Full text of Review (Federal Reserve Bank of St. Louis) : February 1987

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Review ____
Vol. 69, No. 2

February 1987

5 T h e D ollar’s Effective E xch an ge Rate:
A ssessing the Im p act o f Alternative
Weighting S ch e m e s
15 The FOMC in 1986: Flexible Policy for
U n certain T im es

T he Review is p u b lis h e d 10 tim es p e r y e a r by the R esea rch an d P ublic In form ation D epartm en t o f the
F e d e ra l R eserv e B ank o f St. Louis. S in gle-copy su bscrip tion s a r e available to th e p u b lic f r e e o f ch arg e.
M ail req u es ts f o r su bscrip tion s, b a c k issues, o r a d d ress ch a n g es to: R esea rch an d P ublic In form ation
D epartm ent, F e d e r a l R eserv e B ank o f St. Louis, P.O. Box 442, St. Louis, M issouri 63166.
T he views e x p r e s s e d a r e th o se o f the individual au th ors an d d o not n ecessarily r e fle c t official
p osition s o f th e F e d e r a l R eserv e B ank o f St. Louis o r the F ed era l R eserv e System . A rticles h erein m ay b e
rep rin ted p r o v id ed th e s o u r c e is cred ited . P lease p rov id e the B an k’s R esea rch an d P ublic In form ation
D epartm ent with a co p y o f rep rin ted m aterial.

F ed eral R eserve Bank of St. Louis
R eview

February 1987

In This Issue . . .

Effective exchange rate indexes are widely used in econom ic analysis, policy
evaluation and financial planning and forecasting. Because these indexes are
weighted averages of a num ber of exchange rates, their use avoids mistaken
generalizations about the dollar's value that might arise by looking at fluctuations
in a single exchange rate. Their value is generally conceded to depend on both the
currencies included and the structure of the weighting schem e.
In the first article of this Review, “The Dollar’s Effective Exchange Rate: Assess
ing the Im pact of Alternative Weighting Schem es," Mack Ott com pares the effect
of varying the weighting schem e in an effective exchange rate of the dollar against
the 10 leading industrial econom y currencies. Ott finds that several alternatively
weighted effective exchange rates using the same 1 0 currencies yield closely
sim ilar results w hen used in an export equation. This somewhat surprising
outcom e implies that the relative im portance of the weighting schem es used to
derive effective exchange rate indexes needs to be more thoroughly investigated.

In the second article, Philip A. Nuetzel reviews the deliberations and m onetaiy
policy decisions of the Federal Open Market Committee (FOMC) last year. In "The
FOMC in 1986: Flexible Policy for Uncertain Tim es,” Nuetzel discusses the factors
that led the FOMC to take an accommodative policy stance.
To illustrate the FOMC’s approach to policy in 1986, Nuetzel first reviews its
long-run policy decisions for the year. This is followed by a more detailed
exam ination of the FOMC's reasons for reducing its em phasis on M l in guiding
policy, and a discussion of other variables used by the FOMC as policy guides.
Finally, the FOMC’s short-run policy decisions are reviewed chronologically, each
in the context of the prevailing econom ic clim ate in w hich it was made.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

The Dollar’s Effective Exchange
Rate: Assessing the Im pact of
Alternative Weighting Schem es
M ack Ott

M,r

\NY analysts of international econom ics m ain
tain that a multilateral weighted exchange rate is more
useful than any single bilateral exchange rate in as
sessing the value or changes in the value of the dollar .1
A multilateral or effective exchange rate (EER), which
com prises many exchange rates, avoids mistaken gen
eralizations that can result from changes peculiar to a
single currency. Moreover, the EER reflects thirdcountry im pacts on the dollar’s exchange value, which
are excluded in a bilateral exchange rate.
The construction of an EER entails two analytic
problems. First, w hich currencies should be in
cluded? Second, how should the included currencies
be weighted? These issues appear to be inextricably
related, so that the correct choice for one issue would
seem always to be conditional on the correct choice
for the other. Yet, some insights about the relative
im portance of the choice of weights can be obtained
by examining the effects of changing the weights for a
given set of exchange rates.
This article exam ines the weighting issue using the
Federal Reserve Board’s Trade-W eighted Exchange
Rate (TVVEX). In particular, EERs constructed with
trade weights, capital-flow weights and equal ("naive”)
weights are com pared in terms of their explanatory

Mack Ott is a senior economist at the Federal Reserve Bank of St.
Louis. James C. Poletti provided research assistance.
'See Black (1976), Hooper and Morton (1978), Maciejewski (1983),
Dutton and Grennes (1985), Belongia (1986), Cox (1986) and
Rosensweig (1986).

power and out-of-sample forecasts in a trade equa
tion.

THE USE O F EFFECTIVE EXCHANGE
RATES
The usefulness of an EER can be illustrated by
asking w hether the dollar has strengthened or weak
ened during some interval .2As chart 1 shows, the value
of the dollar has appreciated against som e currencies
and depreciated against others since 1973. For exam
ple, the dollar has appreciated against the Canadian
dollar and sterling, is about the sam e in 1986 as it was
in 1973 against the DM, and has depreciated vis-a-vis
the yen and Swiss franc. W ithin this 13-year span,
most currencies have exhibited similar relative pat
terns against the dollar, peaking in 1980 and bottom
ing out in 1985. In contrast, the yen, Canadian dollar,
Swiss franc and sterling each have had substantial
departures from the com m on patterns. The Swiss
currency has been notable for its consistently strong
dollar value — the dollar buying roughly half the
num ber Swiss francs in 1986 that it could in 1973.
Moreover, as chart 2 shows, adjusting these bilateral
exchange rates for different rates of inflation between
the United States and the respective countries yield
2For expository purposes, therefore, we will use levels of the constit
uent exchange rates in illustrating and explaining EERs. For many
analytical applications, levels of the EER are less useful than their
changes; consequently, the remainder of the article will focus on
changes in the variously defined EERs.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 1

N o m in a l Dollar Exchange Rates for G -7 Countries an d S w itzerlan d
Perc e n t

sim ilar patterns. The dollar’s real exchange rates
against these currencies (adjusted by consum er price
indexes) also dem onstrate disparate assessm ents of
the change in the dollar’s value during this period.
Still, m ost analysts believe that the dollar appreci
ated during 1973-86. Such an assessm ent m ust be
based on som e type of weighting schem e — that is, an
average of the curren cies’ exchange rates is implicitly
evaluated. The use of EERs is simply an explicit forma
lization of this principle.

CONSTRUCTING AN E E R : SOME
GENERAL ISSUES
In order to construct an EER, several questions
m ust be answered: W hich currencies should be in
cluded? What m easure of international com m erce

P ercent

should be used to weight these currencies ? 3 Should
the weights be based on bilateral or multilateral ex
change? Should the weights be arithm etic or geom et
ric? What time period should be used for the weights?
It has been com m only argued that the answers to each
of these questions depends upon the purpose of the
analysis — that is, the use to w hich the EER will be
applied .4

Which C urrencies?
This choice generally has been governed by a com
promise between com pleteness of the set of trading
3
With the exception of the IMF’s Multilateral Effective Exchange Rate
(MERM), which has weights generated from the solution of a trade
model, all major EERs are trade-weighted.
"See Hooper and Morton (1978), Belongia (1986) and Rosensweig
(1986).

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

C hart 2

Real Dollar Exchange Rates for G - 7 Countries and Switzerland
Percent

Percent
1973=100
175

1973=100
175

A n n u a l D ata

Germa ny
//

150

/ /X .
A

Cana da
/
/>

jnce

100
^

\\
\\
iL \ \\
\ \

125

Italy

150

\ \

\\
\\

125

100

Japan

Switze rland
\

U.K.
50

50
1973

partners and data availability. Most indexes use the
principal industrial econom ies' currencies. The Inter
national Monetary Fund’s (IMF’s) Multilateral Effective
Exchange Rate (MERM) covers 21 countries, Morgan
Guaranty Trust of New York uses 15 industrial cou n
tries’ currencies and the Federal Reserve Board's
TWEX, the best known example of such an index, is
based on the Group of 1 0 countries plus Sw itzerland .5
The currencies in TWEX are used both because of the
availability of data and because these countries ac
count for m ost international trading activity. More
over, the 10 U.S. trading partners in the G-10 countries
plus Switzerland also account for m ost U.S. foreign
trade. For example, in 1973, these countries accounted
for 60.1 percent of U.S. exports plus im ports; including
the United States, these 11 countries accounted for
5
See Belongia (1986) for a fuller discussion of these indexes and
their characteristics. In contrast, Cox (1986) has recently formulated
an index covering all 131 of the U.S. trading partners.

1986

67.2 percent of world exports plus imports. In 1983,
these proportions fell to 52.5 and 53.8 percent, respec
tively; then rose to 58.5 and 62.4 percent in 1985.

What M easure o f C om m erce?
Except for the IMF’s MERM, all existing EERs are
weighted by some m easure of traded goods and ser
vices, the sum of exports plus im ports .6 Yet, either
capital flows or trade flows — that is, either side of the
balance of payments statistics — would seem to be
reasonable bases for weighting exchange rates. As
Hooper and Morton observe,
The total supply of and dem and for dollars on foreign
exchange markets derive from U.S. dem ands for for
eign goods and fo reign currency-denom inated finan
cial assets and foreign dem ands for U.S. goods and
dollar denom inated financial assets. . . . An excess sup-

6See Dutton and Grennes (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

ply of dollars resulting from a decline in dem and for
U.S. goods or dollar denom inated assets would tend to
cause a decline in the foreign currency price of the
dollar.7

Thus, using capital flows, m easured as the sum of
dom estic investment flows abroad and foreign invest
m ent flows in the hom e country, provides an alterna
tive approach for weighting each currency’s im por
tance. Consider, briefly, the arguments in favor of
each.
T ra d e flow w eights Trade flow weights for the
EER m easure the direct im pact on incom e (through
net exports) of the foreign sector. Thus, a country
w hose trade share is large is one w hose econom y’s
im pact on U.S. markets is large, while a country with a
sm aller trade share has less impact. The larger this
share, the greater is the competitive im portance of
that country’s producers for U.S. producers. Hence,
the EER should also reflect these relative rankings of
U.S. com petitors’ currencies.
Capital flow w eigh ts Capital flow weights for the
EER scale the currencies by the m agnitude of the
financial flows betw een the respective countries. The
currencies of countries with larger investment and
portfolio flows are m ore im portant com petitors for the
dollar in international transactions than are curren
cies of countries with sm aller investm ent and portfo
lio activity. Unlike trade weights, w hich em phasize an
incom e approach to exchange rate determination,
capital flow weights em phasize a financial approach
to the dollar’s valuation .8 An EER using capital flow
weights will reflect these financial market consider-

7Hooper and Morton (1978), p. 784; italics added.

