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APPENDIX
Notes For FOMC Meeting
August 20, 1991
Sam Y. Cross
Today the dollar is trading near its levels at your last
meeting--today it is about 1-2 percent lower than at that time--but
there have been four significant moves in the meantime.
First, in
early July, the dollar rose to over DM 1.84 on optimism about
prospects for the economy and pessimism about the German investment
outlook.
Second, on July 12 the Bundesbank engineered a convincing
round of intervention to support the mark which brought the dollar
back below DM 1.80.
Third, the dollar then softened for a few weeks
to DM 1.70 in response to a string of worse-than-expected reports on
the U.S. economy and in anticipation of a tightening of German
monetary policy.
And fourth, at the end of the period, the dollar
strengthened on a smaller-than-expected tightening of monetary policy
by the Bundesbank, and more importantly, in response to the coup in
the Soviet Union.
Let me comment briefly on each of these four moves.
First, on the dollar's strength against the mark at the
outset of the period, the optimism about the U.S. recovery was based
on a number of reports released in June and through mid-July--notably
increases in the Purchasing Managers index, higher factory orders and
lower jobless claims--which encouraged market participants to forecast
a fairly robust recovery and to think that no further monetary policy
easing would be needed.
But there were also developments in Germany
and eastern Europe which were viewed as negative for the mark:
specifically, the fears in German capital markets about the possible
reimposition of a withholding tax on interest income, unrest in
Yugoslavia, and finally concerns about rising inflation and the
failure of the Bundesbank to raise official rates before its summer
recess.
In that environment, the dollar rose close to its highs for
the period on July 11 after the Bundesbank left interest rates
unchanged at its council meeting that day.
In response, on July 12
the Bundesbank initiated several rounds of intervention, starting
early in the morning.
They were joined by a large number of other
European central banks.
After the New York market had opened, the
U.S. monetary authorities also came in, selling $100 million against
marks, in a demonstration of cooperation.
In response to the official
operations, the dollar fell back over three pfennings to below DM
1.79.
The effectiveness of the July 12 intervention was attributed
to several factors.
by 18 central banks.
First, the operation was broad based, undertaken
In particular, the participation of the U.S.
monetary authorities distinguished this from some previous Bundesbankled interventions which had failed to materially affect the exchange
rate.
Market participants had tended to view the United States as
reluctant to join in efforts to slow the dollar's rise and believed
that the U.S. authorities were not particularly worried about the
dollar being too strong.
clear that the U.S.
Nevertheless, in this instance, it became
authorities thought it appropriate and reasonable
to join the German-led intervention.
Treasury commented publicly that
there was not a problem with the general level of the dollar but with
the speed of the dollar rise.
The second factor important to the success of the operations
was that the total intervention was sizable, reaching almost $1
billion, mostly against German marks.
Third, market participants were
impressed that the Bundesbank maintained a continuing presence in the
market on July 12,
operating several times during the European day and
The market also observed that
selling a total of almost
the United States had come in more than once, including after Europe
had closed.
of the move.
Lastly, market participants were surprised by the timing
Coming just days before the London G.7 summit, it
suggested a high level of cooperation and the possibility of further
coordinated action.
Accordingly, in the days that followed, the dollar remained
below the DM 1.80 level.
In the ensuing weeks, the dollar softened
further, with the perception that the next U.S. and German monetary
policy moves would be in opposite directions.
Market expectations
about the U.S. economy changed with sluggish growth in the U.S. money
supply, lower-than-expected growth in second-quarter GNP, worse-thanexpected employment reports, and the mixed assessment given in the
Federal Reserve's Beige Book.
On the German side, a surprising rise
in inflation in July to 4.4 percent year-over-year fostered
expectations of a tightening of monetary policy at the Bundesbank
council meeting on August 15, and comments about Germany's increasing
price pressures by incoming Bundesbank President Schlesinger served to
heighten these expectations.
In the event, on August 15, the German
authorities raised the Lombard rate 25 basis points, which was less
than expected, and the discount rate 100 basis points.
The fourth and final move of the period occurred after the
change in official rates by the Bundesbank.
The German move was
smaller than expected, and when combined with some favorable signs
about the U.S. economy, lent support to the dollar.
The dollar then
surged well above DM 1.80 following news of the coup in the Soviet
Union.
The dollar's moves against the mark were much more pronounced
than against the yen.
Revelations about Japan's various financial
scandals raised questions about the outlook for Japan's monetary
policy and the yen.
Even so, the yen did not fall precipitously as
market participants concluded that Japanese financial institutions
would repatriate capital invested abroad to shore up capital positions
at home.
In other than our intervention operations during the period,
the U.S. monetary authorities continued to adjust their foreign
currency balances, through off-market sales of foreign currencies and
net sales of SDRs for dollars.
On July 16, the Federal Reserve and
the ESF shared equally selling $3.0 billion worth of yen to the
Japanese Ministry of Finance in spot,
1-month and 2-month forward
transactions, reducing the Federal Reserve's yen balances by $1.5
billion.
The exchange produces for the Federal Reserve realized
profits of $56 million.
Beginning in July, the Treasury also converted some of its
mark balances into dollars, through purchases of SDRs against marks
and sales of SDRs for dollars, producing a net acquisition of $69.9
million for the ESF.
Utilizing a portion of the dollars it acquired through these
various operations, the ESF unwound a $1,000 million warehousing
arrangement on August 8.
on August 22.
Another $1,500 million unwinding will occur
The amount of foreign currencies warehoused by the
Federal Reserve will stand at $2,000 million equivalent.
I should also report that the Treasury and the Netherlands
agreed not to renew the $500 million currency arrangement which
expired on August 17,
1991.
The ten-year old arrangement, set up at
the time of the Iranian crisis, had never been utilized.
-5-
Mr. Chairman, I would like to request the Committee's
approval of the Federal Reserve operations of the period, representing
$50 million against marks, and off-market sales of $1.5
equivalent of yen to the Japanese Ministry of Finance.
billion
Notes for FOMC Meeting
Peter D. Sternlight
August 20, 1991
For several weeks following the Committee's early July
meeting, the Domestic Trading Desk sought to hold reserve
conditions unchanged, consistent with an expected Federal funds
rate around 5 3/4 percent.
On August 6, reserve pressures were
eased modestly against a background of persistent weakness in
money growth, evidence of sluggish recovery and some indications
of abating inflationary pressures.
Consistent with a $25 million
reduction in the allowance for seasonal and adjustment borrowing,
Fed funds were then expected to trade in the area of
5 1/2 percent, equal to the discount rate.
Earlier in the
period, the borrowing allowance had been boosted in two steps by
a total of $75 million in technical moves to keep pace with
ongoing increases in seasonal borrowing.
Thus the net change in
the borrowing allowance was an increase of $50 million to
$375 million.
Actual funds rates have held fairly close to desired
levels, averaging a shade higher much of the time, as might be
expected in a period marked by appreciable needs for reserve
additions.
There was a sharp rise in the funds rate at the end
of the August 7 maintenance period as the large scale of reserve
needs did not become evident until late in the day and the Desk
could provide only a fraction of the needs projected that morning
as dealer propositions were insufficient.
Similarly, borrowing
was fairly close to path levels over the intermeeting period,
excluding some special situation borrowing and apart from a big
bulge on August 7 when unsatisfied reserve needs had to be met at
the window.
That day's borrowing of nearly $5 billion lifted the
two week average to about $700 million.
Large reserve needs over the period reflected typical
seasonal
flows, some fairly frequent overshoots in Treasury
balances at the Fed, and the impact of some off-market foreign
exchange operations.
The latter included both some reductions in
the System's own holdings of foreign currencies and reductions in
the amounts
final
for the Treasury.
"warehoused"
of the interval,
thirds
account sell
In both the first and
the Desk took advantage
of foreign
orders to buy bills and notes outright from foreign
accounts--a total of some $3 1/2 billion all told.
In addition,
the Desk arranged either System or customer repos on most days.
Overnight System repos were employed on August 6 to signal the
System's slightly easier policy stance--a message that the
markets appreciated quickly as Fed funds were then trading at
5 3/4 percent.
As it happened, there was a sizable reserve need
at the time, but the Desk's choice of an overnight rather than
multi-day injection left little room for any interpretation other
than that a policy move was intended.
Market interest rates fell across a broad front during
the intermeeting period, propelled by a combination of concerns
about the strength of the economy's upturn and weakness in broad
money growth measures.
Yesterday morning there were sharp
further rate declines in the wake of developments in the Soviet
Union, but these moves were partially or fully reversed by day's
end.
The System's easing step on August 6 added a bit of impetus
to the downward rate move as it was only partially folded into
expectations at the time.
Information on various inflation
measures was considered mixed over the period--favorable enough
to permit a small step but still providing some caution signals
as well.
Views are also mixed on the likelihood of further
policy steps at this point.
Many see a further easing as
possible, and perhaps likely, in coming weeks if the economy's
rebound continues to look modest and money growth weak, but there
seems to be no overwhelming anticipation of another early easing
step.
At the same time, some market participants who had
anticipated a month or two ago that the next move could just as
likely be to the firming as to the easing side have returned to a
more asymmetric outlook, leaning to the easier side.
Yesterday
in the first flush of reaction to the Soviet news, there seemed
to be, temporarily, a more imminent expectation of another easing
move.
For Treasury issues, the yield declines over the period
ranged from about 35-95 basis points, with the larger declines in
the short-term area--out to about five years.
The rate declines
were mainly in the latter half of the period.
In the first half,
the economic data were mixed, but strong enough to confirm
impressions that the economy had begun to turn upward, while
looming new supplies of Treasury paper kept a damper on
enthusiasm.
Later, some key data were regarded as placing more
doubt on the likely strength of recovery, while broad money
growth looked even more feeble, and against this background the
huge outpouring of new Treasury debt seemed less formidable when
it arrived.
Treasury bill rates fell about 45-80 basis points
over the interval while the Treasury raised about $20 billion
additional funds in the bill market.
The 3- and 6-month issues
auctioned yesterday at average rates of 5.17 and 5.23 percent,
respectively, compared with 5.59 and 5.71 percent shortly before
the last meeting.
In the Treasury coupon sector, yields were down by as
much as 85-95 basis points for 1 to 3 year issues as investors
seem to reach out for yield along the curve when money market
yields declined to less attractive levels.
