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CONFIDENTIAL (FR)
September 29,
To:
Federal Open Market Committee
From:
Messrs. Ellis, Mitchell and Swan
Subject:
19 6 4
Comments on criticisms
of our proposal for the
directive
At the Committee's request we advanced certain specific proposals
for the form and content of the current economic policy directive in a
memorandum dated June 16, 1964.
These proposals were discussed at the meet-
ing held on July 28 and are scheduled for further discussion at the meeting
on September 29,
The purpose of this memorandum is to comment on the main
criticisms of our proposals that were made in the course of the July 28
discussion.
The criticisms are considered below in three groups:
those
relating to the proposal as a whole, those specific to elements 1 and 2,
and those specific to elements 3 and 4.
For convenience, the outline of
the discussion is given below.
I.
Criticisms of proposal as a whole.
A.
The proposal offers no advantages to the formulation of
monetary policy.
B,
The proposal would impose an undue burden on the Committee
and staff.
C. The proposal would involve an undesirable shift of responsibility from Committee to staff.
D.
The proposal is premature; more research is needed before it
would be practical.
E. There are dangers in explicating the Committee's analysis in
the manner proposed.
II.
Criticism of elements 1 and 2.
Material of this type is more appropriately included in the
policy record entry, as at present, than in the directive.
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-2III.
Criticisms of elements 3 and 4.
A.
It is undesirable to specify policy intent and operating
targets in terms of any single measures, for various reasons
(even in the absence of quantification).
B.
It is undesirable to specify policy intent and operating
targets in terms of the particular measures recommended in
the proposal.
C.
It is undesirable to specify policy intent and operating
instructions in numerical terms.
I.
A.
Criticisms of proposal as a whole.
The proposal offers no advantages to the formulation of
monetary policy.
Comment:
Essentially, the Committee's task at each meeting is to reach
agreement on three questions:
(1) the nature and interpretation of economic and financial
developments,
(2)
the policy objectives to be pursued in light of developments,
and
(3) the instructions to be issued to the Desk for the next three
weeks in light of policy objectives.
This task is not easy because the issues are complex, and it
is made more difficult by the uncertainties attaching to facts and analysis
as well as by the inevitable differences of view in a group as large as
the Committee.
We believe that there would be real gains for policy if, as we
recommended, the staff prepared and the Committee deliberated language
dealing specifically and in logically structured fashion with the three
essential questions facing the Committee at each meeting -- proceeding
from developments to policy to instructions.
First, this process would
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3make any weaknesses or inconsistencies in analysis more apparent, and hence
more readily remediable.
Secondly
the Committee would consider language
that was sufficiently clear and detailed to cover the questions at issue
adequately.
Nominal agreement may be possible when language is sufficiently
cryptic, vague, and ambiguous to be susceptible to different interpretations
or to no consistent interpretation at all.
But meaningful agreement can be
reached only on the basis of specific language.
B.
The proposal would impose an undue burden on the Committee
and staff. With a directive of this length and complexity,
an undue amount of staff time would be required in advance
of meetings to prepare draft material for Committee consideration, and an undue amount of Committee time would be
required at meetings in deliberating on the specific language to be adopted.
Comment:
The procedure recommended would be more burdensome for the
Committee and staff than the present procedure.
But we believe it would
be more efficient, mainly because the product--in terms of the quality
of monetary policy decisions--could be progressively improved.
Further-
more, in our judgment, it also would lead to a more effective use both
of staff resources and the Comittee's own time at meetings.
The function of the staff is to provide information and technical
assistance to the Committee in
reaching conclusions on the nature and
interpretation of developments, on policy, and on operating instructions--
that is, on the three essential questions.
To ask the staff to prepare
draft materials for a directive of the proposed type is, in effect, to
ask it to supplement all of the detailed facts, interpretations, and
judgments it provides to the Committee with a formal synthesis organized
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under these headings.
Since this synthesis would follow the sequence and
logical structure of the matters to be decided, its preparation would be
as important a service to the Committee as any the staff could perform,
If the task seems unduly burdensome to a staff of present size and respon-
sibilities, it clearly would be desirable to reorganize staff assignments
in
view of the overriding importance of this service to the Committee,
We also think that the Committee's deliberations would be more
efficient under the proposed procedure than at present.