FEBRUARY 1987

ations and the relative im portance of the non-U.S.
currencies in international finance.

Multilateral o r Bilateral Weights?
Under multilateral weighting, each country receives
a weight equal to its proportion of total trade or capital
flows. Under bilateral weighting, each country re
ceives a weight equal to its proportion of the flows to
and from the United States. Bilateral flows seem closer
to the notion of measuring the im portance of individ
ual U.S. trading partners to U.S. econom ic activity;
however, they omit third-party effects. For example, if
the DM-price of autos rises, other things the same, the
German share of U.S. auto imports would fall, and the
Japanese, Italian and Swedish share of U.S. imports
would increase. Analogously, considering financial as
sets, a multilateral weighting schem e is preferable
because it includes these m ulticountry financial m ar
ket im plications .9

B ase P eriod?
This choice may depend on the period of the analy
sis. If the relative size of trade or capital flows of the
included countries are changing, it would seem that
the base period should be chosen so that the weights
characterize the structure of com m erce or investment
throughout the period of analysis. If the structure
shifted, the weights from an earlier period conceivably
would no longer reflect the current trade or capital
relations .10

Arithmetic o r G eom etric?
The form of the index carries im plications for the
comparative im portance of absolute vs. percentage
changes. Most indexes, in particular the TVVEX, are
weighted geometrically, so that proportional changes
are em phasized."

8While capital flow weights emphasize the financial side of the
balance of payments flows, they are not completely consistent with
the modern asset market view of exchange rate determination
which emphasizes stocks rather than flows; see Dornbusch (1976),
Frenkel (1976, 1981), and Mussa (1979, 1982, 1984). As summa
rized by Mussa (1979, p. 38):
The asset market approach views the exchange rate as being deter
mined by essentially the same forces that determine the prices of other
assets that are traded in organized asset markets, such as the stock
markets and the commodity exchanges. In such markets, prices are
determined not by the balancing of How demands and flow supplies, but
rather by the prices at which the market as a whole is prepared to hold the
total outstanding stocks of the assets in question. Since the assets in
question are durable, the currently determined price of an asset is tightly
linked to the market’s expectation of the future price of that asset, (italics
added)

The measures of capital flows used in constructing the capital
weights are the annual net increment in national asset portfolios by
financial asset class. To the extent that the relative national asset
holdings (stocks) of these financial assets do not change, the
relative net flows would be proportional to the unobserved stocks.

9See Black (1976) and Hooper and Morton (1978). Hooper and
Morton also note that the bilateral construction assigns Canada a 20
percent weight in the EER, which is probably distorted by the crossborder trade in partially completed automobile assemblies. Re
cently, much attention has been focused on the dispute between
adherents of bilateral vs. multilateral trade flows; see Belongia
(1986), Cox (1986) and Rosensweig (1986).
1 Based on this possibility, Cox (1986) uses a moving-average
0
weighting scheme. This makes evaluation of the dollar problematic
since changes in its value may result from changes in weights, not
from changes in exchange values.
1 See Board of Governors of the Federal Reserve System (1978) and
1
Belongia (1986). Among widely used EERs, only the IMF's SDR is
arithmetically weighted.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

Table 1
Alternative Weights for Dollar EER Based on Trade Flows and Capital Flows
Jase years

BelgiumLuxembourg

Canada

France

1972-762
1979-83

.074
.071

.090
.078

.129
.130

1972-76
1979-83

.152
.093

.072
.046

.243
.149

Germany
TWEX:

Italy

Netherlands

United
Sweden

Switzerland

Kingdo

Trade Weights1

.206
.203
CWEX:

Japan

.090
.095

.084
.080

.040
.032

.034
.033

.118
.119

.058
.032

.136
.156

.014
.016

.067
.075

.125
.362

Capital Weights3

.103
.061

.095
.063

.070
.103

NOTES: 'Computed as the ratio of the five-year exports plus imports for the country divided by the sum of exports plus imports for all 10
countries, based on IMF data from the International Financial Statistics tape, July 1986.
2
These weights differ slightly from the Board of Governors' trade weights (see Board of Governors of the Federal Reserve System
[1978]) due to data revisions.
3
Computed as the sum of the negative of non-official capital outflows ( - ) plus non-official capital inflows ( + ) for the five years for
each country divided by the sum of such capital flows for all 10 countries based on data from the IMF Balance of Payments
Statistics, July 1986.

COMPUTATION OF TRADE AND
CAPITAL WEIGHTS FO R E E R
INDEXES
As noted above, the weighting schem es generally
applied in EERs are derived from data on trade flows,
not capital flows. Yet, for the reasons offered above,
capital flows offer a potentially useful alternative for
weighting the exchange rates in an EER.
The construction of the Capital Weighted Exchange
Rate (CWEX) essentially parallels that of the TWEX.
Since TWEX is familiar to m ost readers, we briefly
review its construction, then exam ine that of CWEX.
Following this, we show how each index is put into
real term s; this deflation results in the priced-adjusted
indexes, RTWEX and RCWEX.

TWEX
This index is constructed by com puting the trade
flows (imports plus exports) of each of the non-U.S.
G-10 countries as a percent of the total for all of these
countries. These weights are com puted as the average
for a five-year base period; two periods were used,
1972-76 and 1979-83. TWEX is then com puted as the
product of these weights multiplied by the natural log
(In) of the respective exchange rates, indexed to March
1973. Thus,
111 TWEX, = 100

10 w,
T R,
t
i= 1

= 100 exp

2 w, In Hit,
i= l

where the weight for country i is
10
w, = (Imports, + Exports,)/ 2 (Imports, + Exports,),

j =l
and
R,, =

price in U.S. cents of currency i in M arch 1973
divided by its price at time t.

The alternative forms of the exchange rate index,
equation 1, are show n to em phasize that TWEX is a
geometric rather than an arithm etic average of the
constituent exchange rates. Also, note that TWEX is
specified in average foreign currency units per dollar
and is indexed to its value at the beginning of the
floating-rate period, March 1973. Thus, a rise in TWEX
m eans the dollar’s value is increasing, and values over
1 0 0 mean that its weighted foreign currency value is
greater than it was in M arch 1973.
The weights for the two base periods, 1972-76 and
1979-83, are displayed in table 1.

CWEX
This index is constructed by com puting the nonofficial net capital flows (imports plus exports) of each
of the non-U.S. G-10 countries as a percent of the total
for all of these countries. These capital flows include
direct investment, portfolio investment, other long-

FEDERAL RESERVE BANK OF ST. LOUIS

and short-term capital flows of deposit m oney banks
and nonbank sectors as reported in the International
Monetary Fund’s B a la n ce o f P aym en ts S tatistics; a
detailed breakdown of the included item s appears in
the appendix.1
2
Only non-official capital flows were used. This re
striction is based on the assum ption that private
agents will buy and sell assets based on rationally
formed forecasts of relative asset values and antici
pated changes in those values in order to maximize
their wealth. Official flows, in contrast, may be driven
by attem pts to change values or offset market anticipa
tions. To the extent that these interventionist policies
are successful, they will be reflected in non-official
flows; otherwise, they are merely noise.1
3
Thus, the index is defined parallel to TWEX as
10

(2) CWEX, = 100 exp 2 x, log, R„
i= l
w here the weight for cou ntiy i is
x, = (Capital Outflows, + Capital Inflows,!/
10

(Capital Outflows, -4 Capital Inflows,).
-

j=l

The weights for CWEX for the two base periods are
also displayed in table l . 1
4

Real EERs
For many analytic purposes, price adjusted EERs,
here RTWEX and RCWEX, are m ore useful than nom i
nal EERs. These real indexes, in principle, are co n
structed by weighting the real (price-deflated) ex1 One reservation about the capital weighting scheme is that it adds
2
net capital outflows plus net capital inflows while trade weights are,
in principle, based on gross exports plus gross imports. Yet, the
capital flows used in constructing the CWEX EERs are the sum of
narrowly specified asset categories; hence, while inflows and out
flows within any category (e.g., foreign holdings of corporate equi
ties) are netted out, there is no cancellation across asset categories
(e.g., foreign holdings of corporate equities and foreign holdings of
public sector bonds).
,3See Batten and Ott (1984) for a general discussion of both the
motivation for and the limitations on the efficacy of central bank
foreign exchange intervention.
,4An alternative version of the capital weights was computed because
Switzerland reported no data on direct investment — overseas
investment by the Swiss and foreign investment in Switzerland.
Since direct investment constitutes a substantial portion of the
capital flows for the other countries, this would be likely to bias
downward the weight for the Swiss franc. To compensate for this
omission, a capital-weighted exchange rate index with net errors
and omissions (CWEXO) was computed in the same manner as
TWEX and CWEX; see appendix. The results of its comparative
performance in the tests below, however, were indistinguishable
from those reported and are omitted.

FEBRUARY 1987

change rates; however, this is equivalent to dividing
the nom inal index by the ratio of a weighted index of
foreign CPIs to the U.S. CPI. Thus, the real TWEX
(RTWEX) is obtained as
10

(3) RTWEX, = 100 exp 2 w, [lnR„ - lnCPI,, + lnCPIust)
i= l
10

= 100 exp [ 2 w, lnR„ - 2 w, (lnCPI,, - lnCPIus,)]
i= l
i= l
10

= TW EX/[100 exp 2 w, In (CPVCPI^,)].
i= 1
= TWEX/TWCPI,.

The real CWEX (RCWEX) is obtained analogously as
10

(4) RCWEX, = CWEX,/[100 exp 2 x, In (CPI,/CPIust)
i= 1
= CWEX/CWCPI,.

COMPARISONS OF THE
ALTERNATIVE E E R s
In order to determ ine w hether different weighting
schem es yield different results, em pirical assessm ents
were made of their comparative usefulness. These
em pirical analyses focused on changes, rather than
levels, in the alternative EERs.
First, correlation coefficients were com puted for the
change in the natural logarithm (delta In) of the EERs,
both nom inal and real. Second, the real EERs were
each included as an explanatory variable in a trade
equation with changes in U.S. agricultural exports as
the dependent variable.1 These estim ates and their
5
out-of-sample forecasts provide m easures of the rela
tive explanatory pow er of the different weighting
schem es. In each of these empirical exercises, a
“
naive” EER, in w hich each currency received equal
weight, was also included as a benchm ark (or null
hypothesis) to see w hether the theoretically based
weights yielded superior results.