At the long end,
yields were down a more moderate 35-40 basis points.
The yield
declines were impressive considering that the Treasury raised
some $35 billion in coupon issues, about half of it in the record
$38 billion mid-August financing.
Bidding was robust for the 3-
and 10-year offerings, bolstered in part by the rally that
followed the System's policy-easing move the morning of the
3-year auction.
Possibly reflecting a view that the rally was
carrying yields too far down for the moment, interest was much
more subdued in the 30-year bond, although the cover was a little
better than in the weak 30-year auction three months earlier.
After a bit of a hiccup following the auction, which produced an
8.17 percent average and tailed to 8.19 percent, long yields
declined again, briefly dipping under 8 percent yesterday morning
and closing yesterday at 8.10 percent.
Late in the period, attention in the government
securities market was riveted on a series of announcements by
Salomon Brothers, a primary dealer of long standing and a major
market participant.
The first two acknowledged that the firm had
submitted unauthorized customer bids, or committed other
irregularities, in several recent Treasury auctions which had the
effect of circumventing Treasury limitations on the amount of an
issue that could be awarded to any single entity, while the
third, last Friday, noted that because of these irregularities
and lapses of proper management controls, top management of the
firm was planning to resign.
The New York Fed stated publicly
that it was closely reviewing developments at the firm, and was
seeking explanations of the irregularities and oversights
committed by the firm, along with a description of remedial steps
to prevent a recurrence.
It added that an evaluation of the
firm's steps to address management control failures would be
important in the Fed's review of its relationship with the firm.
Further developments followed this past Sunday, with the Treasury
first announcing that Salomon's ability to participate in
Treasury auctions was being suspended pending review of its steps
to establish proper management controls, and then following the
firm's changes in top management and reassurances from the new
chairman, the Treasury modified its restriction to apply just to
customer bids through Salomon and not to bids for its own
account.
The financial markets had other news to contend with as
well.
Early in the intermeeting period bank holding company
paper came under some renewed pressure as concerns mounted about
poor second-quarter bank earnings due to additional provisions
for loan losses.
The pressures were contained, though, and
subsequently bank paper came into considerably greater favor with
the announcement of several mega-mergers among banks, notably
including Chemical-Manny, then NCNB with C&S Sovran and more
recently BofA with SecPac.
These prospective mergers, and
anticipations of others to come, were seen as likely to improve
the long-run outlook for bank profitability so that on balance
over the period there was an appreciable decline in yield spreads
on bank holding company debt over Treasury yields.
At the short
end, the TED spread comparing bank Eurodollar costs and Treasury
bills also declined.
Yield spreads narrowed even for Citicorp
which went through a special flurry of concern, and some deposit
runs overseas, following Congressman Dingell's remark that that
institution was "technically insolvent"--a comment immediately
denied by Citicorp.
Concern over financial fragility also spread more
noticeably into the insurance industry in the recent period,
following the seizure of Mutual Benefit Life by the State of New
Jersey.
Credit ratings of a number of insurance companies were
downgraded a notch or two and yield spreads on their debt
compared with Treasury issues widened somewhat.
The moves were
modest, however, compared with the widening of bank holding
company spreads some months earlier.
Still, a background of
edginess persists in the financial markets generally, and events
like the revelations at Salomon Brothers do not help.
Michael J. Prell
August 20, 1991
FOMC BRIEFING -- DOMESTIC ECONOMIC OUTLOOK
I had intended to keep my remarks relatively brief this
morning, in light of the extra items on the agenda.
Despite the
Soviet surprise, I'm going to try to stay with that plan.
I want to focus initially--and primarily--on how we saw
things at the end of last week.
As the Greenbook indicated, the
recent news on the economy has been mixed.
Attempting to balance it
all out, we maintained our forecast of a moderate expansion of
economic activity through 1992, but we trimmed the projected growth
for the second half of this year.
I wish I could claim that, with
this adjustment, we now have the outlook nailed down, but my sense is
that the probability distribution of possible outcomes really hasn't
tightened much, if at all, in the past seven weeks--even apart from
the Soviet shock.
Let me just quickly review the good news and bad news of the
intermeeting period.
On the plus side, one would have to point to
evidence of a sustained willingness of consumers to spend and to a
continuing uptrend in housing starts.
Indeed, based on the retail
sales data now in hand, our third-quarter forecast for consumption
might be viewed as conservative.
As for housing, the July starts
figures arrived after we completed our forecast, and they were a bit
above the level we wrote down for the current quarter.
Another bit of good news is to be found in Friday's report on
merchandise trade through June.
For one thing, the numbers were
consistent with our belief that the Commerce Department had built an
unduly pessimistic assumption into its advance estimate of secondquarter net exports.
More important, the report indicated that the
uptrend in our exports of manufactured goods remained very much intact
at midyear; as you know, we have projected that sustained growth of
exports of goods and services will largely offset the effects of the
increase in imports that is likely to accompany the recovery in
domestic activity.
That trade outlook is, of course, a matter of some importance
to the industrial sector, where recent data also have been favorable.
Manufacturing output is estimated to have risen another six-tenths of
a percent last month, putting it at a somewhat higher level than we
had anticipated in the June Greenbook.
So where is the bad news that led us to lower our near-term
forecast for GNP?
In a nutshell, I think two nonfinncial items were
especially influential.
First, there were the labor market data--most
notably, the contraction in production-worker hours last month.
The
July drop in hours in the service-producing sector seems implausibly
large, but we didn't feel we should discount it entirely, especially
given all of the stories of employment cutbacks coming from a variety
of industries.
This brings me to the second major item on my bad-news
list, which is the predominantly negative tone of the recent anecdotal
evidence on the economy.
Comments from the business community, such
as those you conveyed in the conference call a couple of weeks ago,
scarcely have pointed to a real take-off in the economy.
They
suggested that we should anticipate an even more cautious approach to
hiring and investment than we had built into our prior forecast.
On the negative side, too, were several pieces of financial
news.
First, there is the weakness of M2 and M3.
I remain skeptical
about the utility of the aggregates as indicators of short-run
economic performance, but, that said, it is hard to ignore the kind of
softness we've been seeing of late.
And beyond the aggregates, there
are other worrisome developments in the financial sector.
Just when
merger activity evidently has caused the capital markets to look upon
banking firms with greater favor, life insurance companies have come
under greater pressure.
Fears of runs have caused insurers to alter
their lending practices, with negative implications for the
availability of credit to sectors already hit by the bank credit
crunch.
Moreover, it is conceivable that concerns about the security
of insurance policies and retirement savings could have negative
effects on consumer sentiment and spending behavior.
In my view,
these financial imponderables not only widen the distribution of
possible economic outcomes but they also skew it toward the downside.
It is with some difficulty that one translates these rather
murky bits and pieces into a numerical forecast.
Doing our best, we
arrived at a 3-1/4 percent GNP growth rate for the second half of this
year, about 1-1/2 points less than we indicated at last month's
meeting.
We have predicted that part of this shortfall will be made
up during 1992, but the gap between actual and potential output
remains wider throughout the projection.
This expected greater slack in the economy has led us to
stick with our prior forecast of price inflation in the face of some
disappointing figures on labor costs in the second quarter.
It
appears that employers have been making slower progress than we had
thought in reining in compensation increases.
It may be that the
bigger year-on-year increases in consumer prices that we were looking
at until recently have been a more influential benchmark for pay
decisions than we allowed for; if this is the key, the recent better
price numbers and the evident decline in inflation expectations should
help to damp compensation increases in coming quarters.
Also
important, however, is whether businesses can do better in curtailing,
or offsetting in wages, the soaring costs of medical insurance and the
substantial increases in expenses for unemployment insurance and
workers' compensation programs.
The record to date is less than
encouraging.
In light of these considerations, we've raised the rate of
compensation increase in our forecast, but, given the expected
economic environment, we haven't let these higher costs show through
in prices.
This might suggest some upside risk in our inflation
forecast, but we feel reasonably confident that the underlying trend
of price increases is tilted downward at this point and will remain so
unless the economy proves appreciably stronger than we've projected.
I'd like now to conclude with some stunning insights into the
likely economic consequences of the Soviet coup.
don't have any.
Unfortunately, I
Much attention has focused on the possible
implications for oil supplies, demands for grains, and defense
spending.
While this all makes some sense, it seems to me that, until
we have a better fix on the situation within the USSR, any assessments
of these effects are highly conjectural.
At this point, the only
thing I feel fairly comfortable saying is that the Soviet upheaval has
engendered additional uncertainty, and this can hardly be a good thing
for our still unsteady economic recovery.
August, 20,
1991
FOMC Briefing
Donald L. Kohn
The focus of my briefing this morning will be the weakness in
the aggregates, especially M2,
and its possible implications.
The recent behavior of M2 has been extraordinary.
Sluggish
growth in June, declines in July and a flat August are occurring in
the context of substantial previous
a modest expansion of nominal income and spending.
rates and at least
To be sure,
declines in short-term interest
some of the weakness relative to expectations at the last
FOMC meeting reflects an apparent
shortfall in income relative to
expectations, and we can not rule
out the possibility that M2 is in
part telling us that the current level of economic activity is less
than now forecast.
The weakness in M2,
though, seems to be considerably greater
than can be explained by any reasonable estimate of contemporaneous
income, however pessimistic.
shift, broadly defined.
about a year, but
Thus it
implies some sort
of portfolio
Some such shifting has been underway
it seems
for
to have intensified in recent months, as
witnessed by the 5 percent increase in
velocity now estimated for
the third quarter at a time when flat or even declining velocity might
have been expected.
financial assets,
This
shift may involve a reallocation of
a rebalancing of assets and liabilities, or a shift
out of financial assets into
real assets--that is,
greater spending
out of income.
It seems likely that all of these have been occurring, though
the evidence on some is mixed, and we can't identify a considerable
portion of the shifting that has occurred.
folios,
data and anecdotal evidence
In terms of asset
port-
suggest a shift from M2 assets
into market securities, held directly or indirectly by households,
involving importantly a movement out the yield curve in order to preserve nominal returns for a time.
Not only the slope of the market
yield curve, but also the unwillingness of banks and thrifts to compete for intermediate-term deposits and the cutback in deposits sold
through brokers likely have contributed to this shift.
