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FRBSF
WEEKLY LETTER
March 8, 1985
Rules vs. Discretion in Controlling Money
During the last decade, and especially since
October 1979, the Federal Reserve System has
expressed its monetary pol icy objectives in terms
of the growth rates of monetary aggregates, often
with the principal emphasis on M 1 (which
consists of the public's holdings of currency and
checking accounts). Annual and quarterly targets
for these aggregates are established by the Federal Open MarketCommittee (FOMC), and the
System uses its policy instruments -principally
the buying and selling of government securities
in open market operations -to achieve these
targets. Since 1979, the major focus of monetary
policy has been to reduce monetary growth
gradually to a rate consistent with reasonable
price stability over time.
One issue that has commanded the attention of
the FOMC in this period has been whether it
should establish a quasi-fixed rule for responding
to unexpected increases or decreases in monetary growth relative to its targets, or follow a more
flexible approach of treating such divergences on
a case-by-case basis. In the course of describing
the methods of short- run monetary control used
by the Federal Reserve in recent years, this Letter
discusses some of the advantages and disadvantages of a procedure based on rules versus one
allowing greater discretion.
Since most money in the U.S. consists of checking accounts, which are the liabilities of private
depository institutions, the Federal Reserve
cannot directly control the quantity of money
outstanding. However, the central bank can
affect the money stock indirectly because depository institutions are required to hold reserves
equal to specified proportions of certain of their
deposit liabilities, and the supply of reserves is
under the Federal Reserve's control. By increasing or decreasing the supply of reserves, the
Federal Reserve can change the quantity of
deposit liabilities the private banking system is
ableto create. It thus can increase or decrease the
total stock of money in the hands of the public.
Sources of bank reserves
Bank reserves take the form of reserve accounts
held by depository institutions at Federal Reserve
Banks and of cash held in their vaults. They have
two components: nonborrowed reserves and
borrowed reserves. The supply of nonborrowed
reserves is directly influenced by the Federal
Reserve: when the Trading Desk at the New York
Federal Reserve Bank buys or sells government
securities in the open market, nonborrowed
reserves rise or fall.
Borrowed reserves, on the other hand, come into
existence when private banks and other depository institutions borrow from the Federal Reserve
Banks, or "come to the discount window" as it is
usually called. Although the Federal Reserve sets
the interest rate ("discount" rate) on this borrowing, the quantity of borrowi ng - at least in the
short run - is determined mainly by the decisions of individual banks. If, for example, market
interest rates rise and make discount window
borrowing relatively less expensive as a source of
bank funds, borrowed reserves tend to rise. A
portion of the total stock of reserves is thus
determined by the decisions of private depository
institutions rather than exclusively by the monetary authority.
In theory, it would be possible for the Trading
Desk to control the total stock of bank reserves
by using open market operations to offset all
changes in borrowed reserves with equal and
opposite changes in nonborrowed reserves. In
fact, however, the System has neverfollowed
such a total reserves control procedure, although
it frequently has been urged to do so by its critics.
Before February 1984, each bank's required
reserves in a given week depended on its deposit
Iiabilities two weeks earlier, which meant that
total required reserves were predetermined in
any particular week. Since the Federal Reserve
had no option but to supply at least that quantity
of reserves, a total reserves control procedure
was not feasible. Reserve requirements on transaction deposits are now contemporaneous, but it
is still argued thatthe banking system cannot
quickly alter its total deposits, and hence its
required reserves. In practice then, attempts to
control total reserves might cause short-term
interest rates to become unduly volatile. Partially
FRBSF
in response to this concern, such a procedure has
not been implemented even though the shift to
contemporaneous reserve requirements was
urged by many Federal Reserve critics to make a
total reserves control procedure feasible.
Instead, short-run monetary control since
October 1979 has focused on the proportion of
total reserves in borrowed versus nonborrowed
forrn.A rise in this proportion tends to reduce
money growth. Both the Federal Reserve and
individual commercial banks view access to the
discount window as a privilege. There is a general
reluctance to borrow from the Fed, but this
attitude depends on the spread between the
federal funds rate and the discount rate. The
greater the spread, the greater the wi II ingness to
borrow from the discount window. As a result, if
the Trading Desk were to reduce the supply of
nonborrowed reserves, market interest rates
would tend to rise and only then would banks
become willing to borrow more from the discount
window. Hence, such a Desk action increases
the proportion of total reserves that is borrowed,
pushes up interest rates, and causes money
growth to slow as the holding of money becomes
less attractive to the public relative to the holding
of interest-bearing assets.
The reserves control experiment
In the period between October 1979 and October
1982, the Federal Reserve followed what came to
be known as a nonborrowed reserves control
procedure. Given the desired short-run path for
money, and hence for required reserves, the Desk
(after each FOMC meeting) set a path for nonborrowed reserves. Despite the influence of uncontrollable and unpredictable factors such as
changes in Federal Reserve float and in the
Treasury balance, the Desk is able to hit such a
nonborrowed reserves objective with considerable accuracy.
If the demand for money grew more rapid Iy than
planned, the path for nonborrowed reserves was
normally not raised. This rule meant that the
resulting need for additional reserves had to be
met at the discount window. Hence, faster money
growth caused interest rates and the proportion
of borrowed reserves in total reserves to increase.
These higher rates in turn tended to curb money
growth and bring it back toward path. The main
advantage of this "rule-based" procedure therefore was that it had a built-in "automatic stabil-
izer" which tended to moderate departures of
money from the short-run path over time.