Correlation am ong the EERs
The correlations among these five exchange rate
series, both nom inal and real (CPI-deflated), are re
ported in table 2, and the results are striking. The delta
In of these alternative EERs’ tim e series of changes are
nearly perfectly correlated: the correlation coefficients

1 The choice of model was made to facilitate further comparisons with
5
the related work by Belongia (1986) on alternative exchange rate
measures.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

Table 2
Correlation Coefficients for ALn Samples
of Alternatively Weighted G-10 EERs —
Trade, Capital and Naive______________
TWEX72

TWEX79

CWEX72

CWEX79

NAIVE

NOMINAL (January 1972 - August 1986 ; n = 175)
TWEX72
TWEX79
CWEX72
CWEX79
NAIVE

1.000

1.000
1.000

.996
.994
1.000

.973
.973
.972
1.000

.998
.997
.995
.971
1.000

1.000

1.000
1.000

.995
.994
1.000

.970
.970
.970
1.000

Since this article focuses on the usefulness of the
percentage change on delta In EER series, a delta In
version of Belongia’s (1986) model was used to com
pare the results of the alternative EERs. The purpose
of this test was not to determ ine the best trade equa
tion or test the validity of the specific equation esti
mated. Rather, the purpose was simply to see how
differently each EER series performed using a typical
trade equation from the trade literature.
The estim ated equation is

REAL (January 1972 - December 1985; n = 167)’
TWEX72
TWEX79
CWEX72
CWEX79
NAIVE

such as that used by Belongia, provides one direct way
to determ ine determining w hether REERs that vary
only in their weighting schem es also produce dispar
ate regression and out-of-sample forecast results.

.997
.996
.994
,968
1.000

l
(5) Ain X, = a„ +

2 auAin FGNP,_,
i= 0

+
NOTE: All correlations are significant at the .0001 level.
’Deflated by ratio of weighted foreign CPI to U.S. CPI.

Ain (USAGP/USCPI),_,

j=l
3
2

a3t Ain REER,.k + e,,

k= 1
between the five EERs vary from .968 to 1.000 (rounded
to 3 significant digits); this relationship holds for both
nominal and real changes specifications. While the
extremely high correlations both among the EERs and
among the REERs may seem to imply that they will be
virtually identical in any em pirical application, this
generally is not correct. For example, Belongia found
that, although different REERs were highly correlated,
they generated different regression coefficients and
highly divergent out-of-sam ple forecasts. C onse
quently, the regression and forecast com parisons are
included here in order to determ ine w hether or not
these REERs perform identically.

R egression an d Forecast R esults f o r
the EERs
In Belongia (1986), an equation explaining U.S. agri
cultural exports was estim ated utilizing, in turn, five
different REERs: the Federal Reserve Board’s TWEX,
the IMF's MERM and SDR, Morgan Guaranty's EER,
and the U.S. Department of Agriculture’s AG-Export
weighted EER. These estim ates afford a com parison of
the explanatoiy power and out-of-sam ple forecasts of
the five REERs. Belongia found that these real ex
change rates had substantially different regression
and out-of-sample properties, even though the corre
lation coefficients among them ranged from .853 to
.983. Consequently, estim ating some trade equation,

where,
X,
FGNP
USAGP
USCPI
REER

=
=
=
=
=

real exports of U.S. farm comm odities,
foreign real GNP“,
index of U.S. farm prices,
U.S. CPI,
real TVVEX72, TWEX79, CWEX72, CWEX79,
NAIVE and
e = random error term.

The results of estim ating this equation on quarterly
data over I/1973-IV/1981 are reported in table 3; statis
tics for out-of-sample forecasts over 1/1982—
1/1985 are
reported in table 4.
The sum m ed coefficients are displayed for FGNP
and USAGP/USCPI and the individual coefficients for
the Ain REERs. These coefficients and their signifi
cance levels, as reported in table 3, are very similar
across the five specifications for the non-REER vari
ables, as are the R2 and Durbin-Watson statistics. The
latter imply that the residuals do not have significant
first-order correlation. The magnitude, signs and tratios for the REERs are also similar, although the
sums of the REER coefficients differ slightly — the

1 This series, obtainable from the Federal Reserve Board, is a hybrid
6
of weighted foreign GNPs, containing Mexican and other oilexporting countries’ GNPs as well as the (non U.S.) G-10 plus
Switzerland industrial countries’ GNPs.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Estimates of U.S. Agricultural Exports Equation Using Alternatively Weighted G-10
REERs (1/1973—
IV/1981)
Weighting
scheme

Intercept

lAlnFGNP

XAIn(USAGP/USCPI)

AlnREER

t-1

t —2

TWEX72

0.004
(0.202)

1.597
(0.782)

-0 .4 9 5
(2.156)*

0.326
(0.448)

0.751
(1.035)

-1.642
(2.027) +

0.335

2.16

TWEX79

0.004
(0.202)

1.603
(0.782)

-0 .4 8 9
(2.119)*

0.321
(0.442)

0.789
(1.090)

-1 .5 8 9
(1.971) +

0.332

2.16

CWEX72

0.005
(0.242)

1.494
(0.730)

-0 .4 9 8
(2.194)*

0.253
(0.368)

0.664
(0.959)

-1 .5 4 9
(2.018) +

0.324

2.16

CWEX79

0.003
(0.153)

1.712
(0.624)

-0 .4 7 2
(2.138)*

0.461
(0.635)

0.791
(1.084)

-1 .6 4 4
(2.026) +

0.344

2.16

NAIVE

0.004
(0.212)

1.585
(0.775)

—0.486
(2.113)*

0.363
(0.493)

0.771
(1.051)

-1 .5 7 4
(1.940) +

0.329

2.16

NOTE: Absolute t-ratios in parentheses; * indicates significance at 5% level and + indicates significance at 10% level.

CWEX72 being sm aller and CWEX79 larger than the
other three, although not significantly so .17
The out-of-sam ple forecast properties of the five
estim ates of equation 5, differing only in their REERs,
are shown in table 4. Error statistics and Theil statis
tics from the forecast series are displayed. The error
statistics — the m ean error, the m ean absolute error
and the root-m ean-square error (RMSE) — are nearly
identical for the five equations. Thus, the accuracy of
the forecasts does not vary with the weighting schem e
used for the REER. The Theil statistics decom pose the
forecast errors into three com ponents .18 As shown in
these error decom positions, there is no substantive
difference in the pattern of the forecast errors.
The close conformity of the regression and forecast
results for the variously weighted versions of the G-10

"Some differences in these sums may reflect scale differences, as
the CWEX72 and CWEX79 have weights which differ most from
TWEX72;see table 1.
,8Bias measures the proportion of the mean square error (RMSE
squared) due to a tendency to estimate too high or too low the level
of the forecast. Variance measures the proportion of the MSE due to
the variance of predictions differing from the variance of actual
levels. The covariance is, essentially, the residual error proportion.

REERs contrasts starkly with the divergent results
reported for different REERs in Belongia (1986). There
are two key differences betw een Belongia’s and those
shown here. First, the REERs in this study contain the
same currencies; differences betw een them are lim
ited solely to alternative weighting schem es. In con
trast, Belongia used REERs that differed both in their
currencies and in their weighting. Second, the analy
sis here focuses on changes in the In REER; Belongia
focused on levels of these data.

CONCLUSION
Trade-weighted effective exchange rates are widely
used to assess both the value of the dollar as an end in
itself and to provide a broad measure for use in analyz
ing and explaining trade and capital flows. Surpris
ingly, while questions often arise about w hich curren
cies to include or how to weight them, alternatives to
asymmetrically trade-weighted EERs have seldom
been examined.
Several alternative EERs have been exam ined in this
article. An important finding is that the equally
weighted naive EER is highly correlated with both the
traditional trade-w eighted EERs and alternative
capital-flow-weighted EERs over the range of consid

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

Table 4
Out-of-Sample Statistics for Projected Farm Exports Using
Alternatively Weighted G-10 REERs (1/1982-1/1985)
Error Statistics

Theil Statistics
Fraction due to:

Weighting
scheme

Mean
error

Mean absolute
error

RMSE

Bias

Variance

Covariance

TWEX72
TWEX79
CWEX72
CWEX79
NAIVE

0.031
0.031
0.030
0.031
0.032

0.058
0.059
0.058
0.059
0.058

0.080
0.081
0.080
0.082
0.081

0.147
0.151
0.147
0.139
0.155

0.419
0.424
0.434
0.392
0.436

0.434
0.425
0.420
0.469
0.409

ered weights. Moreover, the explanatory and predic
tive power of the alternative EERs, including the naive
EER, were found to be statistically equivalent in an
agriculture export equation. Since these results are for
one set of currencies and for one historical period,
generalizations m ust be advanced with care; however,
these results suggest that further research — both
empirical and theoretical — on the comparative im
portance of the choice of weighting schem es vs. the
choice of currencies to be included in the EER is
w arranted .19

REFERENCES
Artus, Jacques R., and Rudolf R. Rhoneberg. “A Multilateral Ex
change Rate Model,” International Monetary Fund Staff Papers
(November 1973), pp. 591-611.
Batten, Dallas S., and Mack Ott. “What Can Central Banks Do
About the Value of the Dollar?” this Review (May 1984), pp. 16-26.
Belongia, Michael T. “Estimating Exchange Effects on Exports: A
Cautionary Note,” this Review (January 1986), pp. 5-16.

Black, Stanley W. “Multilateral and Bilateral Measures of Effective
Exchange Rates in a World Model of Traded Goods," Journal of
Political Economy (June 1976), pp. 615-21.
Board of Governors of the Federal Reserve System. “Index of the
Weighted-Average Exchange Value of the U.S. Dollar: Revision,”
Federal Reserve Bulletin (August 1978), p. 700.
Cox, Michael. “A New Alternative Trade-Weighted Dollar Exchange
Rate Index,” Federal Reserve Bank of Dallas Economic Review
(September 1986), pp. 20-28.
Dornbusch, Rudiger. “Expectations and Exchange Rate Dy
namics,” Journal of Political Economy (December 1976), pp. 1161—
76.
Dutton, John, and Thomas Grennes. “The Measurement of Effec
tive Exchange Rates Appropriate for Agricultural Trade,” mimeo
graph, Department of Economics and Business, North Carolina
State University (August 1985).
Fisher, Irving. The Making of Index Numbers (Houghton-Mifflin
Company, 1922).
Frenkel, Jacob A. “Flexible Exchange Rates, Prices and the Role of
News’: Lessons from the 1970s,” Journal of Political Economy
(August 1981), pp. 665-705.
Hooper, Peter, and John Morton. “Summary Measures of the Dol
lar’s Foreign Exchange Value,” Federal Reserve Bulletin (October
1978), pp. 783-89.
Maciejewski, Edouard B. “ ‘Real’ Effective Exchange Rate Indices,”
International Monetary Fund Staff Papers (September 1983), pp.
491-541.