Each member
would have before him draft language that was sufficiently clear and
detailed to focus the three essential questions sharply, and he would
be able to identify precisely his points of agreement and disagreement-not only with respect to the proposed language but also with respect to
the conclusions expressed by other members.
At present deliberations
are handicapped by the lack of such a focus for discussion; there
inevitably is some uncertainty with regard to the frames of reference
within which individual members make their remarks and the nature of
unexpressed assumptions.
meetings,
The tenor of discussions at the last few FOMC
as members tried to agree on language communicating the kind of
subtle shifts desired,
demonstrates graphically the need to move toward
more explicit statements of assumptions and desired results in
order to
make policy intentions clear.
If the proposal appears complex it
job is
it
can,
complex.
is only because the Committee's
The Committee has an obligation to do its
job as well as
and an interest--particularly because of the complexity of its
task--in doing it as efficiently as possible.
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C.
Because the Committee is unable td edit a long and complex
document around the table, there would be a tendency to
adopt language proposed by staff without substantive change.
This would amount to an undesirable shift in responsibility
for policy formulation from the Committee to the staff.
Comment:
The Committee always has recognized the need for staff assistance
in connection with information, analysis, and drafting; and it also always
has recognized that responsibility for policy decisions rests on itself
alone.
The proposal calls for staff assistance of a particular but wholly
conventional type.
We believe it is safe to presume that the Committee
would not abdicate its responsibility under the proposal procedure.
In
fact, with the draft directive making explicit the analytical judgments
and expected results, the Committee should find it easier to recognize
and alter any expressions that are at odds with its wishes.
This would
represent a greater degree of Committee control than results under the
present directive, which often has been attacked as being so vague as to
imply abdication of an important degree of Committee responsibility to
its operating staff, most particularly to the Manager.
D.
The proposal is premature; more research is needed before
it would be practical.
Comment:
We agree that continuing and much more intensive research is
essential to improve the basis for the formulation of monetary policy.
At the same time, the Committee must make policy decisions now; and in
our judgment the Committee is not making the best decisions of which it
is capable because:
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(1) it often does not come to grips with either the known or
unknown consequences of its decisions, and
(2) it does not make its decisions on policy and instructions in
clear, complete, and consistent terms.
Because of the lack of knowledge of linkages and market psychology
the decisions may not always be good; but they will be better if maximum
use is made of what is known now..
E.
There are dangers in explicating the Committee's analysis
in the manner proposed, Publication of the Committee's
successive directives in the Board's annual report would
expose the facts the Committee considered most relevant,
the analysis employed, and the specific policy objectives
sought. Detailed explication of these matters would
invite criticism not only of the end product of the Com-
mittee's actions but also of its underlying reasoning.
In effect, it would remove the opportunity for the Committee "to be right for the wrong reasons."
Comment:
Any additional criticism that might result from following the
proposed procedure would depend on how astute the Committee was in its
analysis and how well it understood the power of and limitations on its
specific use of monetary tools,
Surely as a public body it should not
try to cover up its areas of uncertainty by silence.
Moreover, some
serious criticisms to which the Committee is now exposed would be overcome:
that the directives are not intelligible to the informed observer,
and that they do not transmit clear and consistent instructions to the
Manager, thus giving him more freedom than warranted to make policy.
Finally, much present criticism is not constructive simply because the
Committee has not made clear how it formulates the problems facing it
and how it reasons in arriving at conclusions.
The more clearly the
Committee exposes its thinking the more likely that criticism, internal
and external, would be helpful to the Committee.
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-7II,
Criticisms of elements 1 and 2
The main purpose of elements 1 and 2 evidently is to inform
the public better, and the directive is not the appropriate
instrument for that purpose. The proposed substance of these
elements closely resembles that of the opening part of the
policy record entries, and is more appropriately part of the
entries, as at present, than of the directive. It is better
to have such material drafted after the meeting so that it
can reflect discussion at the meeting. Members now have an
opportunity to comment on drafts.
Comment:
The intended purpose of elements 1 and 2 evidently was not made
wholly clear in the June 16 memorandum, and this criticism reflects an
understandable misconception.