And it prob-
ably has been facilitated by a reduction in costs for such transactions, as more households find themselves with investments in families
of mutual funds and as more banks make available brokerage and mutual
fund services in their lobbies.
The information on rebalancing of assets and liabilities is
more ephemeral.
Logically, the persistence of high interest rates on
consumer and mortgage debt in the face of dropping returns on M2 assets ought to prompt a repayment of such debt out of M2, or at least
a downshift in the past propensity to finance spending by borrowing
while continuing to accumulate M2.
Consumer credit has been quite
weak in recent months, despite the strengthening of spending.
How-
ever, available models, taking account not only of spending but of the
normal amortization of debt previously incurred, indicate that the
recent expansion of consumer credit has not been unusually weak.
With regard to the choice between real and financial assets,
weak M2 could be an aspect of the unusually low measured saving rate
of recent quarters as households attempted to maintain spending in the
face of temporarily depressed income.
Arithmetically, with households
saving less out of income, either their borrowing must rise relative
to income or their acquisition of financial assets must decline:
apparently the latter course was chosen, perhaps reflecting the relative incentives discussed above.
Labelling the weakness in M2 a "portfolio shift" does not by
itself indicate whether the behavior of M2 has implications for spending in the future.
The question is whether the factors causing the
shift may also be affecting spending in ways that have not been
anticipated.
It would be entirely appropriate to live with or accommodate
lower M2 growth arising from such things as lower transactions costs
of rebalancing portfolios, or temporary changes in appetites for M2
assets, or responses to rate relationships that have already been
fully taken into account in assessing the outlook for the economy.
For example, weak M2 owing to people reaching for yield would not be a
cause for concern if high long-term rates were a product of anticipated strength in spending, and if low CD rates or relatively high
borrowing costs to consumers reflected credit restraint at depositories that had already been factored into policy decisions.
But if
long-term rates are high in part because corporations worried about
future access to credit are floating huge volumes of bonds, and low
intermediate-term CD rates mean that banks don't anticipate loosening
credit terms and making loans for some time, weak M2 may be signalling
underlying tightness in financial conditions.
In this regard, some examination of corollary indicators of
financial conditions might be useful in assessing the signals from M2.
The first five charts in your financial indicators package show a few
of the usual set of financial indicators formatted to compare their
behavior in recent months with the usual pattern around business cycle
troughs.
Two caveats in viewing these charts:
first, they have been
indexed to the trough month, which abstracts from the absolute level
of the indicator relative to past cycles;
second, one should not
expect to see a "typical" recovery pattern, since the FOMC itself has
not anticipated a "typical" recovery, given the relatively shallow
recession and the Committee's desires to make progress toward price
stability.
The first chart shows M2.
The unusual nature of recent
developments can be seen in the unprecedented weak level of M2 growth
in the upper panel, as well as the stark differences of the current
cycle with historical patterns seen in the lower panel.
The behavior of M1, shown in the next chart, by contrast
looks quite typical.
It has increased at a 6-1/2 percent rate so far
this year, and model results suggest a substantially smaller shortfall
from expectations than for M2.
While the pattern of Ml growth may
provide some comfort about the stance of monetary policy, the reliability of this aggregate is open to question.
The velocity of Ml has
become highly interest sensitive in the 1980s--so much so that the
FOMC was unable to continue to use it as a target variable.
Perhaps
reflecting the behavior of its velocity, movements in this aggregate
generally do not demonstrate a reliable lead over movements in income.
The third chart shows one measure of the real rates that have
accompanied this monetary growth.
The Michigan survey does suggest a
notching down of inflation expectations and this is reflected in the
small rise in real rates earlier this summer.
Much of this rise was
reversed in the first half of August, and these rates are at the lower
end of the range prevailing in the 1980s.
Even so, some other indicators that may be heavily influenced
by real rates have been unusually soft in recent months.
One is com-
modity prices, shown in the next chart, which plots the experimental
index without food and energy.
These prices might also be showing the
effects of a fairly strong dollar, itself perhaps related to real
interest rates.
Another such indicator is stock prices, the next chart.
Before April, stock prices had followed a classic pre-trough pattern,
but since then have traded in a relatively narrow range, in contrast
to the continued gains found in many previous recoveries.
Taken together, these corollary indicators present something
of a mixed picture, but do tend to suggest at least some restraint
relative to the early stages of past cycles, though not the severe
restraint indicated by M2.
As noted above, a less accommodative
policy than is typical might be appropriate, given the nature of the
recession and the Committee's objectives, though the effects of a more
restrictive fiscal policy and credit supply conditions also need to be
taken into account.
Parsing the shortfall in M2 growth into how many
percentage points can be ignored versus how many the Committee would
need to react to does not appear possible with any confidence.
And
policy has recently eased a notch in part responding to money growth.
But the extent of the weakness in money relative to expectations,
along with the various statistical tests that continue to show some
leading indicator properties for M2, suggest that at least a continuation of the recent path of M2, especially in the context of persisting
concerns about credit supply conditions, would be a signal which the
Committee should continue to take into account in its policy
decisions.
The staff forecast for M2 in the bluebook does have a pickup
in M2 over the balance of the quarter.
This is something of an act of
faith, since conventional relationships seem to be failing us.
We are
predicting a return toward, but not all the way to, normal relationships of growth in M2 to growth in income and changes in interest
rates; M2 neither bounces back to recoup some of its recent level
shortfall nor does the extraordinary weakness continue.
Both the
forecasted strengthening of income and the recent policy easing contribute to the pickup in M2.
The events of the last few days might be expected to bolster
M2 growth, beyond that forecast in the Bluebook.
The behavior of
interest rates and stock prices indicate that heightened uncertainty
is causing a shift toward safety and liquidity.
demands for M2 temporarily,
summer.
This might boost
just as it did after the invasion last
But an increase in M2 for this reason would not indicate a
more accommodative monetary policy, since these same forces, and
others associated with turmoil in the Soviet Union, also would be
tending to damp spending.
With regard to the various alternatives, alternative C was
omitted on the grounds that a tightening with money growth at the
lower end of the range and immediately following an easing was an
unlikely choice.
In constructing the alternative A money paths, the
staff allowed for a fairly normal response of money to lower interest
rates.
While such a response seemed to be forthcoming earlier this
year, the recent behavior of M2 may raise questions about what it
would take to boost monetary growth.
In that regard, the staff took
some comfort from the declines in long-and especially intermediateterm market interest rates through last week.
If the yield curve has
been a factor in damping the monetary response to lower short-term
interest rates,
one of the causative factors was the failure of long-
term rates to drop along with short-term rates.
In constructing al-
ternative A the staff was assuming that a System easing would produce
at least some decline in long-term rates, especially if such an easing, like the action earlier this month, were undertaken in the context of softer economic data and a muted outlook for inflation.
For the coming intermeeting period, what the staff projects
may be not particularly important relative to what the Committee
wants.
With M2 and M3 at the lower bounds of their ranges, the Com-
mittee may wish to stress developments in the aggregates over the
short run, especially in keying any downward adjustments to reserve
pressures over the weeks ahead.
In the draft directives on pages 14
and 15 of the Bluebook, the staff suggested a change in the last sentence of the typical directive to deal with the unusual behavior of
the aggregates.
The suggested sentence makes explicit the Committee's
expectation of a pickup in money growth over coming weeks, and ties
that back into the unusually low three-month growth rates that would
ordinarily be written down.
An alternative version of the directive
language also was given should the Committee wish to make any additional stress on the aggregates quite explicit under the current circumstances.
The alternative version moves up the sentence on expected
money growth and elevates deviations from those expectations in keying
intermeeting changes in reserve conditions.
STRICTLY CONFIDENTIAL (FR) CLASS II-FOMC
FinancialIndicators
August 20, 1991
Chart 1
The Yield Curve
Quarterly Data
Spread Between 30-year T-Bond Yield and Federal Funds Rate*
P
1957
1961
1965
1969
1973
Percentage Points
T
1977
1985
1989
* Prior to 1977:Q2, the 20-year constant maturity rate is used.
+ Denotes most recent weekly value.
Selected Treasury Yield Curves
Percent
3-month
30-year
10-year
Chart 2
The Exchange Value of the Dollar
(Monthly G-10 Index)
Nominal
Index Level, March 1973=100
PT
P
P
80
Real
Index Level (Deflated)
P
1968
1970
1972
1974
+ Denotes most recent weekly value.
1976
1978
1980
1982
1984
1986
1988
1990
Chart 3
Stock Indices
(Monthly)
Nominal
Index Level, 1941-43=10
490
25
Standard and Poor's
500 Stock Index
-
420
350
20
280
140
10
70
P/E Ratio
Real
Index Level (Deflated)
400
P
T
P
T
PT
P
T
PT
Standard & Poor's
500 Stock Index
350
250
200
150
100
1968
1970
1972
1974
+ Denotes most recent weekly value.
1976
1978
1980
1982
1984
1986
1988
1990
Chart 4
One-Year Real Interest Rates
Percent
One-Year T-Bill Minus One-Year Inflation Expectations (Michigan)
10
Monthly
+
10
Percent
One-Year T-Bill Minus Change in the CPI from Three Months Prior
24
Monthly
16
8
+
0
1977
1979
1981
1983
1985
Note: T-blll's on a coupon equivalent basis.
less most recent Inflation expectation.
+ Denotes most recent weekly T-bill
1. Projection period plotted quarterly.
1987
1989
1991
Chart 5
Long-Term Real Interest Rates*
10-Year Treasury bond yield less 10-year inflation expectation
Percent
6
5
I
I
I
1980
I
I
I
1982
I
1984
I
I
1986
I
I
1988
1990
Nominal and Real Corporate Bond Rates
Percent
Nominal Rate on Moody's A-rate corporate bonds
I
Real Rate
1978
1980
1982
1984
1986
1988
1990
1. For upper line, inflation expectations measured by Hoey 10-year Inflation expectation until April, 1991. X denotesLivingston survey.
Lower line uses Michigan 5 to 10 year Inflation expectations.
+ Denotes most recent weekly value.