1 lronically, Irving Fisher (1922, p. 365) first advanced the importance
9
of this question 65 years ago after arriving at an analogous empirical
finding for weighting schemes for price indexes:
Among the consequences of the surprising agreement between the
various legitimate methods of calculating index numbers are two which
need emphasis here. The first is that all discussion of “ different formulae
appropriate for different purposes” falls to the ground. The second is
that, the supposed differences among formulae once banished, the real
problem of accuracy is shifted to the other features of an index number,
— the assortment of the commodities included, their number, and data.
. .. Thus the figures for weights in particular may usually be tenfold or
one tenth of the true figures without appreciably disturbing the accuracy
of the resulting index number. Henceforth, the effort to improve the
accuracy of index numbers must center chiefly on the assortment of the
items to be included.

Mussa, Michael. “Empirical Regularities in the Behavior of Ex
change Rates and Theories of the Foreign Exchange Market,”
Policies for Employment, Prices and Exchange Rates, in Karl Brun
ner and Allan Meltzer, eds., Carnegie-Rochester Conference Se
ries on Public Policy, Volume 11 (1979), pp. 9-58.
________ _ “A Model of Exchange Rate Dynamics,” Journal of
Political Economy (February 1982), pp. 72-104.
_________ "The Theory of Exchange Rate Determinations," John
F. O. Bilson and Richard C. Monston, eds., Exchange Rate Theory
and Practice, University of Chicago Press, 1984.
Rosensweig, Jeffrey A. “A New Dollar Index: Capturing A More
Global Perspective,” Federal Reserve Bank of Atlanta Economic
Review (June/July 1986), pp. 12-22.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

Appendix
Sources of Data and Specification of Weights
TWEX: Data are from the July 1986 edition of the
In tern ation al F in an cial Statistics tape of the
IMF. The data utilized are the im ports of
goods and services plus the exports of goods
and services in billions of U.S. dollars, annual
during 1972-76 and 1979-83.
CWEX: Data are from the July 1986 edition of the
B alan ce o f P aym ents S tatistics tape of the IMF.
The data utilized are:
Line

D ata D escrip tio n

Sign/Code

D irect Investm en t
Direct Investment Abroad
Foreign Direct Investm ent at Home

-3L.X4
3Y.X4

P ortfolio Investm en t
53
54
55
56
57
58
59
60

Public Sector Bonds Assets
Official Liabilities
Other Liabilities
Other Bonds Assets
Official Liabilities
Other Liabilities
Corporate Equities Assets
Official Liabilities
Other Liabilities

-6A1X4
6T1X4
6Q1X4
-6B1X4
6U1X4
6R1X4
-6D1X4
6V1X4
6S1X4

O th er L on g -T erm Capital of D eposit M oney Banks
69
70

Drawings on Loans Extended
Repayments on Loans

-5C1Y4
-5C1W4

71
72
73
74
75
76

Other Assets
Liabilities Official (National
Currency)
Liabilities Official (Foreign
Currency)
Drawings on Other Loans
Repayments on Other Loans
Other Liabilities

-5K1X4
5U1X4
5V1X4
5P1W4
5P1Y4
5S1X4

O th er L on g-T erm Capital of O th er S e cto rs
77
78
79
80
81
82
83

Drawings on Loans
Repayment on Loans
Other Assets
Liabilities (Foreign Official)
Drawings on Loans
Repayments on Loans
Other Liabilities

-8C1Y4
-8C1W4
-8K1X4
8W1X4
8P1W4
8P1Y4
8X1X4

O ther S h o rt-T erm Capital of D eposit M oney Banks
89
90
91
92

Assets
Liabilities (National Currency)
Liabilities (Foreign Currency)
Other Liabilities

-5L2X4
5U2X4
5V2X4
5X2X4

O th er S h o rt-T erm Capital of O th er S e cto rs
93
94
95
96
97

Loans Extended
Other Assets
Liabilities (Foreign Reserves)
Other Loans Received
Other Liabilities

-8C2X4
-8K2X4
8W2X4
8P2X4
8S2X4

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

The FOMC in 1986: Flexible Policy
for Uncertain Times
Philip A. N uetzel

J L HE Federal Reserve’s m onetary policy actions
during 1986 were influenced by indications of weak
econom ic growth and m oderate inflation. The incom e
velocity of money, defined as the ratio of nom inal GNP
to the narrowly defined m oney supply M l, declined
even more rapidly in 1986 than it had in the previous
year .1 Interest rates declined on balance over 1986, and
the Federal Open Market Com m ittee (hereafter “Com
m ittee” or “FOMC") viewed their decline and the asso
ciated rapid growth of M l as a desirable development
in light o f the sluggish econom y. As the year pro
gressed, the Committee deem phasized M l as a guide
to policy while focusing on the broader monetary
aggregates, M2 and M3, and several indicators of eco
nom ic and financial conditions. In the uncertain eco
nom ic environm ent that prevailed in 1986, the Com
mittee was flexible in its approach to m onetary policy.
This article reviews the FOMC’s m onetary policy
decisions during 1986. The C om m ittee’s annual
growth objectives for the m onetary aggregates are
discussed in the next section, and the target ranges for
1986 are com pared with actual money growth during

Philip A. Nuetzel is an economist at the Federal Reserve Bank of St.
Louis. Laura A. Prives provided research assistance.
NOTE: Citations referred to as “Record” are to the "Record of Policy
Actions of the Federal Open Market Committee" found in various
issues of the Federal Reserve Bulletin. Citations referred to as “Re
port” are to the “Monetary Policy Report to Congress,” also found in
various issues of the Federal Reserve Bulletin.
’M1 growth from IV/1985 to IV/1986 was 15.3 percent, up from 12.1
percent over the preceding four quarters. Over the same two peri
ods, nominal GNP grew at rates of 4.2 percent and 6.3 percent,
respectively.

the year. Then, the Com m ittee’s views concerning the
rapid growth of M l are considered in more detail, and
other variables that had a significant influence on
policy are discussed. Finally, the short-run directives
issued by the FOMC during 1986 are reviewed chrono
logically.

ANNUAL TARGETS FO R 1986
Each February, the Board of Governors appears b e
fore Congress to report on the annual growth targets
that the FOMC has established for the monetary and
credit aggregates for the com ing year. In July, the
Board reports on the progress made toward meeting
these goals and announces the FOMC’s provisional
growth targets for the following calendar year .2 The
Committee states its annual targets in term s of growth
ranges from the fourth quarter of the previous year to
the fourth quarter of the current year .3 The dates of the
three meetings at w hich the annual target ranges for
1986 were considered are listed in table 1 along with
the ranges established for M l, M2 and M3, and the
actual growth rates of these aggregates during 1986.

2
These reports are required under the Full Employment and Bal
anced Growth Act of 1978, also known as the Humphrey-Hawkins
Act.
3
The Committee's use of the fourth quarter of the previous year as
the base period for establishing the current year’s growth targets
leads to an upward drift in money growth if the growth of an
aggregate during the previous year exceeded the target range for
that year. The "base drift” problem is discussed by Broaddus and
Goodfriend (1984). For a viewpoint that favors base drift, see Walsh
(1986).

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

July 1985 M eeting
The tentative ranges for 1986 established at the July
1985 FOMC m eeting reflected the Com m ittee’s feeling,
at that time, that continuation of the rapid money
growth in the first half of 1985 might be inconsistent
with sustainable econom ic expansion and reasonable
price stability. The tentative 1986 range for M l of 4 to 7
percent was 2 percentage points narrower than the 3
to 8 percent rebased range adopted in July 1985 for the
11/1985—
IV/1985 period ;4 the upper limit of the tentative
M3 range of 6 to 9 percent was one-half percentage
point lower than the upper limit of its 1985 range.
The growth of the three m onetary aggregates
slowed somewhat during the second half of 1985. M l
growth exceeded the upper limit of its rebased range,
however, and its velocity declined even m ore sharply
than it had during the first half.

February 1986 M eeting
The annual growth ranges for 1986 were reconsid
ered at the Com m ittee’s m eeting on February 1 1 - 1 2 ,
1986. For M l growth, the Committee chose a target
range of 3 to 8 percent, w hich was based on expecta
tions that M l growth would slow while nom inal GNP
growth would accelerate. This range was 2 percentage
points wider than the FOMC had tentatively planned,
reflecting continuing uncertainty about the future b e
havior of M l and its velocity. The Board’s report to
Congress stated that:
The width of the M l range reflects continuing u n cer
tainty about the behavior of M l under varying eco
nomic and financial circu m sta n ce s.. . . While the
range for M1 is wide enough to allow for some variation
in behavior of the aggregate's incom e velocity in re
sponse to changing conditions, the range was set on
the assumption that there would not be a large drop in
velocity, such as occu rred in 1985. In that connection,
the Committee will evaluate behavior of M l in light of
its consistency with other monetary aggregates, e co
nomic and financial developments, and the potential
for inflationary pressures.3

The 6 to 9 percent ranges for M2 and M3 established
tentatively in July were affirmed by the Committee at

“Because of the apparent decline in M1 velocity during the first half of
1985, the FOMC decided in July 1985 that the annual range origi
nally established for M1 growth was undesirable. The Committee
voted to move the base period of that range from IV/1984 to 11/1985.
See Hafer (1986) for a discussion of the decision to rebase the M1
range and the influence that declining M1 velocity had on the
FOMC’s decisions in general during 1985.
5Report (April 1986), p. 214.

