the private market.
According to this view, the need for "credibi Iity" on the part ofthe monetary authorities
is not simply rhetoric, but is a means of insuring the structural stability of the private
economy.
JosephBisignano
A more recent case in point was the introduction and subsequent removal of the credit3
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BANKING DATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Assetsand liabilities
largeCommercialBanks
Loans (gross, adjusted) and investments*
Loans (gross, adjusted) - total #
Commercial and industrial
Real estate
Loans to individuals
Securities loans
U.s. Treasury securities*
Other securities*
Demand deposits - total #
Demand deposits - adjusted
Savings deposits - total
Time deposits - total #
Individuals, part. & corp.
(Large negotiable CD's)
Weekly Averages
of Daily Figures
MemberBankReservePosition
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed ( -)
Amount
Outstanding
Change
from
8/20/80
8/13/80
138,115
116,437
33,618
47,214
23,577
888
6,290
15,388
43,587
31,537
29,401
62,589
54,400
23,369
-
Weekended
-
Change from
year ago
Dollar
Percent
7
43
101
127
27
97
48
12
246
297
121
375
361
437
-
-
-
Weekended
8/20/80
8/13/80
41
36
5
57
31
88
6,719
7,983
1,990
7,307
652
1,038
1,278
14
1,280
896
1,272
10,190
10,370
4,443
5.1
7.4
6.3
18.3
2.8
53.9
- 16.9
0.1
3.0
2.9
4.1
19.4
23.6
23.5
Comparable
year-ago period
11
230
219
* Excl\.ldes trading account securities.
# Includes items not shown separately.
Editorialcommentsmaybeaddressed
to theeditor (William Burke)or to the author.... Freecopiesof this
andother FederalReservepublicationscanbe obtainedbycallingor writing the PublicInformationSection,
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