Chart 6
Experimental Price Index for 21 Commodities (Weekly)
ALL COMMODITIES
Index, 1986 01= 100
ALL COMMODITIES EX. CRUDE OIL
Index, 1986
ALL COMMODITIES EX. FOOD AND CRUDE OIL
1982
1983
1984
1985
1986
Q1=100
Index, 1986 01=100
1987
1988
1989
1990
1991
Chart 7
Growth of Real M2 and M3
M2
Percent
Percent
Percent
PT
1962
1967
Note: Four-quarter moving average deflated by
PT
1972
the CPI.
PT P
1977
T
1982
1987
1992
Chart 8
Inflation Indicator Based on M2
Ratio scale
150
Current price level (P)
Long-run equilibrium price level
given current M2 (P*)
11111
100
50
Projected
Percent
12
1956
1962
1968
1974
1980
1986
1. Change in GNP implicit deflator over the previous four quarters.
Note: Vertical lines mark crossing of P and P*.
For 1990:Q4 to 1992:Q4 P* is based on the staff M2 forecast and P is
simulated using the price gap model developed by Hallman, Porter and Small.
BOARD OFGOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
To
Federal Open Market Committee
Date August 14,1991
Subject: Alternative Operating Procedures
From Donald Kohn
In response to the Committee's request at its last meeting, the
attached memo reviews possible alternatives to the current operating
procedure, which concentrates on the level of the federal funds rate,
adjusts the expected level of the rate in discrete steps based on the
Committee's judgment using a number of economic and financial
indicators, and transmits those adjustments in an obvious way to the
financial markets.
In their discussion, Committee members seemed to
have been motivated by two related objectives.
"announcement effect" of each change in policy.
One was to reduce the
The other was to
remove at least some of the discretionary element of changes in the
federal funds rate, allowing reserve conditions to vary automatically
with changes in other variables, such as the demand for reserves or
money.
In his memo, Mr. Lindsey discusses two types of possible
alterations in operating procedures.
One would involve somewhat looser
targeting of the federal funds rate than the narrow area around a
single level that has become the practice in recent years, without any
necessary implications for how the target is arrived at.
Included in
this category are greater toleration of short-run deviations from the
expected level of the funds rate, a range for the expected level, and a
return to borrowed reserve targeting.
The other type of change is to
establish a formal link between reserve conditions or the federal funds
rate and movements in money or reserves.
Allowing some ambiguity with respect to System intentions would
tend to diffuse reactions to any change in policy, because it could
take some time for such a change to be recognized by the market.
It
would allow underlying demands for reserves, including those resulting
from shifting expectations for monetary policy, to show through a
little more into short-term rates, and might enable the desk to "test
the waters" with respect to a possible shift in policy without
committing irretrievably to such a shift.
On the other hand, ambiguity
about Federal Reserve intentions risks misperceptions and associated
interest rate volatility and delays in getting desired changes in
interest rates into the market.
A shift toward ambiguity might be
difficult to explain to the public, and could result in heightened
demands for explicit announcements of Fed targets, unless it were also
accompanied by a shift toward operating procedures that placed a
greater reliance on reserve or money quantities to guide open market
operations.
Such a reliance would introduce a greater element of
automaticity into changes in the federal funds rate, which could then
be seen as falling out of a process of equilibrating shifting demands
for money or reserves to a predetermined supply.
The difficulty is to
identify a measure of money or reserves--or another policy indicator-that has a sufficiently tight relationship to the ultimate objectives
of policy to justify allowing short-term interest rates to change
primarily in response to deviations of the indicator from a preset
path.
In the early 1980s, the Committee moved away from use of Ml (and
by implication total or nonborrowed reserves) as such an indicator, and
considerable doubts have been expressed about the short-run relation of
M2 to the economy or prices.
However, these conclusions could be re-
examined in light of more recent experience.
There are a number of possible operating procedures that are
not treated in the accompanying memo.
Among these are tying movements
in the funds rate formally to incoming information on real variables.
such as employment or GNP. or on nominal variables such as nominal GNP
or prices.
Variables in the first group cannot be controlled over time
by the central bank, and a focus on them alone could endanger the
Committee's price stability objective.
The latter group may engender
difficulties with lags in the effect of policy; however, combinations
of these variables could be explored to key automaticity in federal
funds rate responses.
Another class of procedures not addressed in the
memo are those that would combine discretionary changes in federal
funds rates under most conditions with greater automaticity when
movements in money or reserves approach the outer limits of ranges
established by the Committee.
Such limits could be defined by the
annual ranges or they could be keyed to even longer-term trends in
money or in money-based measures such as P*.
4
A letter from Al Broaddus at the Federal Reserve Bank of
Richmond advocating additional research into reserve-based operating
procedures also is attached as background for Committee discussion.
BOARD OF GOVERNORS
OF
THE
FEDERAL RESERVE SYSTEM
Office Correspondence
To
Date
Mr. Donald L. Kohn
Subject:
August 14, 1991
Alternative Operating Procedures
From David E. Lindsey
Introduction
At the last Committee meeting, the staff was asked to prepare
an overview of alternative operating procedures that would move away
from the practice of recent years in which adjustments to the intended
federal funds rate have been entirely discretionary,
have been quickly
recognized by market participants as discrete changes in the stance of
monetary policy,
and therefore have tended to constitute "announce-
ments" of Federal Reserve policy.
In recent years, as in the 1970s.
the Federal Reserve has been perceived as being responsible for the
average rate at which federal funds trade, within a relatively narrow
margin for variation, over intervals as short as a reserve maintenance
period.
But as the funds rate has become more nearly a discretionary
policy-determined variable,
the less could it
be characterized as
responding to market forces balancing demands and supplies for money or
reserves.
Accordingly, sustained increases in the federal funds rate
are more likely to be seen as deliberate policy decisions,
rather than
as a byproduct of procedures to attain other, more basic policy
objectives, such as monetary control.
Partly as a consequence, an
entirely discretionary policy also risks an undesirable inertia in the
federal funds rate, so that policy may not effectively counter cyclical
developments in the economy or make progress toward price stability.
On the other side of the ledger, current procedures likely have
damped the short- and intermediate-term volatility in security prices
that can arise through variability in the relationship of interest
rates to alternative operating objectives or through market
misperceptions about policy intent.
Tying open market operations to
movements in monetary aggregates or in reserves likely would have
contributed considerably to short- and intermediate-term variation in
interest rates at a time when questions were being raised--within and
outside the Federal Reserve System--about the relationship of money and
reserves to the objectives of the Committee, except over fairly long
periods.
Indeed, current operating procedures have evolved in a series
of steps over the 1980s as a result of concerns about avoiding
inappropriate interest rate movements and unnecessary volatility that
can result from shifts in demands for money or borrowed reserves.
Structural changes in the Ml demand function induced the
Committee in October 1982 to replace its nonborrowed reserves operating
target tied to a desired path for Ml with an operating target for
adjustment plus seasonal borrowing.
For a brief time, the borrowing
objective was informally linked to deviations of M2 from path, but by
early 1983 its setting had become wholly discretionary, eliminating the
last vestige of any mechanism involving automatic feedback from
undesired movements in a monetary aggregate to discount borrowing and
hence to the funds rate.
The Committee reacted to the fragile state of
financial markets after the stock market crash of October 1987 by
instituting a flexible approach to the borrowing objective that was
tantamount to federal funds targeting, although in a form not as rigid
as in the 1970s.
Attempts to revert to the borrowed reserves operating
target in 1988 were frustrated by the breakdown in the discount window
borrowing function.
Finally, after market misinterpretation of open
market operations around Thanksgiving 1989, the Manager has had to pay
even more attention in day-to-day open market operations to funds rate
objectives, allowing the prevailing funds rate more frequently to
override reserve projections in guiding day-to-day operations.
In this
evolutionary process, the FOMC has judged, at least implicitly, that
the advantages gained in each adaptation, by avoiding potentially
inappropriate funds rate movements possible with earlier procedures,
have outweighed the disadvantages noted above.
The table on the next page vividly demonstrates the effects on
one measure of funds rate variability of these procedural changes.
The
root mean squared deviation of the maintenance-period average effective
federal funds rate around the Desk's expected level has dropped with
successive shifts from nonborrowed and borrowed reserves targeting to a
focus on the federal funds rate.
1. The subsequent increase in funds rate volatility, especially from
December 1990 to March 1991, was associated with the reduction of
nontransactions reserve requirements to zero. For a time, reserve balances
fell to levels at which reserve demands for clearing purposes dominated
demands to satisfy reserve requirements. More recently, this effect has
been significantly mitigated by growth of required reserve balances as
transactions balances have increased, by increased required clearing
balances, and by additional experience gained by institutions in operating
with lower reserve balances.
Deviation of Effective Federal Funds Rate From Desk's Expectations
(Maintenance Period Averages)
Mean Absolute
Deviation
---
Root-MeanSquared Deviation
percentage points ---
Oct. '79 - Oct. '82
.43
.55
Oct. '82 - Oct. '87
.15
.23
'89
.09
.11
12/12/90
.08
.10
12/13/90 - 3/20/91
.14
.17
3/21/91
.09
.13
Oct. '87
- Thanksgiving
Thanksgiving
'89 -
- 8/7/91
Excludes the period encompassing the end of 1980.
Excludes
Excludes the
the periods
periods encompassing
encompassing the
the ends of 1982 and 1986.
ends of 1982 and 1986.
The increased attention to the federal funds rate does not
appear to have greatly hampered the execution of policy.
Over the
nearly nine years since the nonborrowed reserves procedure was
replaced, discretionary movements in the operating target--first for
borrowed reserves and then for the funds rate--have seemed adequate to
avoid the excessive policy inertia in a cyclical context that some
observers contend characterized policy implementation in the 1970s.
Changes in the operating target at FOMC meetings have been supplemented
by frequent adjustments during intermeeting periods, at times also
involving a full or partial pass-through to the funds rate of discount
rate changes.
Even since the essential form of current procedures
emerged in the fall of 1987, this policy flexibility has continued to
produce substantial cumulative movements in the funds rate--upward as
well as downward--that were able to sustain economic expansion while
holding the line on inflation through the rest of the 1980s and then to
cushion the downturn in economic activity that began last summer.
Looking forward to a time when a tightening of monetary policy
may be called for, however, the disadvantages associated with
transparent discretionary control over the federal funds rate could be
seen as relatively more important than they have been during the easing
trend of recent years.