Table 1
FOMC Annual Monetary Growth Ranges
and Actual Money Growth:
IV/1985-IV/1986
Dates of meeting

July 9-10,1985'
February 11-12, 1986
July 8-9, 1986

4-7%
3 -8
[3—
8]2

6-9%
6-9
6-9

Actual Growth Rate

15.3%

8.9%

8.7%

'The ranges established for 1986 at this meeting were tentative.
Mr. Martin dissented from this action because he preferred a
somewhat higher growth range for M1 to guard against the
possibility that velocity would continue to decline or grow slug
gishly in 1986. Ms. Seger dissented because she felt that higher
growth ranges were more consistent with sustaining economic
expansion and reducing financial strains in the economy.
2
The Committee did not establish any new range for M1 growth at
this meeting and agreed that growth in excess of the existing
range would be acceptable, taking account of the growth of the
broader aggregates and other economic and financial develop
ments.

the February m eeting. The growth of these broader
aggregates had been within their target ranges in 1985,
and it was observed that "on balance over the past few
years, the behavior of M2 and M3 seem ed to have been
less affected by in stitu tion al and in terest rate
changes .”6

July 1986 M eeting
Over the first half of 1986, the growth rates of M2 and
M3 were roughly in the middle of their target ranges.
M l growth slowed in the first quarter from its pace in
1985, but accelerated sharply in the second quarter,
leaving its annualized growth rate from Decem ber
through Ju n e at 13.3 percent, m ore than 5 percentage
points above the upper bound of the Com m ittee’s
target range for the year. Other evidence reviewed by
the Com mittee at the m eeting of July 8-9, 1986, sug
gested that the rate of econom ic growth had slowed
considerably in the second quarter from the 2.9 per
cent growth of real GNP registered in I/1986.7 Further

6Record (June 1986), p. 410. The Committee also adopted a moni
toring range for the growth of total domestic nonfinancial debt of 8 to
11 percent.
'Revisions showed that real GNP grew at a rate of 3.8 percent in
1/1986 and 0.6 percent in 11/1986. All of the data used in the text in
discussing the Committee’s deliberations are those that were avail
able to the Committee at the time.

FEDERAL RESERVE BANK OF ST. LOUIS

more, wage and price increases continued to m oder
ate over the first half of the year, even w hen the direct
effects of declines in food and energy prices were
eliminated.
The Com m ittee reaffirmed the long-run growth
ranges of 6 to 9 percent for M2 and M3. In their
discussion of the range for M l growth, however, the
m em bers again em phasized uncertainties affecting
the outlook for M l velocity and the changes in M l’s
com position resulting from the rapid growth of its
deregulated, interest-bearing com ponent. Interest
rates had declined by 1 to 2 percentage points during
the first half and were thought to be associated with
the rapid growth of M l. Some m em bers thought that
the M l range should be eliminated, "at least pending
the reestablishm ent of a more predictable relation
ship with overall m easures of econom ic activity .”8 A
majority, however, preferred to retain a range for M l
“even though they believed its operational signifi
cance could only be judged in the perspective of
concurrent econom ic and financial developments, in
cluding the behavior of M2 and M 3 .”9 Rather than
raising or rebasing the existing M l range, the Commit
tee acknowledged its desire to accom m odate u ncer
tain changes in M l dem and by agreeing that, after
accounting for the behavior of the broader aggregates
and other developments, including trends in interest
rates, growth of M l in excess of 8 percent would be
acceptable for 1986.

Actual M oney Growth in 1986
The actual growth rates of the m onetary aggregates
for 1986 are reported at the bottom of table 1. M l
growth of 15.3 percent was 7.3 percentage points
above the upper bound of its range set early in the
year. This growth rate represents a significant acceler
ation from the already rapid 12.1 percent growth of M l
from IV/1984 to IV/1985. In com parison, M l’s average
annual growth rate over the 1960-84 period was only
5.8 percent.
One reason why the Com m ittee accepted the rapid
M l growth during 1986 was that the growth rates of
M2 and M3 were quite close to the 9 percent upper
limit of their target ranges for the year. M2 growth of
8.9 percent and M3 growth of 8.7 percent were slightly
more rapid than their respective growth rates of 8.7

FEBRUARY 1987

percent and 7.7 percent over the IV/1984-IV/1985 p e
riod. The Committee felt, however, that the behavior of
these aggregates was generally consistent with its
overall policy objectives. The Board’s mid-year report
to Congress stated that “during a period of greater
overall price stability and adequate capacity relative to
the dem ands placed upon it,” m onetary policy had
been able "to accom m odate dem ands for money and
credit, helping facilitate further declines in interest
rates___”10

THE FOMC’s GUIDES FOR POLICY
IMPLEMENTATION
The Com m ittee’s use of a variable as a policy guide
is based on assum ptions about the effect of that vari
able on real econom ic growth and the rate of inflation,
w hich are of ultimate concern, as well as the ability of
policy actions to influence that variable. As noted
previously, the deemphasis of M l as a policy guide
was a reaction to the instability of M l velocity. In this
section, we review the Com m ittee’s explanation for
the unusually rapid growth of M l relative to nominal
GNP and its reasons for believing that the relationship
between M l and econom ic activity would be subject
to a high degree of uncertainty for some time. We then
discuss the Com m ittee’s reasons for continuing to use
other variables as policy guides, such as M2 and M3,
the level of interest rates, the foreign exchange value of
the dollar, real GNP and indicators of output and
prices.

Institutional Changes and Ml
In accounting for the rapid growth of M l in 1986, the
Committee em phasized that the com position of M l
had changed in part because of the deregulation of
deposit interest rates and minimum balance require
m ents that had taken place under the Monetary Con
trol Act of 1980 and the Garn-St. Germain Act of 1982."
From 1980 to 1985, for example, the proportion of
interest-bearing checkable deposits (other checkable
deposits, or OCDs) in M l rose from 5.5 percent to 27.6
percent, a trend that continued in 1986.
Table 2 shows the annualized growth rates of M l
and its three m ajor com ponents for each quarter of

,0Report (September 1986), p. 603.
aRecord (October 1986), p. 708.
9lbid.

"For a discussion of federal policy on deposit interest rate ceilings, or
Regulation Q, and the phaseout of deposit regulation, see Gilbert
(1986).

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Table 2
Growth of M1 and Its Major Components in 1986
(seasonally adjusted, compounded annual rates)
Period

Currency

IV/1984—
IV/1985

7.5%

IV/1985—
1/1986
1/1986-11/1986
11/1986-111/1986
111/1986—
IV/1986

7.5
6.6
7.5
8.3

IV/1985—
IV/1986

Demand
deposits

7.5

1986 and for the year as a whole. The OCD com ponent
of M l grew at 28.6 percent, 6.4 percentage points faster
than its 1985 growth rate. Growth in dem and deposits
was also quite rapid, accelerating from 8.9 percent in
1985 to 11.6 percent in 1986. Growth of the public’s
currency holdings was unchanged at 7.5 percent.
The Com m ittee attributed m uch of the rapid
growth of OCDs and dem and deposits, and hence
declining M l velocity in 1986, to declining interest
rates and subsiding inflationary expectations. In the
m idyear report to Congress, the Board stressed that
“the advent and expansion of interest-bearing check
ing accounts over the years have attracted more
savings-type balances and have increased the respon
siveness of M l to interest rate changes .” 12 Com m ent
ing on the rapid growth of dem and deposits, Chair
m an Paul Volcker said that th ere were “som e
indications of a greater willingness of businesses to
hold dem and deposits at a time of lower interest rates,
partly because, with interest rates down, a larger bal
ance is necessary to com pensate banks for a given
am ount of services .” 13
Chart 1 shows the paths of selected short-term

Other checkable
deposits
22.2%

12.1%

4.7
15.4
13.3
13.4

17.9
28.1
34.2
34.9

9.1
16.4
17.6
18.2

11.6

28.6

15.3

8.9%

interest rates and the growth of M l over 1985 and 1986.
There were m ajor accelerations in M l growth accom
panied by declining short-term rates during the
spring of 1985, the late w inter and spring of 1986, and
the sum m er of 1986. On the other hand, there were
also accelerations of M l growth during periods of
relatively stable interest rates in the sum m er and the
late fall of 1985, and the fall of 1986. The consensus at
the Com m ittee’s m eeting in July 1986 was that rapid
M l growth during the first half of the year reflected
lagged adjustm ents to declining inflationary expecta
tions and interest rates; it did not seem to hold the
usual potential for reigniting inflationary pressures
w hen judged in the context of other developments,
including m ore restrained growth of the broader
aggregates .14
While the Committee thought that M l still had
some informational value, it did not wish to restrain
the process of adjustm ent that it felt was responsible
for rapid M l growth and declining velocity. Chairman
Volcker stated in July 1986 that “. . . a firm conclusion
concerning the nature and stability of future velocity
characteristics may take years of experience in the
new institutional and econom ic setting .” 15 The Chair
m an w ent on to summarize the Com m ittee’s attitude
toward the use of M l as a policy tool:

,2Report (September 1986), p. 614. Support for the view that the
interest elasticity of money demand has increased with deposit
deregulation can be found in Keeley and Zimmerman (1986), Roth
(1985), Mehra (1985) and Wenninger (1986).

1 See the Record (October 1986), p. 708.
4

1 Volcker (1986), p. 640.
3

t5Volcker (1986), p. 641.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

Chart 1

Short-Term Interest Rates and M l Growth

1985

1986

1J_ M l g r o w t h r a t e s a r e c o m p o u n d e d a n n u a l r a t e s o f c h a n g e o f f o u r - w e e k m o v i n g a v e r a g e s o f M l f r o m f o u r w e e k s p r e v i o u s .