The main purpose was not to inform the
public better--although that end would be served incidentally--but to
sharpen the Committee's focus at meetings on the question of its assessment of economic and financial developments, with the expectation that
this would lead to better policy decisions.
A policy record entry pre-
pared after the meeting obviously offers no advantages to the policy
discussion itself.
On the other hand, since the directive would be
incorporated in the policy record entry, elements 1 and 2 could serve
as a substitute for the equivalent material now included in the entry.
It can be argued that it is appropriate to include these
elements in the directive for logical completeness, since they would
set forth the key facts and analysis underlying the Committee's policy
intent and instructions, as described in succeeding elements.. The sub-
stance of elements 1 and 2 can be considered as an expanded and more
analytical version of the statements in the first paragraphs of directives
of the present type listing the factors that "this policy takes into
account."
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On the other hand, for the intended purpose it is not essential
that these elements be included in the directive; what is important is that
the Committee consider, and adopt by formal vote, language describing rele-
vant developments and its interpretation of them.
Such language might be
separated from the directive itself--which would then consist of the statements of policy intent and instructions directly pertinent to the Desk's
operations--and recorded in the minutes and policy record entry as "the
Committee's consensus on economic and financial conditions."
Any dissents
from the language approved by the majority--which might or might not be
associated with dissents on elements 3 and 4--could be noted and explained.
Whatever the mechanics adopted, the Committee should have before it at
each meeting a draft statement on the economic and financial situation to
serve as a focal point for discussion and debate.
One final comment may be in order.
The policy record entries are
prepared in accordance with Section 10 (10) of the Federal Reserve Act,
which reads in part, "The Doard of Governors . . . shall keep a complete
record of the action taken by the . . . Federal Open Market Committee upon
all questions of policy relating to open-market operations and shall record
therein the votes taken in connection with open-market operations and the
reasons underlying the action of the . . . Committee in each instance."
In
short, while all members of the Committee and all Reserve Bank Presidents
not currently serving have an opportunity to comment on drafts of the policy
record entries, these entries are official documents of the Board, and final
decisions on their language accordingly are taken by the Board rather than by
the Committee.
Under the terms of the Act, the Committee can issue and cause
to be published its own official assessment of economic and financial condi-
tions by formally voting on such language in connection with the determination
of open market policies.
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III.
A.
Criticisms of elements 3 and
It is undesirable to focus on any single measure for
specifying the Committee's policy intent (even if not
stated in numerical form) or on any measure more specific
than "money market conditions" for operating target
purposes, for a number of reasons.
(1)
These include:
The relevant linkages are too complex and changeable,
and are not adequately understood
Comment:
The overriding consideration is that the Committee must and
now does reach conclusions on policy and operating targets, however
complex, changeable, and uncertain the linkages.
Moreover, in the two
paragraphs of the present directives it now specifies its policy intentions and targets ("It is the . . . Committee's policy to accommodate
moderate growth in the reserve base, bank credit, and the money supply. ..
".
. operations shall be conducted with a view to maintaining about
the same conditions in the money market . . . while accommodating moderate
expansion in bank reserves").
By using three measures in the first para-
graph and two in the second (of which one--reserves--is included in both
for reasons that are not wholly clear) the Committee does, indeed, avoid
focusing on single measures.
But this is only at the cost of ambiguity
and potential inconsistency within each paragr
h and between the two,
The main purpose of the proposals for elements 3 and
4 was
to enable the
Committee to deliberate, and reach judgments on, policy intent and operating instructions in
a more efficient manner.
We believe that the Committee
should acknowledge the fact that it cannot necessarily achieve all desired
objective
s
simultaneously,
choices often confronting it.
and that it
should face up to the hard
"
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-10-
(2)
It is probable that a measure which is appropriate at one
time may be found inappropriate at another.
Comment:
There is no need for the Committee ever to feel "frozen in" by
the fact that it has selected certain variables for citation in previous
directives.
Circumstances change,
experience accumulates, knowledge
grows, and the composition of the Committee is modified over time.
At
each meeting the Committee can formulate its statements of policy intent
and operating targets in the manner which seems most appropriate to it
then.
It can choose to use a different variable on a continuing basis
if its judgment so dictates; or it can modify the statements of intent
and targets for a short interval if special temporary circumstances make
the usual types of statements inappropriate.