This memo briefly discusses a variety of
alternative procedures, in order to provide background for the
Committee's discussion of the issues and possible decision to have the
staff undertake a more thoroughgoing analysis.
Consideration of
alternatives--ranging from more minor changes to more major ones-basically involves traveling backward in time through this process of
evolution in operating procedures.
Even more radical approaches to
policy implementation than the Committee has attempted in the past.
such as pursuing a total reserves or total base operating target or
restructuring discount window arrangements to establish a penalty rate,
also are catalogued.
Alternative Procedures:
Summary
Three alternatives would result in some ambiguity about the
federal funds rate associated with the Desk's operating objective, but
would retain discretion over changes in the operating target--by the
Committee at FOMC meetings and. through delegated authority, by the
Chairman between meetings--in response to a variety of economic and
financial developments.
1.
Gear open market operations somewhat more to reserve
projections and less to the prevailing funds rate, thereby
providing a little more scope for funds rate variability
and at times increasing market uncertainty about the funds
rate objective, while still retaining the single-valued
federal funds rate objective.
2.
Establish a range for the funds rate objective, say 1/8 to
1/4 percentage point in width, along with alternative 1.
thereby reintroducing an element of indeterminacy to the
intended funds rate and providing some scope for "testing
the waters" prior to formal changes in the stance of
operating policy.
3.
Reestablish an operating target for discount window
borrowing that no longer would be "approached flexibly" by
the Trading Desk, thereby allowing still more scope for
funds-rate variability to emerge in response to unpredicted
shifts in the borrowing relation or market expectations of
an impending change in the discount rate or the borrowing
objective.
The next two alternatives would institute an automatic response
of the operating target to deviations of M2 from the Committee's path.
4.
Establish an operating target for discount borrowing that
would automatically be adjusted by some fraction, say 1 or
2 percent, of the divergence of M2 from a preset path.
This procedure would mimic the behavior of a nonborrowed
reserves operating target in an institutional setting with
a uniform 1 or 2 percent reserve requirement on all
components of M2. and thus promote variations in the
federal funds rate in response to unanticipated movements
in M2, as well as to unpredicted shifts in the borrowing
relation or to varying market expectations.
5.
Establish an operating target for the federal funds rate
that would automatically be adjusted by some fixed amount
for each $1 billion of the divergence of M2 from a preset
path.
This technique would essentially replicate the
behavior of a nonborrowed reserves operating target in an
institutional setting with a uniform reserve requirement on
all components of M2 and with a stable borrowing function,
thus short circuiting effects of instability in the
borrowing relation or of varying market expectations while
still retaining the automatic funds rate response to
unanticipated movements in M2.
For example, adjustments of
2-1/2 or 5 basis points for each $1 billion deviation of M2
from path would be virtually equivalent to a uniform 1 or 2
percent reserve requirement against M2 and a borrowing
function in which a $100 million change in borrowing
widened or narrowed the spread of the funds rate over the
discount rate by 25 basis points.
The final two alternatives would further reduce the interestresponsiveness of reserve supply, either through establishing a total
reserves or total monetary base operating target or by establishing a
penalty discount rate.
6.
Establish a total reserves or total monetary base operating
target, thereby curtailing the safety-valve role of the
discount window over periods longer than one day.
Federal
funds and other short-term rates would vary considerably in
response to changes in demands for reserves.
Short-run
control over M1 (but not necessarily M2) would be enhanced.
7.
Establish a penalty discount rate above the expected
trading area for the funds rate, perhaps in combination
with a nonborrowed reserves operating target,
thereby
further curtailing the safety-valve role of the discount
window, additionally elevating the equilibrating role of
reserve demands in determining the funds rate, promoting
still
rates,
more variability at least of short-term interest
and implying as a side effect even closer short-run
control over Ml.
Alternative Procedures:
1.
Discussion
Gear operations less to the prevailing funds rate.
Even if
the Committee retained a single-valued funds rate objective, it could
be made a little less transparent to market participants if open market
operations were geared somewhat more to projected reserve needs and
less to actual funds trading at "Fed time" each morning.
This approach
would provide a bit more scope for variation in the funds rate in
response to reserve market pressures or changing market expectations.
The Manager could widen the current implicit quasi-"intervention
points"--in which reserves are drained
(added)
when the rate moves far
enough below (above) the objective regardless of projected reserve
needs.
Instances of operations both to add and drain reserves in
same maintenance period hence would occur less often.
the
Signals from
open market operations themselves about the funds rate objective would
become slightly more difficult for the market to read.
More occasions
might arise in which questions about the Federal Reserve's intended
rate on federal funds were raised, and policy moves to change the funds
rate objective might less often be immediately recognized by market
participants.
As with the other alternatives as well, the issue to be
assessed is what would be gained on balance by such a change in Desk
operations.
The Federal Reserve would place a little more distance
between itself and day-to-day movements in the funds rate.
That rate
also would come a little more to reflect underlying factors affecting
the supply and demand for reserves, including market expectations of
Federal Reserve policy moves.
Conceivably, additional flexibility at
times could be used to assess market reaction to movements of the funds
rate far enough away from the previously perceived objective to foment
market suspicions of a current or imminent policy change.
At other
times, however, markets could perceive the possibility of a policy move
when no such change is intended, inducing a subsequent "whipsawing" of
securities prices once the unchanged basic policy stance became more
apparent over time.
It also might take longer for markets to recognize
an intended change in policy, which would delay the response but could
tend to diffuse public discussion of such changes.
2.
Reestablish a range for the funds rate objective.
Committee selection of a range for intended funds rate trading also
could be combined with the last alternative's approach by the Desk to
open market operations.
This alternative would further loosen up funds
rate variability by introducing some indeterminacy in the operating
target for the funds rate, say of 1/8 or 1/4 percentage point.
Market
participants thus would be less able to pin down the intended policy
stance at any point in time, and expectations and pressures in the
reserves market would have even more room to show through to actual
funds trading.
Enough ambiguity about Committee intent would be
restored to permit more frequent probes by the System into market
responses to changes in the funds rate, with enhanced opportunities to
"validate" those changes in the funds rate that seemed to have avoided
untoward market reactions.
Under such a system, implementation of
policy on a daily basis could become somewhat more flexible and
judgmental.
The rationale for simply introducing more flexibility and
ambiguity into the System's approach to its federal funds target may be
difficult to explain to a public grown accustomed to having little
doubt about the current federal funds rate objective and to instantaneous recognition of changes in such objectives.
One possible
response would be increased calls from Congress to announce our current
objectives.
3.
Reestablish a borrowed reserves operating target.
The Desk
could be instructed essentially to abandon its flexible approach to the
formal borrowing objective now used in constructing reserve paths.
The
Committee could instruct the Manager to make a reasonable effort to
attain the path objective for adjustment plus seasonal borrowing,
regardless of implied funds rate movements, except perhaps for
especially sizable ones.
This alternative would again make the federal
funds rate, for a given discount rate, depend importantly on the
behavior of depository institutions in tapping the discount window.
Over the period of rigorous pursuit of a borrowed reserves
objective--from October 1982 through the stock market crash of October
1987--the two-week maintenance-period average effective funds rate
deviated from the Desk's expectation by no more than 23 basis points
two-thirds of the time (table following page 3).
There is reason to
think that comparable pursuit of an operating target for borrowed
reserves in the current financial environment would yield a higher
figure.
With the heightened reluctance of banks to avail themselves of
discount credit, borrowing has moved closer to a frictional level at
positive funds rate-discount rate spreads; the reluctance to borrow
also seems to have manifested itself in a much less interest-elastic
borrowing relationship than in the mid-1980s.
If so. Desk attempts
to attain a borrowing objective over a maintenance period would imply
wider funds rate movements in current circumstances in response to
unanticipated shifts in the borrowing relation or to daily shocks to
other factors affecting reserve supply or demand of comparable size to
those of the earlier period.
Compared with the approach of recent years, this alternative
would afford more scope for market expectations about the System's
impending policy stance to show through to the funds rate.
supplementing other sources of information about market expectations
2. At that time, the bluebook incorporated a relationship in which a 25
basis point change in the spread was associated with a $100 million change
in adjustment plus seasonal borrowing. In recent bluebooks, the assumed
relation has been 100 basis points per $100 million of borrowing--four
times as steep. Only some of the steepening is believed to be associated
with the narrow spread observed so far this year and the induced borrowing
levels close to frictional minimums.
now available in futures and forward quotes on federal funds and other
instruments.
Under this alternative, the Federal Reserve could back
well away from transparent targeting of the federal funds rate.
However, with the degree of funds rate volatility likely to be even
greater than experienced during the regime of borrowed reserve
targeting, and with the rate movements not closely connected to broader
monetary, financial, or economic developments, the Committee's
tolerance for funds market variability undoubtedly would be tested.
4.
Establish an operating target for discount borrowing
automatically tied to misses of M2 from target.
This approach would
approximately conform to the nonborrowed reserves procedure of October
1979 to October 1982, but with automatic movements in borrowed reserves
linked to deviations from target of M2 rather than Ml.
The borrowed
reserves objective would be changed as the intermeeting period
progresses by an amount equal to some specified fraction, say 1 or 2
percent, of the absolute divergence of M2 from a target path set by the
FOMC for the intermeeting period.
The alternative hence is designed to
mimic the workings of a nonborrowed reserves operating target in an
institutional setting in which a uniform required reserve ratio of 1 or
2 percent is established on all components of M2.
The procedure
thus would institute a primary role for intermediate-term control over
M2 in the policy process.
Systematic movements in the funds rate in
the same direction as unpredicted swings in M2 growth would be overlaid
3. Required reserves, which today cover only transaction deposits, currently are 1.46 percent of M2 as a whole. Prior to the reduction in nontransaction reserve requirements to zero late last year. this figure was
1.84 percent.
on the unsystematic variability in the funds rate associated with the
operating target for borrowed reserves, as discussed in the context of
the last alternative.
The systematic part of funds rate movements
would act automatically to counter over- or under-shoots of M2, helping
to restore the aggregate to its target over time.
One critical issue is whether the Committee would be prepared
to elevate M2 as the dominant determinant of systematic movements in
the funds rate over intermeeting periods, thereby eschewing discretion
in favor of an automatic monetary control mechanism.
The shorter- and
even intermediate-run relationships between M2 and nominal spending are
usually seen as being much less reliable than the longer-run
connection.