Experience over the first half of 1986 underscored the
difficulty — I would say impossibility — of conducting
m onetary policy in current circum stances according
to one or two simple, preset criteria . . . the weight of
the evidence strongly suggests that M l alone during
this period of econom ic and institutional transition is
not today a reliable m easure of future price pressures
(or indeed a good short-term "leading indicator” of
business activity). The m ore restrained perform ance of
the broader aggregates, as well as the perform ance of
the econom y and prices themselves, point in a differ
ent direction.'6

M2 and M3
In recent years, the velocity behavior of M2 and M3

16lbid., p. 642.

have not changed as radically as M l’s. Apparently, the
shifts in asset holdings resulting from the com bina
tion of falling interest rates and deposit deregulation
have occurred largely within the broader aggregates
and have not led to as large a surge in their growth as
in M l’s.
The FOMC has responded by assigning more weight
to M2 and M3 as policy guides .17 In 1986, the Commit -

1 Monetary policy actions have a weaker influence on the broader
7
aggregates than on M1, however, because most of the non-M1
deposit liabilities included in M2 and M3 are not subject to reserve
requirements. Moreover, information on these aggregates is avail
able at a longer lag. See Lawler (1981). Also, Hafer (1981) presents
empirical evidence suggesting that M2 is less controllable through
policy actions than M1.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Organization of the Committee in 1986
The Federal Open Market Committee (FOMC)
consists of 1 2 m em bers: the seven m em bers of the
Federal Reserve Board of Governors and five of the
12 Federal Reserve Bank presidents. The chairm an
of the Board of Governors is, by tradition, also
chairm an of the Committee. The president of the
New York Federal Reserve Bank is, also by tradition,
its vice chairm an. All Federal Reserve Bank presi
dents attend Com m ittee m eetings and present
their views, but only those who are m em bers of the
Committee may vote. Four m em berships rotate
among Bank presidents and are held for one-year
term s beginning on March 1 of each year. The
president of the New York Federal Reserve Bank is a
perm anent voting m em ber of the Committee.
Members of the Board of Governors at the begin
ning of 1986 included Chairman Paul A. Volcker,
Vice Chairman Preston Martin, Hemy C. Wallich, J.
Charles Partee, Em m ett J. Rice and Martha R. Seger .1
The term of J. Charles Partee expired on February 1.
The two open seats on the Board were filled by
Wayne D. Angell and Manuel H. Johnson on Febru
ary 7. Preston Martin resigned from the Board effec
tive April 30.2 On August 19, H. Robert Heller joined
the Board, and, on August 22, Manuel H. Johnson
took the office of vice chairm an. Henry C. Wallich
resigned from the Board effective D ecem ber 15, and
Em mett J. Rice resigned effective D ecem ber 31.3
The following Bank presidents voted at the m eet
ing on February 11 and 12, 1986: Robert P. Black
(Richmond), E. Gerald Corrigan (New York), Robert
P. Forrestal (Atlanta), Silas Keehn (Chicago) and
Robert T. Parry (San Francisco). The Committee
m em bership changed in March and the presidents’
voting positions were filled by E. Gerald Corrigan
(New York), Roger Guffey (Kansas City), Karen N.
Horn (Cleveland), Thom as C. Melzer (St. Louis) and
Frank E. Morris (Boston ).4

The Committee m et eight times at regularly
scheduled m eetings during 1986 to discuss eco
nom ic trends and to decide upon the future course
of open-market operations .5 As in previous years,
telephone or telegram consultations were held o c
casionally betw een scheduled meetings. During
each regularly scheduled meeting, a directive was
issued to the Federal Reserve Bank of New York.
Each directive contained a short review of eco
nom ic developments, the general econom ic goals
sought by the Committee, the Com m ittee’s longrun monetary growth objectives and instructions to
the Manager of the System Open Market Account at
the New York Bank for the conduct of open-market
operations. T h ese in stru ction s typically were
stated in terms of the degree of pressure on reserve
positions. The latter were associated with expected
short-term growth rates for M l, M2 and M3 that
were in turn considered to be consistent with de
sired longer-run growth rates of the m onetary ag
gregates .6 The Committee also specified interm eet
ing ranges for the federal funds rate. These ranges
provide a m echanism for initiating consultations
between meetings whenever it appears that the
constraint of the federal funds rate is proving in
consistent with the objectives for the behavior of
the m onetary aggregates.
The account manager has the m ajor responsibil
ity for formulating plans regarding the timing, types
and am ount of daily buying and selling of securities
in fulfilling the Com m ittee’s directive. Each m orn
ing the m anager and his staff plan the open-market
operations for that day. This plan is developed on
the basis of the Com m ittee’s directive and the latest
developments affecting m oney and credit market
conditions, the growth of the monetary aggregates
and bank reserve conditions. The m anager also
consults with the Board of Governors’ staff. Present
market conditions and open-m arket operations
that the m anager proposes to execute are dis-

'Ms. Seger did not attend the May FOMC meeting.
2Mr. Martin did not attend the April meeting.
3
Mr. Wallich did not attend the May and November meetings. Mr.
Rice did not attend the December meeting.
“Robert H. Boykin (Dallas) voted as an alternate for Mr. Melzer at
the May meeting.

5No formal meetings were held in January, March, June and
October.
6ln July, the FOMC agreed that M1 growth in excess of its annual
target range would be acceptable and discontinued statements
regarding the Committee's expectations for short-run growth in
M1.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

cussed each m orning in a telephone conference
call involving the staff at the New York Bank, the
Board and one voting president and his staff. Other
m em bers of the Com m ittee may participate and are
informed of the daily plan by internal m em o or
wire.
The directives issued by the Committee and a
summary of the reasons for Committee actions are
published in the "Record of Policy Actions of the
Federal Open Market Com m ittee.” The “Record” for
each m eeting is released a few days after the Com
mittee meeting. Soon after its release, it appears in
the F e d e ra l R eserv e Bulletin. In addition, "Records”
for the entire year are published in the annual
report of the Board of Governors. The "Record” for
each meeting during 1986 included:
1)

a staff summary of recent econom ic develop
m ents — such as changes in prices, employment,
industrial production and com ponents of the na
tional incom e accounts — and projections of gen
eral price, output and em ploym ent developments
for the year ahead;

tee often evaluated potential changes in policy on the
basis of the recent growth of these aggregates, among
other factors. For example, in April, the Committee
viewed the growth of M2 and M3 at rates within their
target ranges as evidence that the rapid growth of M l
did not represent an excessive buildup of liquidity .18 At
later meetings, when M2 and M3 were near the upper
limits of their ranges, m em bers expressed m ore con
cern about the im plications of accom m odative policy
for inflation .19

Interest Rates
The Com m ittee also evaluated potential changes in
its policy stance during 1986 in the context of recent
movements in interest rates. By im plem enting an ac
commodative policy in 1986, the Committee sought to
provide the reserves necessary to support increases in
money dem and .20 At two meetings, though it felt that

2 ) a summary of recent international financial
developments and the U.S. foreign trade balance;

3) a summary of open-market operations, growth
of the m onetary aggregates and bank reserves and
m oney m arket conditions sin ce the previous
meeting;
4) a summary of the Com mittee's discussion of
the current and prospective econom ic and finan
cial conditions and the current policy consider
ations, including money market conditions and the
movement of m onetary aggregates;
5) decisions of the Committee;
6 ) a policy directive issued by the Committee to
the Federal Reserve Bank of New York;

7) a list of the m em bers’ votes and any dissenting
com m ents; and
8 ) a description of any actions regarding the
Com m ittee’s other authorizations and directives
and reports on any actions or consultations that
may have occurred between the regularly sch ed
uled meetings.

less restrictive reserve conditions were desirable, the
Committee contem plated that the easing would be
achieved through discount rate reductions by the
Board. This was expected to facilitate a market ten
dency toward lower interest rates .21 Moreover, the
appropriateness of potential interm eeting adjust
m ents in the provision of reserves were viewed as
conditional on near-term changes in rates, including
potential discount rate reductions.
While it sought to prom ote easier credit market
conditions, the Committee also took account of move
m ents in long-term interest rates as indicators of
changes in inflationary expectations. For example, an
increase in interest rates before the Septem ber m eet
ing, together with some other developments, was in
terpreted as a sign of an increase in expected inflation.
This was one factor that led to a vote for “maintaining
unchanged conditions of reserve availability, ” and one

1 See the Record (September 1986), pp. 649-50.
8
,9See the following Records: November 1986, pp. 784-85; January
1987, pp. 34-35; February 1987, pp. 120-21.
“ See Report (September 1986), pp. 612-13.

2 See the following Records: October 1986, p. 710; November 1986,
1
p. 784. The same point is discussed in Record (June 1986), pp.
411-12.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

m em ber believed that less ease in policy im plem enta
tion was desirable at that tim e .22

International D evelopm ents
Concerns about the external sector also influenced
the FOMC's policy actions in 1986. The foreign ex
change value of the dollar had declined substantially
on a trade-weighted basis since early 1985. As a result,
the trade deficit was expected to decline during 1986,
but it widened instead and was a continuing elem ent
of uncertainty in the econom ic outlook. Throughout
the year, the Committee expressed doubts about the
timing and magnitude of any improvement in the
trade balance because it believed that foreign pro
ducers would attem pt to m aintain their U.S. market
shares by reducing their profit margins ,a The Commit
tee also felt that increases in U.S. net exports would be
hindered by sluggish growth in the econom ies of
some m ajor U.S. trading partners in the absence of
more stimulative policies abroad .24
While the falling dollar improved the prospects for a
sm aller trade deficit, Committee m em bers noted that
it also had a potential inflationary im pact .25 Further
more, the trade deficit implied large capital inflows
from abroad that were financing dom estic econom ic
activity. Loss of confidence in the dollar might require
sharp increases in dom estic interest rates to maintain
the inflow of foreign capital; m em bers of the Commit
tee often m entioned this risk to econom ic expansion .26
In general, the Com m ittee felt that greater caution
should be exercised in providing reserves in the event
of sharp dollar depreciation during interm eeting
periods .27
“ See the Record (January 1987), p. 34.
^Mann (1986) presents evidence in support of this view. See Report
(April 1986), p. 216, Report (September 1986), p. 610, and the
following Records: June 1986, p. 409; July 1986, p. 480; January
1987, p. 33.
2 See Report (September 1986), pp. 604-05 and p. 610, and the
4
following Records: July 1986, pp. 480-81; October 1986, p. 707;
January 1987, p. 33. Also see the Record in Press Release, Federal
Reserve Board of Governors, February 13,1987, p. 7. There were,
in fact, limited moves toward expansionary policies in some major
industrial nations during the year, including coordinated rounds of
discount rate reductions with the Federal Reserve.
2 See the following Records: June 1986, p. 409; November 1986, pp.
5
783-84; January 1987, pp. 33-34; February 1987, p. 120.
“ See the following Records: June 1986, p. 412; October 1986, p. 710;
November 1986, p. 784. Also, see Report (September 1986), p.
641, for a brief discussion of the risks of sharp depreciation of the
dollar on foreign exchange markets, and how those risks influenced
the Board’s decisions on discount rate reductions.
2 See the following Records: June 1986, p. 412; October 1986, p. 710;
7
November 1986, pp. 784-85; January 1987, p. 35; Press Release,
February 13, 1987, p. 11.

