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Authorized for public release by the FOMC Secretariat on 2/3/2021



January 13, 1976



Federal Open Market Committee


Arthur L. Broida

Attached is a memorandum from Governor Holland transmitting the preliminary second stage report of the Subcommittee
on the Directive.
It is contemplated that this report will be considered
by the Committee at a meeting subsequent to that of January 20.


Authorized for public release by the FOMC Secretariat on 2/3/2021




January 13,




Federal Open Market Committee
Robert C. Holland, Chairman
Subcommittee on the Directive

Attached is the preliminary second stage report of
the Subcommittee on the Directive.
The report is in the form
of a summary of the findings of the Subcommittee at this stage
of its work. In the near future, a separate second stage staff
report containing an elaboration of the summary report will be
distributed to the Committee. The latter document will be
lengthy because of the broad scope of the Subcommittee's second
stage inquiry and the complexity of the analysis that is involved.
To assist the FOMC and the Subcommittee in appraising
these findings, the Subcommittee plans at some point to ask a
panel of knowledgable outside economists to review and comment
on the Subcommittee's work to date. For this reason, the
attached report has been entitled a preliminary report.

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Federal Open Market Committee



Subcommittee on the Directive

Subject: Improvements in FOMC
Operating Procedures: Preliminary
Report (Stage II)


January 13, 1976

This, the second, phase of the Subcommittee's investiga-

tion has consisted of a broad inquiry into the thrust of the FOMC's
Directive, its corollary instructions and its attendant operating and
policy procedures.

The second stage report encompasses a summary of

findings and conclusions (which are presented in the following numbered
sections), with a staff report to follow related to the principal points
and a large number of staff background papers prepared for the

The Subcommittee on the Directive reported its conclusions

and recommendations from the first stage of its inquiry in March 1975.
That phase of its inquiry was limited to the evaluation of alternative
reserve measures that might serve in place of RPD as a short-term
operating target to the extent the FOMC pursues a monetary aggregateoriented approach to policy.

The Subcommittee recommended that the

FOMC replace RPD with nonborrowed reserves (NBR) as the monthly operating

The second phase of the Subcommittee's work particularly

involved the question of what role intermediate targets, such as monetary
aggregates or interest rates, could most helpfully play in the formulation

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- 2 and operation of monetary policy.

Investigation of this question has

led to consideration of such issues as relationships among operating,
intermediate, and ultimate targets; the circumstances under which
targets should be altered in response to incoming information; and
how best to take account of uncertainties as to the structure of the
economy, the current position of the economy, and the likely course of
important exogenous variables.

The Subcommittee's studies suggest that FOMC decision-

making procedures would benefit in some respects if they were to evolve
in ways broadly consistent with a developing branch of economic analysis
called optimal control theory.¹

Optimal control analysis provides a

framework within which the process of policy formation, as well as advances
in research, understanding and operational refinement, can evolve

Historically, changes adopted by the FOMC have been

evolutionary in nature, and in recent years there has been a movement in
the direction of greater focus on the behavior of monetary aggregates as


This type of analysis involves a systematic approach to decision-making
at discrete intervals over a time horizon under circumstances in which
there is uncertainty about the response to policy actions. In essence,
it would call for the continuous evaluation of progress toward achieving
objectives by, among other things, systematically utilizing incoming
information to re-evaluate the extent to which objectives are being
attained or are attainable, and to modify the use of policy instruments
as needed.

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- 3 -

key variables in the monetary policy decision process.

Optimal control

analysis, on the other hand, focusses on ultimate variables such as the
rate of growth of real output, the rate of price change and unemployment.
Nevertheless, it need not be inconsistent with optimal control analysis to
use monetary aggregates or other intermediate targets since, under conditions of fundamental uncertainty, it is reasonable to shift the focus
from ultimate to more knowable and controllable variables.