Thus, absent a situation in which inflation has become
intense and the central bank's credibility has been brought into
serious question, the underlying case for emphasizing shorter-run
monetary control has been viewed as being much less persuasive than the
case for longer-run control.
Indeed, the Committee in the operating
paragraph of the current directive has placed the monetary aggregates
only third on the list of factors governing intermeeting adjustments of
the policy stance.
Thus, the Committee would need to assess whether
the systematic variation in the funds rate automatically produced by
variations in M2 from its intermeeting target path under this procedure
typically would serve to promote its broader policy objectives.
4. The dynamics of such an automatic feedback relationship from M2
misses to changes in short-term interest rates interacting with the delayed
effects over time of changes in short-term interest rates on spending,
opportunity costs, and M2 demand actually is extremely complicated, perhaps
involving induced cycles in M2 growth and nominal income.
Another issue involves the unsystematic component of funds rate
variation that also would emerge under this alternative as a result of
changes in borrowing behavior, as discussed in the context of the
previous alternative.
Of course, the Committee could constrain overall
funds rate movements during the intermeeting period by appending bands
of, say, 2 or 3 percentage points on either side of the initial
expectation for the funds rate.
The Desk could be instructed not to
allow the funds rate to move persistently outside these limits.
Alternatively, to avoid the extra funds-rate volatility associated with
reliance on borrowed reserves as the operating target, the following
procedure instead contemplates using the funds rate as the operating
target to be adjusted automatically in reaction to M2 target misses.
5.
Establish an operating target for the federal funds rate
automatically tied to misses of M2 from target.
Under this approach,
the funds rate operating target would be adjusted by, say, 2-1/2 or 5
basis points for each $1 billion by which M2 diverges from an
intermeeting target path.
The procedure would mimic nonborrowed
reserves targeting in a banking system with a 1 or 2 percent reserve
requirement applied uniformly to all of M2 combined with a perfectly
stable relationship connecting each 1/4 percentage point change in the
funds rate-discount rate spread to a $100 million change in borrowed
reserves in the same direction.5
Although this approach would minimize unsystematic variation in
the funds rate to around the levels seen in recent years, systematic
5. Similar responsiveness of borrowing to the spread is estimated to
have prevailed over a period at least as long as the decade ending in 1987.
rate swings related to deviations of M2 from target would remain.
The
close tie of the funds rate to M2 behavior would represent a clear
departure from Committee practice since 1982, and would raise the
fundamental issues surrounding the switch to an automatic mechanism
designed to control M2 over the intermediate run.
The absence of a
reserve-based orientation in the automatic monetary control mechanism
would differentiate this alternative from past practice and from many
proposed techniques keyed to monetary control.
The artificiality of
such a system could make explaining its rationale to the public and
Congress more difficult.
Such an artificiality would apply as well to
the linking of automatic changes in the funds rate to the behavior of
other, nonmonetary variables such as the price level.
6.
Establish a total reserves or total base operating target.
This even more radical alternative would at least ground monetary
policy implementation on a reserves basis.
However, by considerably
reducing the interest elasticity of reserve supply over intervals
longer than a day, volatility at least of short-term interest rates
would be appreciably amplified.
The role of reserves demand in
equilibrating the federal funds market would be much enhanced.
Funds
rate movements would need to be large enough to bring required plus
excess reserves demand into alignment with the targeted level of
supply, implying the potential for sizable interest rate variations in
reaction to changing reserve demands.
Because required reserves now
only apply to transaction deposits, this approach implicitly could
improve short-run control over these deposits, and hence over Ml.
However, the Committee for some time has deemphasized this aggregate as
a guide to monetary policy.
In addition, M2 in the process could be
destabilized to the degree that the M1 and non-M1 components of M2
unexpectedly evince differential growth rates, as has been the case
this year.
7.
Establish a penalty discount rate.
Instituting a penalty
discount rate would further reduce the interest sensitivity of reserve
supply by maintaining discount window borrowing under most circumstances at frictional levels.
Because using such borrowing as an
operating target would no longer be feasible, this alternative would
appear most consistent with selection of a nonborrowed reserves, or in
this case virtually equivalently, a total reserves operating target.
The system would work much like that of the previous alternative,
except that the safety-value feature of the discount window also would
be circumscribed on a daily basis, adding still more to funds rate
volatility in response to shocks to reserve demand or supply.
This
feature would imply more daily volatility in the funds rate than
recently seen even if the Committee continued to pursue a funds rate
operating target.
An administered penalty discount rate, with minimal
administrative pressure on adjustment borrowing, would tend to cap the
funds rate.
Even so. funds-rate volatility still could be substantial
at levels of funds trading below the discount rate.
FEDERAL
RESERVE
BANK
OF
RICHMOND
POST OFFICE Box 27622
RICHMOND, VIRGINIA
23261
(804) 697-8000
Research Department
August 7, 1991
Mr. Donald L. Kohn, Director
Division of Monetary Affairs
Board of Governors of the
Federal Reserve System
Washington, DC 20551
Dear Don:
The purpose of this letter is to respond to your request, at the July
FOMC meeting, for assistance in responding to the Chairman's request that you
look into the feasibility of shifting to a reserve operating instrument.
understand the Chairman's request,
As I
he does not expect you to deal with the
substantive issue in any detail at the August meeting; he merely wants you to
recommend whether it is worthwhile to do further research on it.
We want to persuade you that such a project would be productive despite
the extensive work that has already been done.
Much has changed since the
early 1980s when most of the recent research on operating targets and
procedures was completed.
Some of the detailed questions addressed in the
earlier literature could probably be revisited profitably in the context of
the current institutional regime, which, as you are well aware, is quite
different from the early 1980s.
Moreover, considerable new research bearing
on the choice of operating procedures has been completed in recent years.
and your staff are probably aware of most of this work, but some of it may
have escaped your notice.
You
Mr. Kohn
Page 2
August 7, 1991
We would offer three arguments for reopening research on these issues.
First, there is a reasonable prospect that a change to some kind of reserve
target operating regime would improve monetary control compared to current
procedures.
Second, some recent research suggests that the present operating
regime may be an especially inappropriate one for pursuing our stated longerrun goal of price stability.
(In fact, as indicated below, some of the recent
work indicates that the current regime may be actually inconsistent with price
stability.)
Finally, several recent papers shed new and highly interesting
empirical light on the extent to which shifting to a reserve instrument would
increase the volatility of interest rates.
This is important, of course,
because the likelihood of increased rate volatility is one of the principal
objections raised in the past to moving to a reserve-oriented operating regime
and to increasing monetary control more generally.
I have attached a list of references at the end of this letter and am
enclosing copies of some of the especially pertinent papers for your
convenience.
I should note that the views expressed here are mine and those of other
members of the research staff.
them.
Bob Black would probably agree with many of
But he might disagree with some and want to add additional points.
He
is currently on vacation, and in the interest of time I am sending you this
without his input.
Reason 1:
Reserve tarqeting may improve monetary control.
Several papers written over the last 20 years or so have addressed the
question of whether an interest rate variable or a reserve variable would
produce better money supply control.
Perhaps not surprisingly, this research
Mr. Kohn
Page 3
August 7, 1991
has not produced definitive conclusions.
At a minimum, however, this
literature viewed as a whole certainly does not preclude the possibility that
a reserve instrument is preferable.
Further, in one of the most recent of
these studies [11] McCallum and Hoehn demonstrate that a reserve instrument is
optimal in one fairly general theoretical macro model assuming contemporaneous
reserve accounting.
On balance, this literature tilts our priors moderately in favor of a
reserve instrument.
From the perspective of monetary control, further
research appears to us, at least, to be justified.
This justification is reinforced by the important institutional changes
that have occurred in recent years.
Much of the earlier research was
completed when the Fed was still focusing primarily on one or another version
of Ml and we still had lagged reserve accounting.
in a nearly contemporaneous accounting regime.
We are now focusing on M2
The shift to a broader
aggregate that includes a sizable nonreservable component may reduce the
intuitive appeal of a reserve instrument for many Committee members and
others, but the shift to nearly contemporaneous accounting significantly
increases the appeal.
In particular, as Marvin Goodfriend indicates in one of
the enclosed papers [6], the shift to contemporaneous accounting has made it
feasible to use total reserves as the reserve instrument.
In principle, total
reserves has important advantages over alternative reserve instruments like
nonborrowed reserves from the standpoint of monetary control [see 6, pp. 7678].
In any event, additional research is needed to sort these issues out in
the context of the changed institutional environment.
Mr. Kohn
Page 4
August 7, 1991
Most of the formal analysis of the choice among operating instruments
has been conducted as though there were no constraint on the Fed's willingness
and ability to alter the federal funds rate (either directly or, in the case
of borrowed reserve or nonborrowed reserve-lagged accounting regimes,
indirectly) when the funds rate is the instrument.
As I believe nearly
everyone who has had much experience with the FOMC would acknowledge, it is
often very difficult in practice for political and other reasons for the
Committee to make or allow the funds rate movements required for reasonably
close monetary control.
constraint.
The use of a reserve instrument would loosen this
Indeed, evidence of such a loosening is one of the main lessons
of the 1979-82 nonborrowed reserve regime, even though nonborrowed reserves
were not a pure reserve instrument under the lagged accounting system then in
effect.
In this latter regard, the experience with nonborrowed reserve targeting
between 1979 and 1982 is sometimes cited as evidence bearing on the choice
among operating instruments.
There was, of course, substantial unanticipated
variation in money supply growth in much of this period as well as heightened
interest rate variability.
The extensive Board staff study released in
February 1981 [7], however, indicated that much of the variability in money
growth in the early part of this period appeared to be due to developments
unrelated to the change in operating procedures, such as the temporary credit
control program in the spring of 1980.
Further, as suggested above, there is
a legitimate question regarding the extent to which the 79-82 nonborrowed
reserve regime was actually a reserve-targeting regime in the usual sense of
the term.
In one of the enclosed papers [2], Tim Cook shows that about two-
Mr. Kohn
Page 5
August 7, 1991
thirds of the movement in the funds rate in this period was due to judgmental
adjustment of the weekly borrowing target and changes in the discount rate
rather than to automatic adjustment of the borrowing target induced by market
forces.