Real Activity and Prices
Finally, the FOMC’s decisions in 1986 were guided
by available data on production, employment, wages
and prices, and projections of econom ic activity based
on recent developments. Consum er prices rose by
only 1.1 percent in 1986, the lowest rate of inflation by
this m easure since 1965. Steep declines in oil prices
early in the year contributed to the low rate of in
flation, but wage and price pressures were otherwise
quite m oderate. Monthly data on production and em
ployment and the growth of real GNP indicated, over
m uch of the year, that the expansion was proceeding
at a slower pace than the Com mittee had anticipated .28
Throughout the year, the m em bers generally antici
pated more rapid real growth and inflation in later
quarters. Nevertheless, current indications of sluggish
growth, m oderate price pressures and downside risks
in the econom ic outlook weighed heavily in the Com
m ittee’s decisions to m aintain the accommodative
stance of policy .29 The Com m ittee's views on the desir
ability of interm eeting adjustm ents in policy im ple
m entation also depended upon indications of the
pace of econom ic growth and inflation, among other
developments ,30

SHORT-RUN POLICY O BJECTIVES
The FOMC m eets eight tim es each year to review
econom ic developments and discuss the status of
policy and its im plem entation. At each meeting, the
Com mittee's decisions are sum m arized in a directive
issued to the Federal Reserve Bank of New York. The
directive is then used by the Manager for Domestic
Operations, System Open Market Account, to guide
the day-to-day im plem entation of m onetary policy
through open-m arket operations during the intermeeting period.
Becent policy directives specify the Com m ittee’s
decision about the appropriate "degree of pressure on
reserve positions” of depository institutions for the

“ Real GNP grew 2.1 percent over the IV/1985—
IV/1986 period. At the
February 1986 meeting, the forecasts of real GNP growth of the
members of the Committee and Federal Reserve Bank presidents
had a central tendency of 3 to 31 percent. See the Record (June
/2
1986), p. 408. At the July 1986 meeting, the forecasts for the year
had a central tendency of 21 to 3 percent. See the Record (October
fe
1986), p. 706.
^For example, see the following Records: June 1986, p. 411; Sep
tember 1986, p. 650; October 1986, p. 710.
“ For example, see the following Records: June 1986, p. 412; July
1986, p. 482; September 1986, p. 650; February 1987, pp. 120-21;
Press Release, February 13,1987, p. 11.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
FOMC Short-Run Operating Specifications
Meeting
date

Expected
growth rates

Target
period

Intermeeting
federal funds
range

Degree
of reserve
pressure

December 16 -1 7 ,1 9851

November 1985March 1986

7-9%

about 6-8%

6-10%

decrease somewhat

February 1 1 -1 2 ,19862

November 1985March 1986

about 7

about 6

about 7

6-10

unchanged

April 1,1986

March 1986June 1986

about 7-8

about 7

6-10

unchanged

May 2 0 ,19863

March 1986June 1986

about 12-14

about 8-10

5-9

unchanged

July 8 - 9 , 19864

June 1986September 1986

not specified5 about 7-9

about 7-9

4-8

decrease somewhat

August 1 9 ,19866

June 1986September 1986

not specified

about 7-9

4-8

decrease slightly

September 2 3 ,19867

August 1986December 1986

not specified

7-9

7 -9

4-8

unchanged

November 5, 1986

September 1986December 1986

not specified

7 -9

7-9

4 -8

unchanged

December 15-16,1986

November 1986March 1987

not specified

about 7

4-8

unchanged

'Mr. Black dissented because he felt that a decrease in the degree of reserve pressure was undesirable, given the rapid growth of M1.
2Mr. Martin and Ms. Seger dissented because they believed that the risks to the economic expansion would be lessened by reductions in
short-term interest rates, including an eventual reduction in the discount rate. They favored some easing of reserve conditions in order to
facilitate these reductions.
3Mr. Wallich dissented because he was concerned about the inflationary implications of rapid monetary expansion and felt that open-market
operations should be directed toward somewhat greater restraint.
“Mr. Melzer dissented because he felt that easing under current circumstances could have an adverse impact on inflationary expectations
and lead to an undesirably sharp depreciation in the value of the dollar on foreign exchange markets. He also noted that the outlook for the
quarters ahead appeared to be consistent with the economy's long-run growth potential, and that further ease, in his view, would generate
inflationary pressures without encouraging much faster growth in real output. He therefore favored maintaining the existing degree of
reserve pressure.
5
The directive stated that "While growth in M1 is expected to moderate. . . that growth will continue to be judged in the light of the behavior of
M2 and M3 and other factors.” See Record (October 1986), p. 711, and subsequent Records referenced in the footnotes to the text.
6Mr. Melzer dissented because he was concerned that further ease might heighten inflationary expectations and put excessive downward
pressure on the foreign exchange value of the dollar. He also felt that the prospects for economic growth had improved during the
intermeeting period. Mr. Wallich dissented because he felt that policy should be directed toward slowing the growth of the monetary
aggregates and reducing the potential for inflation. Mr. Wallich and Mr. Melzer preferred to maintain the existing degree of pressure on
reserve positions.
7
Mr. Wallich dissented because he believed that a slight tightening of reserve conditions was desirable in light of the persistence of rapid
monetary growth and the threat that it presented to continued price stability.

period before the next m eeting .31 In addition, each
directive gives the Com m ittee’s expectation of the
growth of various m onetaiy aggregates for som e shortrun target period, contingent upon the stated degree

3 See the directives contained in any of the Records of Policy Actions
1
referenced below.

of reserve pressure, and specifies an interm eeting
range for the federal funds rate. If reserve conditions
proved to be inconsistent with a federal funds rate in
that range, the chairm an could call for a Committee
consultation before the date of the next meeting. Table
3 shows the Com m ittee’s expectations for m oney
growth at each m eeting in 1986. The table also shows
the interm eeting federal funds range established at

FEDERAL RESERVE BANK OF ST. LOUIS

each m eeting and the degree of pressure to be applied
to reserve positions.

February M eeting
The econom ic data reviewed at the February m eet
ing indicated a m oderate and, perhaps, improving rate
of econom ic growth. Real GNP grew at an annual rate
of 2.4 percent in IV/1985, w hich was slower than its 3
percent growth in the previous quarter. Several indica
tors of real activity, however, such as industrial pro
duction, housing starts and new orders for nonde
fense capital goods had shown strength in D ecem ber
after performing sluggishly in prior m onths. Moreover,
substantial gains in em ploym ent were reported for
January.
The Com m ittee discussed a num ber of uncertain
ties that clouded the outlook at the February meeting.
The sharp decline in oil prices in early 1986 was
expected to have broadly favorable effects on the econ
omy. These effects were difficult to assess, however,
and energy-producing regions of the country and
some oil-producing, developing countries with large
debt burdens were likely to suffer. While prospective
fiscal restraint associated with deficit reduction under
the Gramm-Rudman-Hollings legislation was thought
to have had a beneficial im pact on financial markets, it
was expected to have adverse effects on aggregate
demand. Some m em bers expressed concern over the
strength of business investment in light of the u ncer
tainties surrounding tax reform legislation, w hich was
likely to tilt the com position of tax liabilities toward
businesses and away from households.
Despite these considerations, m em bers generally
agreed that the econom y was likely to grow at a faster
rate during 1986 than it had in 1985. Some of the
positive factors cited were the effects of rapid M l
growth, lower interest rates, higher stock prices and
further declines in the foreign exchange value of the
dollar. In fact, some m em bers felt that inflationary
pressures might crop up several quarters ahead.
The growth of M l and M2 had slowed in the weeks
prior to the February meeting, and m oney growth was
close to the rate expected by the Com m ittee in Decem
ber for the November-to-March period. While that fact
was encouraging, some m em bers were concerned
about the failure of short-term interest rates to decline
further in recent m onths in response to the relatively
accom m odative stance of m onetary policy that had
prevailed for some time. There was general accord on
the desirability of im plem enting policy “in a m anner
that would not in itself signal or encourage higher

FEBRUARY 1987

interest rates or impede the tendency for som e market
rates to d ecline .”33 There was, however, a perceived
risk of "a cum ulating decline in the exchange rate that
might discourage willingness to hold dollars at declin
ing interest rates. In these circum stances, nearly all
participants agreed that little or no change in reserve
availability was w arranted .”33
The Com mittee viewed its policy stance as accom
modative, but som e m em bers felt that further easing
might be necessary in light of the risks of a weakening
econom y. In fact, “the point was made that the dis
count rate might need to be reduced to permit or
accom m odate a market tendency toward lower inter
est rates and that such a move would be a desirable
com plem ent to open market operations. .. .’’MOn the
other hand, m em bers felt that the desirability of a
reduction in the discount rate would depend on
evolving circum stances and the prospects for similar
action by m ajor foreign central banks .35

April M eeting
Interest rates of all m aturities declined during the
period betw een the February and April meetings, with
long-term rates falling more sharply than short-term
rates. The foreign exchange value of the dollar also
declined on balance. At the tim e of the April meeting,
however, there were conflicting signals about the pace
of econom ic activity. Spending and real output were
thought to have grown more rapidly during the first
quarter than in the sluggish fourth quarter .36 On the
other hand, growth was clearly weak in som e key
sectors, and production and em ploym ent data for
February were disappointing. On the bright side, de
clines in oil prices dom inated the inflation outlook,
and were viewed as instrum ental in lowering in
flationary expectations.
The Committee decided to m aintain "about the
existing degree of pressure on reserve conditions .”37
This was felt to be consistent with the long-run ob jec

“ Record (June 1986), pp. 411-12.
“ Ibid., p. 411.
Mlbid.
3 The Federal Reserve announced a reduction of the discount rate
5
from 71 to 7 percent on March 7. Subsequently, this action was
/2
matched by several foreign central banks.
“The Commerce Department had reported a downward revision in
real GNP growth in IV/1985 to 0.7 percent.
3 Record (July 1986), p. 482.
7

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

tives for growth in the m onetary aggregates. The
growth of M l had accelerated in Februaiy and March,
and was near the upper end of the Com m ittee’s an
nual range, but the growth of the broader aggregates
had been m oderate. The Com m ittee discussed the
possibility that dem ands for M l balances could grow
substantially if interest rates continued to decline.
Furthermore, the velocity of M l rem ained weak, and
some m em bers suggested that a m ore accommodative
posture with respect to m oney and reserve growth
might well becom e desirable. For the weeks im m edi
ately ahead, however, "m ost of the m em bers felt that
there should be no presum ptions about the likely
direction of any interm eeting adjustm ents .”38

ing at some point in the future .”41 The growth of the
broader aggregates had been well w ithin their respec
tive target ranges for 1986, however, w hich “raised
questions as to w hether the growth of M l really repre
sented a potentially excessive buildup in liquidity or
was more of a shift in the com position of liquid hold
ings in response to relative movements in interest
rates .”42 The m em bers generally agreed that some
slowing in M l growth was likely in the weeks ahead,
but, because of uncertainties about the timing and
extent of the slowdown, “som e proposed omitting
num erical references in the directive to the Commit
tee’s expectations for m onetaiy growth in the second
quarter ." 43 This proposal was rejected by the majority.