As evidence

and research deepen our understanding of economic behavior, optimal
control analysis holds forth the promise of a systematic and disciplined
framework in which the monetary aggregates, along with information from
other variables, can be more fruitfully integrated into the analysis.


is not a retrogression to a system of simply "looking at everything."
Some innovations in FOMC procedures in recent years have been
in accord with such an approach.

These changes include the adoption of

longer time horizons for policy evaluation, the consideration of the
meaning and implications of behavior of a sizable number of variables in
policy discussions, revisions of policy decisions (and, therefore, of
the FOMC's so-called intermediate targets) as information and forecasts
change through time, and--although done loosely--the linkage of shortterm and long-term considerations.

It is the conclusion of the Subcommittee

that an optimal control approach provides a conceptual framework which,
while not practically operational in the present state of the art, nontheless; (a) provides valuable qualitative insights into many aspects of the
monetary policy decision-making process, and (b) can serve as a useful
guide to the evolution of improved FOMC procedures.

Efforts should proceed

toward making this conceptual framework more operational, even though it
may require some years to make it directly useful for policy purposes.

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The Subcommittee believes that ultimate FOMC policy interest

lies in real economic activity and the price level.


achieving a consensus on the precise ultimate objectives of monetary
policy remains inherently difficult and probably would be unwise,
partly because of problems in distinguishing among; (a) objectives
that appear practicably attainable given constraints on policy within
the policy horizon; (b) those that would be more desirable but do not
appear to be attainable (though they might in fact develop); and (c)
objectives that are most desirable in some lasting sense (such as price
stability with full employment) but would be attainable, if at all,
only over a much longer horizon than normally considered. In each of
these areas, agreement concerning ultimate objectives would require a
greater degree of certainty concerning the structure and behavior of
the economy than currently exists, particularly concerning the relationships between the operating instruments of monetary policy and ultimate

If, nevertheless, the FOMC did explain its policy decisions

in terms of ultimate objectives rather than in terms of the monetary
aggregates, the System would run the serious risk of becoming the focal
point of political controversy concerning the goals and priorities
chosen in an area surrounded by many unresolved economic and social
questions, and where other public policies may have more influence than
monetary policy in achieving or falling short of some such goals.
Against this background, it appears wise to us to continue
the practice of characterizing monetary policy in terms of intermediate
monetary aggregates rather than ultimate economic objectives.

But we

believe these monetary variables should be interpreted as intended values

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- 5 subject to modification based on Committee reassessmemt of unfolding
economic performance rather than as invariant targets.

That is, if

intentions about future monetary values are not realized by a
significant margin, a reconsideration or recalculation of the policy
strategy should be induced based on new information--including the
observed forecast errors of the intermediate variables.


upon the information that is available, this recalculation might
involve either setting new intended values for the monetary variables
or, alternatively, the adjustment of reserve targets and interest rate
ranges so as to return the monetary variables to the original path.
The FOMC would have to decide the scope and extent of adjustments of
these kinds in the light of all of the information available to it at
the time, enriched by the additional understanding of the meaning of
this information flowing from ongoing research and experience.
This recommended approach seems broadly consistent with the
manner in which the monetary variables are already in fact being used by the

The precise degree of emphasis that ought to be placed on

any particular intermediate monetary variable can properly evolve
through time as experience and research improve our understanding.

monetary variables have key value to the Federal Reserve

(a) they are an important part of the transmission process by

which Federal Reserve actions affect economic performance, and (b) as
variables whose values are much influenced by the Federal Reserve,

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-6their behavior is important to public understanding of the role and
operations of the central bank.

Partly to facilitate such a use of monetary aggregates,

our analysis suggests certain evolutionary changes in staff and FOMC
procedures that can be introduced now in pragmatic steps in harmony
with the above-outlined control principles.

These changes should

improve the usefulness of analyses presented to the FOMC and strengthen
the decision process of the Committee.
(a) The Subcommittee believes that further steps should
be taken by the staff to achieve greater integration
between the longer-run Green Book projections and the
shorter-run Blue Book analyses of financial market

The intent of the changes would be to

improve the analysis made available to the Committee
of the linkage between shorter-term tactics and longerterm strategies.