To our thinking, the Committee's unwillingness (perhaps for
understandable reasons) to vary the funds rate sufficiently to ensure adequate
monetary control when the Committee is targeting the funds rate directly or
indirectly is the central difficulty with a funds rate instrument.
This fact
alone seems to us to be sufficient reason to take another look at the
desirability of shifting to a reserve instrument.
One of the traditional objections to using a reserve instrument to
tighten monetary control is that it would produce significantly greater
interest rate variability.
This point is addressed in the discussion of
reason 3 below.
Reason 2:
Interest rate targeting may destabilize the price level.
Our second reason can be stated more briefly than the first but it may
well be more fundamental.
particular, [9])
There is increasing empirical evidence (see, in
that the creation of the Fed profoundly and permanently
altered the pattern of interest rate movements in U.S. financial markets
compared to what had existed before 1914.
In particular, short-term interest
rates have been much more persistent, in a statistical sense, since 1914 (see
[9], pp. 361-2, for evidence).
This was obviously true in the 1930s and 1940s
when the System was pegging rates, but it is true in other periods as well.
number of economists now believe that smoothing short-term interest rate
movements has been an important objective of monetary policy throughout the
A
Mr. Kohn
Page 6
August 7, 1991
Fed's history (see [4], [5], and [8, pp. 224-6]) with the result that the
funds rate now has approximately the characteristics of a random walk--i.e.,
the expected value of the funds rate in the future equals its current value.
This situation has important implications regarding the effect of
policy-induced movements in the funds rate on longer-term interest rates.
Specifically, if the funds rate follows a random walk, and one accepts the
expectations theory of the term structure of interest rates, it follows that
Fed adjustments of the funds rate will have significant impacts on longer
maturity short rates such as three- and six-month T-bill rates, and perhaps
even intermediate- and long-term bond rates.
(Mankiw, Miron and Weil [9,
pp. 362-363] use a simple expectations model of the term structure to show why
movements in short-term interest rates have a greater effect on longer-term
rates when the movements in short rates are persistent than when they are
not.)
Tim Cook and Tom Hahn [3] have provided detailed empirical evidence
that funds rate movements in the late 1970s (prior to October 1979)--when the
Fed was controlling the funds rate directly and unusually precisely--had a
strong effect on the movements of longer-maturity short rates, a moderate
effect on intermediate-term rates, and a small but measurable effect even on
long-term bond rates.
Mankiw, Miron and Weil [9, pp. 363-366] provide similar
evidence using data on three- and six-month rates on various instruments.
Against this background, one can think of a number of reasons why the
System might want to smooth interest rates.
Marvin Goodfriend has suggested
[5, pp. 16-18] that the System may smooth the funds rate in order to enhance
the effect of its actions on longer-term rates in accordance with the points
made above.
("Longer-term" rates in this context include six- and perhaps
Mr. Kohn
Page 7
August 7, 1991
three-month rates.)
According to this view, it then conducts stabilization
policy through the impact of movements in longer-term rates on broader
macroeconomic variables.
Whatever reason the Fed may have for smoothing interest rates, the
evidence is pretty strong that we do in fact smooth them, which brings me to
the main point in this regard.
Goodfriend has shown (in [4]) that if the Fed
is trying to smooth interest rates while pursuing its usual stabilization
objectives, it may make the price level non-trend-stationary.
In plainer
language, Marvin's analysis implies that the Fed's evident tendency to smooth
the funds rate (which is a function of using the funds rate rather than
reserves as the operating instrument) may well preclude achieving long-term
price stability.
We recognize that Marvin's analysis is conducted at a fairly
high level of abstraction and that further research might raise questions
about his results and conclusions.
Nonetheless, there is reason for concern
when a carefully prepared study indicates that our operating procedure may be
inconsistent with one of our major stated policy objectives.
In any event
this certainly seems to be another reason for taking another look at our
procedures.
Reason 3: New evidence suggests reserve targeting may not increase and might
even reduce the variability of longer-term interest rates.
The third reason for reopening research on operating procedures builds
on some of the points made in discussing the second reason.
As I noted above,
a long-standing objection to shifting to a reserve instrument has been the
fear that it would cause a sharp increase in the variability of very shortterm interest rates--particularly the funds rate--which might be transmitted
to longer-term rates.
The volatility of longer rates in parts of the 1979-82
Mr. Kohn
Page 8
August 7, 1991
period is sometimes cited as evidence supporting this view.
I suspect that
many of the current FOMC members would have this concern if a change in
regimes were proposed.
The recent research I have already cited that finds a fundamental
difference in the behavior of interest rates before and after the creation of
the Fed is directly relevant to this issue.
and Weil [9] is especially germane.
The recent paper by Mankiw, Miron
These authors make four basic points.
First, as noted earlier, they provide empirical evidence that the process
generating short-term interest rates in U.S. markets changed significantly
with the creation of the Fed.
much more persistent.
In particular, shocks to short rates became
Second, as also noted above, they use a simple term
structure model to show that one would expect short-term interest rate
movements to have a greater impact on longer-maturity rates in a regime
characterized by persistent short rate movements than in one not so
characterized.
Intuitively, when short rates are generally mean reverting,
market participants expect most shocks to short rates to be temporary and
reversed by subsequent movements.
Hence, current movements in short rates
have only a small effect on expectations of future levels of short rates.
Consequently, these movements have relatively small effects on the levels of
longer-term rates.
Third, using data that goes back to 1890, these authors
provide empirical evidence that short rate movements did in fact have
significantly smaller effects on longer-term rates before the Fed came into
existence than after.
In other words, an identifiable change in the regime
governing interest rate behavior occurred with the creation of the Fed.
Mr. Kohn
Page 9
August 7, 1991
Finally, the authors show empirically that market participants recognized the
regime change and adjusted to it rapidly.
Mankiw, Miron and Weil's analysis suggests that if the variability of
the funds rate were to increase with a future shift to a reserve targeting
regime, the variability of longer-term rates, which are of greater importance
to the general economy, might not.
Past experience, as they say in the
investment ads, is no guarantee of the future.
But the Mankiw, Miron and Weil
paper is well done and its results and their implications deserve serious
consideration.
In any case, Don, these are the reasons why we believe it would be
worthwhile for the Committee to take another look at the instrument question.
If you agree, and the Committee decides to do it, we would be happy to help in
any way we can.
Sincerely yours,
J. Alfred Broaddus, Jr.
Senior Vice President and
Director of Research
Enclosures
xc:
Mr. Lindsey
References
1.
Axilrod, Stephen H., and David E. Lindsey, "Federal Reserve System
Implementation of Money Policy: Analytical Fundations of the New
Approach." American Economic Review, May 1981, pp. 246-252.
2.
Cook, Timothy, "Determinants of the Federal Funds Rate, 1979-1982."
Economic Review, Federal Reserve Bank of Richmond, January/
February 1989, pp. 3-19.
3.
Cook, Timothy, and Thomas Hahn, "The Effect of Changes in the Federal
Funds Rate Target on Market Interest Rates in the 1970s." Journal
of Monetary Economics, November 1989, pp. 331-351.
4.
Goodfriend, Marvin, "Interest Rate Smoothing and Price Level TrendStationarity." Journal of Monetary Economics, May 1987,
pp. 335-348.
5.
Goodfriend, Marvin, "Interest Rates and the Conduct of Monetary
Policy." Working paper 90-6, Federal Reserve Bank of Richmond,
August 1990. Forthcoming in Carnegie-Rochester Series on Public
Policy.
6.
Goodfriend, Marvin, "The Promises and Pitfalls of Contemporaneous
Reserve Requirements for the Implementation of Monetary Policy."
Economic Review, Federal Reserve Bank of Richmond, May 1984,
pp. 3-12.
7.
Federal Reserve Board, Staff Study on the New Monetary Control
Procedures, 2 volumes, February 1981.
8.
Mankiw, N. Gregory, and Jeffrey A. Miron, "The Changing Behavior of the
Term Structure of Interest Rates." Quarterly Journal of
Economics, May 1986, pp. 211-228.
9.
Mankiw, N. Gregory, Jeffrey A. Miron, and David N. Weil, "The
Adjustment of Expectations to a Changing Regime: A Study of the
Founding of the Federal Reserve." American Economic Review, June
1987, pp. 358-374.
10.
McCallum, Bennett T. "On Consequences and Criticisms of Monetary
Targeting." Journal of Money, Credit, and Banking, November 1985,
Part 2, pp. 570-597.
11.
McCallum, Bennett T., and James G. Hoehn, "Instrument Choice for Money
Stock Control with Contemporaneous and Lagged Reserve
Requirements." Journal of Money, Credit, and Banking, February
1983, pp. 96-101.
12.
Pierce, James L, "Federal Reserve Operating Targets, Past and Present."
Business Economics, July 1991, pp. 27-32.
References
Page 2
13.
Poole, William, "Optimal Choice of Monetary Policy Instruments in a
Simple Stochastic Macro Model." Quarterly Journal of Economics,
May 1979, pp. 197-216.
14.
Poole, William, "Federal Reserve Operating Procedures: A Survey and
Evaluation of the Historical Record Since October 1979." Journal
of Money, Credit, and Banking, November 1982, Part 2, pp. 575-596.
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
To Federal Open Market Committee
From
Date August 14 1991
Subject:
Operational Paragraph of Directive
Donald L. Kohn
At the last Committee meeting, Chairman Greenspan mentioned
that Governor Kelley had some suggestions regarding the treatment of
the order of the factors to be considered in judging intermeeting
adjustments to reserve conditions.
A memo to the Chairman from
Governor Kelley on this subject is attached as background for Committee
discussion.
At Governor Kelley's request, I have also attached a brief
memo on how his various alternatives might be implemented.
The final
element in the package is a copy of the July directive, for reference.
Attachment
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
Date May 20,
1991
To
Chairman Greenspan
Subject: Operational Paragraph of
From
Edward W. Kelley, Jr.
FOMC Domestic Policy Directive
The
primary purpose of
the
Domestic
Policy
Directive is, of course, to instruct the Desk on its
management of Open Market Operations.
The further
purpose of the Directive is to create an historical
record of the deliberations of the Committee.
The
key second sentence
of
the Operational
Paragraph begins with a recitation of the areas of
concern to the Committee.
These areas of concern
traditionally appear in rank order of the importance
assigned to each by the Committee and have varied
significantly over time.