As a side-effect of the non borrowed reserves
rule, interest rates tended to become more variable than they had been prior to October 1979.
This would not have been a disadvantage if most
changes in the quantity of money demanded
reflected changes in the level of economic activity
which the Federal Reserve wished to "lean
against." However, critics ofthe procedure
argued that, to the extent that changes in money
demand represented temporary or random fluctuations that the central bank should have been
content to accommodate because they did not
significantly affectthe growth of nominal GNP,
the interest rate fluctuations unsettled the money
markets without serving any useful money control
purpose.
Since late 1982, the FOMC has come to the view
that many changes in money represent increases
or decreases in the demand for money that do not
appreciably influence real output and prices.
Hence, a control procedure that automatically
offsets all short-run money demand fluctuations
is not necessary. A more discretionary system
would enable the central bank to decide, on a
case-by-case basis, which variations in money
demand should be accommodated and which
should be offset.
The result of this re-appraisal is the present
borrowed reserves control procedure which
focuses on the level of discount window borrowing rather than on nonborrowed reserves. Under
this procedure, an initial path for nonborrowed
reserves is derived by subtracting from required
reserves (in turn derived from the short-run
money path) the objective for discount window
borrowing, and adding an assumed level of
excess reserves. The Trading Desk may alter this
initial path for nonborrowed reserves between
FOMC meetings as needed to achieve the borrowing objective. Importantly, under the current
control procedures and in contrast to the proce~
dure used before the fall of 1982, there is no fully
automatic mechanism by which the level of
borrowed reserves changes in response to deviations of observed money from its short- ru n path.
However, the FOMC's directive to the Trading
Desk usually does indicate the economic condi~
tions under which the borrowing objective would
be altered.
Although both procedures described operate by
varying the ratio of borrowed to nonborrowed
reserves, there is a considerable difference
between pre- and post-fall 1982 control procedures. Under the current procedure, as long as
the borrowing objective is unchanged, the Federal
Reserve passively supplies as many nonborrowed
reserves as the banking system demands with
little Fed-induced change in interest rates. In
. general, only when the borrowing objective is
altered are the degree of Federal Reserve pressure
on banks' reserve positions -and hence on
short-term interest rates -changed. Under the
earlier procedure, by contrast, nonborrowed
reserves were the active policy variable that
automatically transmitted short-run variations in
reserve market conditions and money demand to
changes in borrowed reserves and interest rates.
Evaluating the current procedures
The considerable reversal in M1 growth between
the first and second halves of 1984 raises the
question of whether the current control procedu res are adequate. M 1 grew at an 8-percent
annual rate in the first six months of 1984 but
only at a 4-percent rate between June and
December. Critics have argued that, although
short-term rates rose in the earlier period and
declined sharply after September, these changes
would have taken place sooner under a nonborrowed reserves procedure and that, as a result,
monetary growth wou Id have been smoother
over the year as a whole.
This criticism of the current procedure is the
latest example of a more general and longstanding criticism that the central bank attempts to
smooth market interest rates and so causes monetary growth to be determined by demand. The
Federal Reserve often is charged by its critics
with inadvertently accommodating the public's
demand for money rather than independently
controlling its supply, and thus with producing
pro"cyclical rather than contra-cyclical money
growth. To avoid this tendency, critics argue that
control procedures should incorporate some
automaticity in the response of borrowed reserves, and hence interest rates, to deviations of
money from target. The nonborrowed reserves
control procedure incorporated such an automatic
response since money deviations necessitated
changes in the level of discount window borrowing.
The important pol icy debate is over the extent to
which interest rates should move automatically
in response to deviations of M1 from some
pre-determined target. The choice is between
greater short-term discretion over interest rates
and possibly tighter short-run control over money
growth. As already mentioned, the principal
feature of the nonborrowed reserves approach;
which distinguished it from both earlier and later
control procedures, is that interest rates tended to
respond somewhat automatically to deviations of
money from its target path.
All monetary control procedures operate ultimately by causing variations in interest rates that
affect the public's willingness to hold and depository institutions' incentives to supply money. On
a theoretical level, a strong argument may be
made on monetary control grounds for a nonborrowed reserves regime because under such a
procedure, interest rates respond quickly to deviations of money from path since no explicit
policy decision is required. In 1984, however, the
FOMC was willing to permit the wide swings in
interest rates required to hold M1 within its
long-run target range, so the argument for a
rule-based procedure may be less applicable in
that recent experience. Nonetheless, the debate
over short-run monetary control always will
involve the extent to which interest rates should
be permitted to move in order to reduce deviations of money from target, and the issue of "rules
versus discretion" will remain a hot one.
Brian Motley and Joseph Bisignano
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 of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .•.. Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments l 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities2
Other Secu rities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( - )
Amount
Outstanding
02/13/85
188,177
170,084
52,449
62,211
32,542
5,269
11,010
7,083
194,596
45,998
28,226
12,923
135,675
Change
from
02/06/85
636
744
384
48
48
21
- 106
2
1,727
1,764
-2,019
46
84
43,714
38,966
19,955
Period ended
02/11/85
31
21
10
Change from
02/22/84
Dollar
Percent 7
7.3
12,697
14,815
9.5
5,961
12.8
2,622
4.4
5,637
20.9
5.3
266
- 10.2
1,245
- 10.9
868
10,575
5.7
3,582
8.4
733
2.6
992
8.3
6,005
4.6
86
-
3,436
92
416
-
783
1,038
Period ended
01/28/85
123
57
66
Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes u.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
s Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
1
2
8.5
-
2.0
4.9
4)Joesf>H
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