For example, the quarterly interest

rate and monetary growth patterns underlying the GNP
projections and the longer-run targets for the monetary
aggregates should be stated explicitly.

The relation-

ship and consistency of shorter-run operating instrument
alternatives to these longer-run projections should
also be indicated explicitly.

The Committee need not

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believe, of course, that a particular short-run
operating strategy is uniquely related to a given
longer-run forecast of GNP, but the staff's estimate
of the most likely relationship would clearly assist
(b) The Subcommittee believes the FOMC would benefit
from the presentation of several alternative conditional forecasts of economic performance, based on
alternative assumed ultimate objectives or alternative
possible policy strategies.

Therefore, it is recommen-

ded that the staff be asked to present perhaps three
alternative Green Book and Blue Book forecasts at
each quarterly chart show, or more frequently under
special circumstances.

Because monetary policy

influences some key ultimate variables (e.g. the rate
of change of prices) more slowly than others (e.g.
unemployment), it is also recommended that the staff
be asked to present conditional forecasts over a sufficiently long time horizon to make apparent the major
effects of the different assumptions underlying each

Only a limited number of variables should

be presented for the alternatives to a central conditional
forecast, and the results should be expressed in
terms of differences from this central forecast. Means

Authorized for public release by the FOMC Secretariat on 2/3/2021

have already been developed to make this process

Finally, the Subcommittee recommends

that the staff should be encouraged to develop
and present the ranges of probable forecast
error in these presentations.

Given the conclu-

sion pointed to by staff studies that the greater
the uncertainty, the less aggressive policy actions
should be, this information would assist the Committee
in reaching its decisions.
(c) The more comprehensive economic analyses presented
quarterly (or when special circumstances dictate)
should provide, in the view of the Subcommittee,
the basis for decisions concerning the longer-term
conditional objectives for the monetary aggregates.
Intervening monthly meetings should focus more upon
reviewing performance, analyzing deviations from
expectations and deciding upon which, if any,
specifications should be changed.

Authorized for public release by the FOMC Secretariat on 2/3/2021
-9(d) These proposals should not be construed as limitations on the scope of inquiry of individual members
of the Committee. Of course, members of the FOMC
are not bound by, or limited to, the analyses the
staff presents at Committee meetings.

All members

should be able to obtain, within limitations on
staff time, alternative econometric model simulations
or other analyses designed to answer pertinent
questions of particular interest to individual members.

It would be particularly helpful if the staff

in its presentation would indicate when significantly
different policy implications flow from econometric models
that incorporate alternative views of the structure of
the economy. Each FOMC member can and should voice
disagreements or reservations concerning staff analyses.
With this in mind, the Subcommittee suggests that the staff
also provide summary results of selected outside analyses
and forecasts to the FOMC on a regular basis.

In light of the attention still to be given to the monetary

aggregates as expressed in paragraph 5, the Subcommittee reaffirms the Stage
I recommendation that the FOMC replace RPD with nonborrowed reserves as the
monthly operating target. Although the most recent empirical evidence suggests
that a similar improvement in the target's relations to the aggregates could
be obtained by shifting to the nonborrowed source base, the Subcommittee
continues to believe that the possibility of occasional undue money market
disturbance would be lessened by use of nonborrowed reserves.

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10 -

The possibility of using the Federal funds rate as an operating target was also investigated.

The Subcommittee tentatively rejected

this possibility, partly on the grounds that the relationship of the
funds rate to monetary aggregates or ultimate economic objectives does
not appear to be sufficiently stable outside the estimation periods,
given limited available evidence. More importantly, past experience seems
to suggest that use of a Federal funds rate operating target can lead the
FOMC to be more laggard in its policy changes than if greater emphasis
is placed on reserve and monetary aggregate movements.