(3) It is probable that the selection of a few measures would
invite criticisms for "misses" that are not necessarily
significant in light of movements of other, unmentioned,
measures.
Comment:
The Committee is exposed to criticism of potentially greater
severity under present procedures than any that seem likely to eventuate
under the proposed procedure.
In particular, it can be criticized for
apparently failing to recognize that its various stated policy intentions
and targets may be inconsistent (which would suggest that its knowledge
of linkages is poorer than is in fact the case); and for "missing" the
stated objectives of moderate growth in particular variables during
periods when growth is not moderate by any standard.
since
Moreover,
the controlling statement has in practice turned out to be
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that relating to money market conditions, the Committee can be criticized
for specifying pious hopes without operational significance (relating to
reserves, credit, and the money supply) in its official directive.
(4)
Manager must consider more variables, in more complex
interrelations, than it would be feasible to spell out in
a statement of instructions; and an attempt to be more
specific would result in undesirable constraints on operations.
The
Comment:
While the Manager (properly) considers diverse variables in
making his day-to-day decisions, and while these variables can indeed
occur in different combinations, it does rot necessarily follow that
the Committee is incapable of giving the Manager more specific instructions without having deleterious effects on his operations.
As has been
noted in various discussions on this subject, in the course of deliberations
individual members often mention targets formulated in terms of specific
variables, and the Manager takes account of such comments in his operations.
However, as long as (1) the Committee as a whole does not vote on such
instructions, (2) not all members make such comments, and (3) different
members mention different sets of variables, the Committee simply is not
making its intentions as clear as it might, and the Manager cannot be
held as closely accountable for his operations as would be desirable.
The structure proposed for element 4, involving a "first"
instruction qualified by a number of "subsidiary" instructions (possibly
including one relating to "money market conditions"), would seem to allow
for as much scope and flexibility for formulating instructions as is
likely to be required under almost any circumstances.
Under this structure
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-12-
the Committee could give the Manager whatever degree of discretion it
believes appropriate.
At the same time, any specific instructions it
chooses to give would be transmitted formally, within the directive, by
vote of the full Committee.
The Committee as a whole is
accountable for
the Manager's operations, and the orderly procedure is for the Committee
as a whole, rather than individual members speaking for themselves, to
instruct the Manager.
B.
It is undesirable to focus on the particular measures
recommended for specifying the Committee's policy intent
and operating instructions.
(1)
In particular, it is not desirable to single out reserves
required to support private demand deposits as the principal variable for expressing the Committee's policy
intent. To do so is to commit the Committee to an overly
simple and monolithic view of the mechanism through which
policy influences nonfinancial developments. It also
slides over such questions as the appropriate interpretation
of changes in time deposits and in Government deposits,
Comment:
The proposed directive was drafted specifically to avoid a
commitment to any particular theory of monetary causation.
Both the
views of those who feel the impact of policy runs from reserves to the
money supply to economic activity, and the views of those who feel it
runs from reserves to bank credit to credit conditions to economic
activity, are accommodated within the framework of element 3.
Whatever one's analytic preference, there can be no argument
with the proposition that the System's policy is effectuated by changes
in the reserves made available to the banking system.
influence
Such changes
both the money supply and the banking system's contributions
to total credit flows.
The common element in both theoretical structures
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is
bank reserves.
In the very short run, the System's
own direct participa-
tion in financial markets can be a criti cal element in the supply of and
demand for specific financial instruments and,
of course,
expectational
effects engendered by System operations have influence in all credit markets.
However, the full and longer lasting impact of policy is through
changes in bank reserves resulting from open market operations.
Reserves, in turn, are but one stage in the linkage that extends
to more ultimate financial objectives such as money supply, bank credit, and
general credit conditions.
(The structure of element 3 in the "trial run"
directives distributed before the August 18 and September 8 meetings was
modified to emphasize this "means vs. ends" relationship somewhat more
than did the illustrative directive attached to the June 16 memorandum.)
Since statements on these subjects also are included, no analytical commitment is implied by the proposed use of reserves for specifying policy intent
Nor is any commitment implied by the reference in element 3 to
private demand deposits; statements on currency in circulation and time and
Government deposits are called for as well.
All that the proposed directive
asks of those who prefer a money supply line of causation is that they be
willing to specify the desired rate of expansion in each category of bank
deposits and of currency.