A summary of their recent
history is attached. While the semantics have evolved
somewhat, the order of concerns has not changed since
June, 1988.
Earlier this spring, I suggested to the FOMC that
the rank order currently in place might no longer be
factually accurate.
The notion received no support.
Perhaps all members, other than myself, felt then and
may still feel that this presentation continues to be
accurate.
If so,
fine.
However, other possible
reasons for not considering any change may exist, and
if this is the case, a review may be in order. Let me
suggest considering the following options:
1.
Assume this convention continues to be useful
and should be retained, which leads to the
further assumption that the recitation should
be an accurate reflection of Committee discussion. Initiate a meaningful reopening of
this list, based on the above, whenever
appropriate.
2.
Continue to use the existing language without
active review.
3.
If this convention has outlived its usefulness, consider the possibility of changing the
structure of the operational paragraph to
delete the recitation of the areas of concern
to the Committee.
Attachment
EXHIBIT 6
Order in which Policy Variables Conditioning Reserve Pressure Appeared in the FOMC Directive
MEETINGS
FIRST
SECOND
THIRD
FOURTH
FIFTH
3/85 to 7/85
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
INFLATION
CREDIT
MARKET
CONDITIONS
EXCHANGE
RATES
8/85 to 4/86
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
EXCHANGE
RATES
INFLATION
CREDIT
MARKET
CONDITIONS
5/86
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
FINANCIAL
MARKET
CONDITIONS
EXCHANGE
RATES
7/86 to 2/87
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
EXCHANGE
RATES
INFLATION
CREDIT
MARKET
CONDITIONS
3/87
EXCHANGE
RATES
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
INFLATION
CREDIT
MARKET
CONDITIONS
5/87
INFLATION
EXCHANGE
RATES
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
7/87
INFLATION
MONETARY
AGGREGATES
STRENGTH OF
EXPANSION
8/87 to 9/87
INFLATION
STRENGTH OF
EXPANSION
EXCHANGE
RATES
MONETARY
AGGREGATES
11/87
FINANCIAL
MARKET
CONDITIONS
STRENGTH OF
EXPANSION
INFLATION
EXCHANGE
RATES
MONETARY
AGGREGATES
12/87 to 5/88
FINANCIAL
MARKET
CONDITIONS
STRENGTH OF
EXPANSION
INFLATION
EXCHANGE
RATES
MONETARY
AGGREGATES
6/88
INFLATION
STRENGTH OF
EXPANSION
EXCHANGE
RATES
FINANCIAL
MARKET
CONDITIONS
MONETARY
AGGREGATES
8/88 TO 11/88
INFLATION
STRENGTH OF
EXPANSION
MONETARY
AGGREGATES
EXCHANGE
RATES
FINANCIAL
MARKET
CONDITIONS
OPERATIONAL PARAGRAPHS OF FOMC DIRECTIVES
June 29-30, 1988 through July 5-6, 1989
"...
existing degree of pressure on reserve positions.
Taking
account
of
indications
of
inflationary
pressures, the strength of the business expansion,
developments in foreign exchange and domestic financial
markets, and the behavior of the monetary aggregates,
August 22, 1989 through November 13, 1990
"...
existing degree of pressure on reserve positions.
Taking account of progress toward price stability, the
strength of the business expansion, the behavior of the
monetary aggregates,
and developments
in
foreign
exchange and domestic financial markets, ..."
Dec. 18, 1990
"...
existing degree of pressure on reserve positions,
taking account of a
rate. Depending upon
trends in economic
monetary aggregates,
exchange and domestic
possible change in the discount
progress toward price stability,
activity, the behavior of the
and
developments
in
foreign
financial markets, ..."
Feb. 5-6, 1991 through March 26, 1991
"... existing degree of pressure on reserve positions.
Depending upon progress toward price stability, trends
in economic activity, the behavior of the monetary
aggregates, and developments in foreign exchange and
domestic financial markets, ..."
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
Office Correspondence
To
Governor Kelley
From
Date August 14,1991
Subject:
Donald L. Kohn
Implementation of Alternative Ap-
proaches to Intermeeting Adjustment Wording
In your memo of May 20, 1991 you raised three possible alternatives for the wording of factors that might influence intermeeting
changes in open market operations.
The following are my suggestions
for implementing each alternative you gave, along with some possibilities should the Committee wish to adopt new language general enough to
apply in a variety of situations.
1. Retain wording; modify as appropriate.
Members seem reluctant to modify directive language at FOMC
meetings.
In part, this may be because such suggestions typically are
made at the very end of the meeting, after the decisions have already
been made about the stance of policy immediately following the meeting
and about the "tilt"
to the intermeeting language.
One concern may be
that delicately balanced compromises among members and between members
and their consciences may come undone in the process of debating
changes in language.
This reticence probably is exacerbated by the unexpected
nature of most such proposals, so that Committee members have not had
an opportunity to consider their ramifications ahead of time.
While
unanticipated suggestions cannot be ruled out, part of this problem
could be addressed by a discussion in the bluebook of possible variations in directive language.
If the Committee so desired, the staff
could put forward some alternatives in the bluebook, when it seemed
appropriate.
It would be most useful if Committee members themselves
alerted the staff ahead of the meeting to possible changes they wanted
considered, so that a discussion could be included in the bluebook,
giving time for members to consider the pros and cons in a more deliberate way than can occur at the meeting.
2. Continue existing language without review or modification.
No implementing suggestions necessary.
3. Delete list of factors guiding intermeeting adjustments.
This suggestion could be implemented by simply deleting the
"depending upon.." clauses in the directive.
Thus, the July directive,
for example, would read: "In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of
pressure on reserve positions.
Somewhat greater reserve restraint or
somewhat lesser reserve restraint might be acceptable over the intermeeting period.
The contemplated reserve conditions..."
The Committee
discussion, which would be reflected in the policy record, would still
provide background to the Chairman and the manager as to which sorts of
information should receive the most weight in considering intermeeting
adjustments, but any such instructions would not be included in the
directive.
4. Adopt new language on factors guiding intermeeting adjustments that does not seem to raise questions about their order.
The suggestions below would substitute for the current list,
and would seem to be sufficiently general to apply in a wide range of
circumstances.
One possibility, addressed in alternatives b and c
below, would be to reference the Committee's long-term objectives as a
context for evaluating short-run developments.
Those objectives are
already included in the directive, leading off the paragraph on longrun ranges.
References to the monetary aggregates are included in brackets.
Some mention of the aggregates as guiding policy might be appropriate
in light of the long-run ranges adopted and the sentence currently in
the operational paragraph of the directive about expected growth over
the current quarter.
a.
markets,
"Depending on developments in the economy and financial
[including the behavior of the monetary aggregates [relative
to their long-run ranges,]] somewhat greater reserve restraint...."
b.
"In the context of the Committee's long-run objectives
for price stability and sustainable economic growth, somewhat greater
reserve restraint....in the intermeeting period, depending on developments in the economy and financial markets,
the monetary aggregates
[including the behavior of
[relative to their long-run ranges,]]."
4
c.
"Somewhat greater reserve restraint.... over the inter-
meeting period, depending on developments in the economy and financial
markets,
[including the behavior of the money supply,] evaluated in the
context of progress toward the Committee's longer-run objectives of
price stability and sustainable growth in output."
BOARD
OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
STRICTLY CONFIDENTIAL (FR)
Class
I -
FOMC
President Corrigan
TO:
DATE:
July 3, 1991
Federal Reserve Bank of New York
FROM:
Donald Kohn
At the meeting of the Federal Open Market Committee today,
at which you were present, the Federal Reserve Bank of New York was
authorized and directed, until otherwise directed by the Committee,
to execute transactions in the System Account in accordance with the
following domestic policy directive:
The information reviewed at this meeting suggests
that economic activity has begun to recover from the
recent recession. The unemployment rate rose to 6.9
percent in May, but total nonfarm payroll employment
edged up and the average workweek posted a sizable
gain. Manufacturing output has risen in recent months,
led by appreciable increases in assemblies of motor
vehicles.
Consumer spending has been bolstered in part
by an upturn in personal income. An increase in orders
points to a firming in demand for business equipment,
but nonresidential construction remains weak. Housing
starts rose over April and May, and sales of new and
existing homes continued to advance. The nominal U.S.
merchandise trade deficit in April was somewhat below
the average rate in the first quarter. Increases in
consumer prices have been small in recent months.
Most interest rates have risen slightly since the
Committee meeting on May 14.
The trade-weighted value
of the dollar in terms of the other G-10 currencies
increased substantially on balance over the intermeeting period.
M2 grew at a moderate pace over May and June,
while M3 changed little. For the year thus far, expansion of M2 and M3 has been in the middle portion of
the Committee's ranges.
-2-
The Federal Open Market Committee seeks monetary
and financial conditions that will foster price stability and promote sustainable growth in output. In
furtherance of these objectives, the Committee reaffirmed at this meeting the ranges it had established
in February for growth of M2 and M3 of 2-1/2 to 6-1/2
percent and 1 to 5 percent, respectively, measured from
the fourth quarter of 1990 to the fourth quarter of
1991. The monitoring range for growth of total
domestic nonfinancial debt also was maintained at 4-1/2
to 8-1/2 percent for the year. For 1992, on a tentative basis, the Committee agreed to use the same ranges
as in 1991 for growth in each of the monetary aggregates and debt, measured from the fourth quarter of
1991 to the fourth quarter of 1992. With regard to M3,
the Committee anticipated that the ongoing restructuring of thrift depository institutions would continue
to depress the growth of this aggregate relative to
spending and total credit. The behavior of the
monetary aggregates will continue to be evaluated in
the light of progress toward price level stability,
movements in their velocities, and developments in the
economy and financial markets.
In the implementation of policy for the immediate
future, the Committee seeks to maintain the existing
degree of pressure on reserve positions. Depending
upon progress toward price stability, trends in
economic activity, the behavior of the monetary
aggregates, and developments in foreign exchange and
domestic financial markets, somewhat greater reserve
restraint or somewhat lesser reserve restraint might be
acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent
with growth of M2 and M3 over the period from June
through September at annual rates of about 5-1/2 and 3
percent, respectively.
No change was made in the Authorization for Domestic Open
Market Operations.
@FedFRASER