Studies completed for the Subcommittee of the question

of the choice of the operating target among various possible reserve and
money market measures indicate that the particular choice made is not
of very great significance, provided that once the choice is made the
possible alternatives--for example, the funds rate--are used as information variables.

In the current stage of development, however, we are unable

to extract information systematically from short-run Federal funds rate
movements with enough precision or enough certainty to aid in determining
when changes in the reserve target are called for.

In addition, members

of the Subcommittee believe qualitatively that substantial variability of
short-term interest rates entails market costs that could, at times, be
advantageously constrained, even though it has not yet been able to develop
quantitative verification and assessment of these costs relative to the
benefits of closer control of reserves.

Other Committee members may not

agree that there are significant costs associated with market interest rate

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- 11 fluctuations.

Even so, the Subcommittee believes the latter would agree

that monetary policy procedural transitions should be effected gradually
and smoothly.

Based on these considerations, the Subcommittee concludes

that the Federal funds rate constraint should continue to be a part of the
Directive, but that its role should be more that of an information variable
that would trigger consideration of the possibility of changing either the
operating reserve target or the Federal funds rate range whenever the
constraint was reached.
Meanwhile, it is recommended that the staff continue to try
to pin down the costs of short-run interest rate variability that are
believed to be significant in order that the necessary cost-benefit
assessments might be made. The importance of resolving this issue stems
from the fact that too narrow a Federal funds rate constraint, in a world
of uncertainty concerning the relationships between reserves, the funds
rate, the monetary aggregates and economic performance, is likely to
translate into avoidable errors in achieving NBR targets, intermediate
monetary aggregate

intentions and desired ultimate objectives.

The Subcommittee believes the conclusion that greater uncertainty
should lead to smaller policy changes corresponds to the intuition of the
Committee members and is reflected in FOMC decisions. But small changes
in a reserve operating target imply greater variation in the Federal funds
rate in response to short-run fluctuations in financial market relationships.

It is the judgment of the Subcommittee that we are, in fact, quite

uncertain about short-term financial market relationships.


and in accordance with the discussion in paragraph (7), it is recommended
that the Federal funds rate range ordinarily be specified at 2 percentage

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- 12 points.

In addition, it is recommended that the full amount of allowable

change be used where necessary to achieve the monthly average target level of
nonborrowed reserves.

Changes during the inter-meeting period should,

of course, be effected on an orderly basis.

Recent practice indicates

that changes of about 1/4 of a percentage point per week in either direction would ordinarily meet this criterion.

As experience is gained over

time, it seems reasonable to expect that the maximum weekly change in the
average funds rate and in the range should be gradually widened,particularly
if and when the size and duration of deviations of NBR from its target path
grow large.

The Stage I recommendation that the Manager be instructed to

consult with the Chairman whenever it becomes apparent that the reserves target
cannot be achieved within the specified limit on Federal funds rate movements is reaffirmed.

This information, along with other relevant information

from the behavior of other variables, could then be used to decide whether
Committee action would be desirable or necessary to change the reserve target
or the limit on the Federal funds rate.

To assist the FOMC in appraising these findings, the

Subcommittee plans at some point to ask a panel of knowledgable outside
economists to review and comment on

the current stage of the Subcommittee's

investigations as well as appropriate supporting staff papers.

The presenta-

tion of these materials would be accompanied by suitable qualifications to
insure that they are understood to contain suggestions as to further
evolutionary changes in policy procedures that require additional

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- 13 empirical work and adjustment based on experience.

Suggestions concern-

ing the best way to proceed in answering the empirical questions raised
in the process of the Subcommittee's inquiry will also be solicited from
the panel.

A summary of the comments, criticisms and suggestions of

these economists will be submitted to the FOMC.

After meeting with the panel of outside economists, the

Subcommittee plans to continue working with the staff on the empirical
work outlined above.

In addition, work will begin on its Stage III

studies, which will consider possible regulatory and institutional
changes that might produce a more effective execution of monetary policy.