For those who prefer analytically the asset side
of the ledger, the sum of the reserve growth specified for each type of bank
liability determines the growth in total bank credit, enabling proponents of
this point of view to compensate for those changes in bank credit which
reflect diversions of credit flows from other instruments into time and savings deposits at commercial banks, thereby focusing on the expansion of bank
credit attributable primarily to expansionary or contractive monetary policy,
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-14We cannot avoid the fact that reserves are related by law to
deposits rather than to some asset or group of assets--and that net
reserve availability is therefore affected by changes in the Treasury
balance,
shifts of funds between time deposits and other liquid claims,
and the absorption or release of reserves by the currency component of
the money supply.
The purpose, and advantage, of the approach suggested
for element 3 is that it provides for the systematic treatment of the
behavior of these various aspects of reserve utilization.
(2) In the present state of knowledge it would be premature
to attempt to specify expectations regarding the credit
conditions that would be associated with a particular
policy on reserves, as called for in the second part of
element 3.
Comment:
Whether it is considered important to include a statement of
expectations with regard to credit conditions would depend in
part on
whether one believes that such conditions are a key link in the chain
of causation from reserves to economic developments.
The purpose of
including a statement on credit conditions as well as on reserves in
element 3 was to accommodate those who held this view.
And the state-
ments were organized (one as an expression of intent, the other as an
expectation) so that they would not be potentially inconsistent, ex ante,
even though the expectation might well be disappointed.
To those who consider credit conditions to be a key variable
in the causal chain, the fact that the relations between reserve changes
and credit conditions are uncertain at any time is troublesome primarily
because it makes uncertain the appropriate reserve policy.
But if those
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who prefer this approach are to reach any conclusions on reserve policy
now, they must be prepared to exercise judgment now regarding the probable
relations in a particular period.
The problem of uncertainty, of course,
is not unique to this question; it affects the Committee's operations no
matter what methods of analysis are used or what directive procedures are
followed.
Not only are judgments on uncertain issues likely to be better
when the problems are faced directly, but progress in reducing the range
of uncertainty also is apt to be made more rapidly.
(3) It is not desirable to focus on free reserves in the first
instruction of element 4 because (a) it would reinforce
the position of those who exaggerate the importance of
free reserves in monetary policy formulation, and it would
give free reserves even more weight than many critics
believe they have; and (b) free reserves are not an
effective means of operational control.
Comment:
It is by no means clear that the use of free reserves in the
proposed manner would reinforce criticism of the sort the Committee has
experienced in the past.
Much of this criticism was directed to the
assumption imputed to the Committee that a particular level of free
reserves always had the same implications for the economy.
Under the
proposed procedure the Committee probably would be adjusting the level
of free reserves at frequent intervals in the effort to stay on course
with respect to its longer run policy objectives, and this is a logically
respectable undertaking.
Indeed, by increasing the frequency of changes
in the general level of free reserves, and by making it clear that the
Committee considered the free reserve measure useful primarily for shortrun operating target purposes, the proposed procedure might finally lay
this issue to rest.
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-16Whether free reserves are an effective operating variable
ultimately is an empirical question, but an excellent a priori case
can be made that they are.
If the Committee's judgment is that some
better variable is at hand now it should be used instead.
(4) The subsidiary instruction relating to bill rates is
undesirable because (a) knowledge by the market that
the Committee was setting limits to such rates would
have a rigidifying effect, and (b) it would be preferable to authorize the Manager to exercise judgment,
not reacting to rate movements that seem to him
clearly temporary, and reacting gradually to other
movements
rather than abruptly when certain limits
are reached.
Comment:
This subsidiary instruction was proposed on the grounds that
the Committee currently had an interest in limiting the range of bill
rate fluctuations, among other reasons in order to minimize short-term
capital outflows.
If the Committee would prefer to have the Manager make
gradual adjustments as the rate approached a limit, it could so instruct
him.
(The language used might follow that of alternative 6 (d) on page 3
of the a pendix to the Secretariat's memorandum of April 8, which called
for operations to "moderate any tendency of the rate of three-month
Treasury bills to approach the limits of the range _
to
_
per cent.")
Similarly, appropriate instructions could be framed if the Committee wanted
the Manager to avoid reacting to rate movements he deemed temporary.
(However, at the meeting of March 3, 1964, the Manager indicated that it
would be difficult to implement such an instruction.
of the minutes for that meeting.)
See pages 79-80
In any case, if the Committee wants
the Manager to modify his operations in the event of certain bill rate
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-17developments,
we believe (to repeat) that the Committee as a whole should
decide on the appropriate instructions, and should include them in the
directive.
As to whether knowledge by the market that the Committee had
issued such instructions would have a rigidifying effect, it might be
noted that instructing the Manager to moderate outsize bill rate
fluctuations is not the same thing as setting a specific bill rate target.
The limits would become relevant only if and when the market rate approached
them, and there would be room for fluctuation between the limits of any
amplitude the Committee might choose.
This would leave a considerable
amount of uncertainty as to the duration of any particular rate level,
and would keep alive and active the private market's trading functions.
Secondly, if the Committee believes that, say, the bill rate should not
fall below 3.50 per cent for an extended period for balance of payments
reasons, and the market should infer such a limit from the operations of
the Desk, then that discovery would itself probably give rise to private
expectational responses that would help to moderate any decline of the
rate below the level the Committee desires.
C.
It is not desirable to specify policy intent and operating
instructions in specific, numerical terms.
(1) In particular, it is undesirable to specify policy intent
in quantitative terms because it would be difficult to
determine the appropriate numerical target in the present
state of knowledge,
Comment:
Quantitative statements have a great advantage over purely
verbal statements:
of accuracy in communication, among Committee members
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-18in their deliberations, between the Committee and the Account Manager,
and between the Committee and the public.
That it may be difficult to
determine the "appropriate" quantity does not gainsay the fact that some
quantity will emerge from operations conducted on the Committee's behalf;
the only question is whether the outcome is to be determined by chance
or by the Committee.
If the statement of policy intent relates to the
measure or measures with which the Committee is primarily concerned,
there is nothing to be gained by leaving the outcome to chance.
(2)
It is undesirable to specify a numerical operating target
in terms of a range of free reserves, even if the instruction is qualified, because:
(a) If the range was narrow enough to be meaningful, the
Manager probably often would be unable to meet it because
of errors in his data and projections. A high frequency
of misses would imply that the Committee lacks control
over the operations of the Desk, and might lead to much
capricious and uninformed criticism of the Committee.
(b) Because of errors in data and shifts in reserve distribution,
different indications often may be given by current free
reserve estimates and by other indicators of money market
conditions.
Pursuit of a free reserve target may therefore
result in operations that are contrary to the current
market tone, and in wider short-run swings in money market
conditions. It may also require operations that are
larger and more frequent than at present. System actions
would appear arbitrary and capricious to the market, tending to undermine the continuity of market atmosphere.
Comment:
A number of means could be used to ameliorate certain of these
problems, and others could be found by experimentation.
One approach
would be through administrative changes, such as improving the current
reporting of reserve factors (which would reduce the size of misses) and
authorizing the Manager to enter into reverse repurchase agreements
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(which would allow the Manager to adjust the free reserve statistics and
the tone and feel of the market more precisely in
the closing days of the
reserve weeks).
the form of the instruc-
tions in
Another would involve changes in
element 4, such as specifying a central value rather than a range
of free reserves (with the understanding,
ade clear in
the record,
that
precise performance could not be expected) and specifying that the instruction applied to the central tendency
over a three-week period and not
separately to values for individual days or weeks.
A more quantitative wording
of instructions does not necessarily
mean more slavish attention to reserve statistics, in ignorance of other,
quite quantifiable,
indicators of the tone and feel of the market, or
even of credit conditions more broadly viewed.
The Manager can be directed
to pay as much or as little attention to reserve statistics at any
particular time as the Committee may wish.
But generally, we believe that
whatever the policy intent of the Committee, a more specific and quantitative instruction,
appropriately qualified, would be clearer than the kind
of instruction issued at present, and therefore preferable.
Time and again
the Manager has indicated that he has a quantitative interpretation of tone
and feel instructions, and it
specified by the Committee.
is important for the record that these be
In general, we believe that the Committee is
capable of overcoming any difficulties of the kinds discussed above.
@FedFRASER