The Board announced another reduction in the
discount rate of one-half point, to 6 V2 percent, effec
tive April 21. The Com m ittee held a telephone confer
ence on that date and agreed to make no changes in
the current directive. Becent data indicated that
growth in the m onetary aggregates had accelerated,
however, and the m em bers felt that, in im plem enting
open m arket operations, “a degree of caution should
be exercised to avoid an im pression that a further
change in the discount rate was sought over the p e
riod immediately ahead .”39

While som e evidence of slower real growth had
emerged by the time of the May meeting, a num ber of
factors pointed toward more rapid growth later in the
year. These factors included rapid money growth,
higher prices of financial assets, lower energy prices
and further depreciation of the dollar against the
currencies of m ajor trading partners. In response to
these elem ents in the outlook, “m ost of the mem bers
indicated that they were in favor of continuing to
direct open market operations at least initially toward
m aintaining the existing degree of reserve availabil
ity .”44 In their discussion of possible interm eeting ad
justm ents, m ost m em bers em phasized a potential
need for restraint in response to signals of a strength
ening econom y if growth in the m onetary aggregates
did not slow as anticipated. The directive stated that,
under those circum stances, “somewhat greater re
serve restraint would be acceptable,” but in the event
of slower m oney growth and sluggish econom ic activ
ity, “somewhat lesser reserve restraint might be ac
ceptable .”45

May M eeting
The acceleration in the growth of M l continued,
and the appropriateness of using that aggregate as a
guide to policy was prom inent in the discussion at the
Com m ittee’s m eeting on May 20. As of early May, M l
was well above the 8 percent upper limit of its target
range for 1986. Some m em bers noted that the rela
tively rapid growth of M l balances needed to be ac
com m odated in light of the continuing adjustm ents to
earlier declines in inflationaiy expectations and inter
est rates and som e indications of weakness in the
econom y .40
Other m em bers suggested that the rapid m oney
growth might represent excessive growth in liquidity
that eventually would have inflationary consequences.
In this view, rapidly growing cash balances "were
available to support a considerable pickup in spend-

Ju ly M eeting
Some optimism was expressed at the July meeting
about the prospects for econom ic growth over the
second half, and the outlook for inflation rem ained
favorable. There was concern, however, about the

’'Record (September 1986), p. 648.
“ Ibid.

42lbid., p. 649.

wlbid., p. 483.

“ Ibid., p. 650.

“ The Commerce Department’s preliminary estimate of real GNP
growth in the first quarter was 3.7 percent, but industrial production
declined on balance over the three months ending in April. More
over, weakness among oil producers and uncertain but potentially
adverse changes in the tax code were retarding business fixed
investment.

■ Ibid., pp. 651-52. In response to rapid growth in required reserves
“
and currency in circulation, the limit on changes in System Account
holdings of U.S. government and federal agency securities between
Committee meetings was temporarily raised by the Committee from
$3 billion to $9 billion on June 18.

"Ibid., p. 650.

FEDERAL RESERVE BANK OF ST. LOUIS

sluggish pace of business investment, the lack of im
provement in the trade balance, and the “sharp con
trasts in the econom ic perform ance of different sec
tors and regions of the country and . . . strains on
financial institutions that serviced the depressed
industries.
At the previous meeting, the m em bers had antici
pated that a move toward restraint might be n eces
sary. By July, the favorable inflation outlook and con
cern over slow econom ic growth led m ost of the
m em bers to believe ‘‘that som e easing was desirable,”
which they preferred to im plem ent “at least initially,
through a lower discount rate rather than through
open market operations."4 The m em bers accepted a
7
directive “that called for some decrease in the existing
degree of reserve pressure, recognizing that relaxation
could be accom plished in the first instance by a re
duction in the discount rate.”4
8
The Committee continued to anticipate a slowdown
in the growth of M l, w hich had decelerated somewhat
in Ju n e but was still quite rapid (see chart 1). Consider
able doubt rem ained about the extent and timing of
such a slowdown, however. With the growth of the
broader aggregates around the midpoints of their
ranges for the year, and in the context of an unex
pectedly sluggish economy, the Committee mem bers
agreed that rigid adherence to the original M l target
was inconsistent with their objectives. Because of
their uncertainty about the usefulness of M l as a guide
to policy under prevailing conditions, “ m ajority of
a
the m em bers expressed a preference for not indica
ting a specific rate of expected growth for M l in the
short-run operational paragraph of the Com m ittee’s
directive. ”8
4

August M eeting
The rapid growth of M l continued through July and
into early August. The broader aggregates also grew

“ Record (October 1986), p. 707.
47lbid., p. 710. Of course, a cut in the discount rate should increase the
demand for borrowed reserves by depository institutions. Under the
borrowed reserve operating procedure currently used by the openmarket desk, this would result in open-market purchases of securi
ties unless the borrowed reserves target is increased. See Gilbert
(1985) for a discussion of the current operating procedure and two
others that have been used by the open-market desk since 1970.
The borrowed reserves targets used by the desk during each year
are published during the following year in the Federal Reserve Bank
of New York Quarterly Review.
“ Record (October 1986), p. 710. On July 10, the Federal Reserve
announced a 1 2-point reduction in the discount rate to 6 percent.
/
49lbid.

FEBRUARY 1987

quite rapidly, leaving them near the upper lim its of
their target ranges. At the Com m ittee’s August m eet
ing, there was some concern about w hether the rapid
growth in all three aggregates had inflationary im pli
cations. Moreover, there had been further deprecia
tion in the foreign exchange value of the dollar during
the interm eeting period. The cheaper dollar was ex
pected to put some upward pressure on prices, even
though there were not yet any signs of the longawaited reduction in the trade deficit. There was some
evidence that econom ic growth was accelerating from
the weak pace of the second quarter, including strong
consum ption dem and and housing activity.5 Never
0
theless, the data reviewed at this meeting continued to
indicate a lack of balance in term s of growth among
different sectors of the econom y and only m oderate
wage and price pressures. In view of the fact that
interest rates had resum ed their decline since early
June, the m em bers agreed that m oney growth had not
been excessive.
The m em bers considered a num ber of uncertainties
that continued to cloud the econom ic outlook in Au
gust. These included downside risks related to the
effects of tax reform legislation, rising consum er debt
burdens and sluggish growth of the econom ies of
several m ajor U.S. trading partners. There was also
uncertainty about the course of the federal budget
deficit and its im pact on the econom y.
The Committee agreed that “some slight easing in
the degree of reserve pressure” was appropriate, and
once again stated that this “might be accom plished
through a reduction in the discount rate."5 The m em
1
bers felt that an interm eeting adjustm ent in either the
direction of ease or restraint might be warranted,
depending on ensuing developments. It was noted,
however, that in the event of a further cut in the
discount rate, a significant depreciation of the dollar
on foreign exchange markets would call for “a little
greater caution in the provision of reserves through
open market operations . . . .”5 The Board reduced the
2
discount rate by Vz percentage point to 5Vz percent
effective August 21.

Septem ber M eeting
Short-term interest rates fell somewhat after the
reduction in the discount rate, but long-term rates

“ The preliminary estimate of real GNP growth in 11/1986 was 1.1
percent.
5 Record (November 1986), p. 785.
1
“ Ibid.

FEDERAL RESERVE BANK OF ST. LOUIS

FEBRUARY 1987

rose sharply, and by the time of the Committee s
m eeting on Septem ber 23, the value of the dollar on
foreign exchange m arkets had changed little. The
growth rates of M2 and M3 decelerated in August but
were still fairly rapid, and M l growth accelerated from
its already rapid pace before slowing sharply in early
September.

in the trade balance rem ained elusive and, in large
part, dependent upon stronger econom ic growth
overseas to spur demands for U.S. exports. One mem
ber referred to increasing protectionist sentim ent as a
threat to real growth and price stability. In addition,
tax reform legislation appeared to be deterring busi
ness investment, particularly in structures.

Most Committee m em bers believed that, despite an
apparently stronger econom y in the third quarter, an
improvement in the trade balance was critical to sus
tained growth. At the same time, the m em bers felt that
there were com pelling reasons for expecting some
upward price pressures in the quarters ahead, includ
ing the likelihood of price increases for imports and
im port-com peting goods stem m ing from the decline
of the dollar, and a continuing reversal of the earlier
decline in world oil prices. In addition, there had been
indications of a resurgence of inflationary expecta
tions in financial markets and in markets for precious
m etals. Because "m onetary policy had moved toward
an increasingly accommodative posture over the
course of recent m onths,” several m em bers believed
“that it was now time to pause and observe develop
,5
m en ts___1 3 The Committee voted for “no change in
the current degree of pressure on reserve positions.”5
4
In fact, while not ruling out the possibility of a move
toward ease, most of the m embers believed that any
potential intermeeting adjustm ent would more likely
involve some restraint, depending on the behavior of a
num ber of guides reflecting econom ic and financial
conditions.

The Committee expected inflation to accelerate
somewhat over the quarters ahead because of the
lagged im pacts of the dollar’s depreciation and energy
price developments. On the other hand, relatively low
rates of capacity utilization in m ost industries, m oder
ate wage growth and continuing efforts by businesses
to reduce costs and improve productivity were factors
that would help to hold inflation in check. Moreover,
the value of the dollar on foreign exchange markets
had stabilized during the interm eeting period. If con
tinued, that stability would limit a potential source of
upward price pressure.

N ovem ber M eeting
The Committee's expectation that money growth
would fall somewhat from its exceptionally rapid pace
during the sum m er m onths was fulfilled in September
and October: M2 and M3 advanced at annual rates of
9.3 and 8 percent over the two m onths, and M l growth
slowed to a rate of 12.5 percent. Meanwhile, econom ic
activity appeared to be growing at a moderate rate.5
5
At the Com m ittee’s November meeting, the m em
bers saw a continuation in the moderate pace of
econom ic expansion as a likely outcome, but certain
aspects of the outlook were disturbing. Improvement

“ Record (January 1987), p. 34.
“ Ibid., p. 35.
5 Real GNP grew at an annual rate of 2.4 percent in 111/1986, accord
5
ing to the preliminary estimate, after growth of only 0.6 percent in
11/1986.
“ Record (February 1987), p. 120.

Given the prospects for sustained, moderate growth
in econom ic activity and recent moderation in the
growth of the monetary aggregates, the Committee
voted for “maintaining unchanged conditions of re
serve availability.”5 With regard to possible interm eet
6
ing adjustm ents, some m embers felt that an easing
might be desirable in the context of indications of
weakness in the economy, while others felt that
money growth below the Com m ittee’s expectations
should be tolerated in the absence of rising interest
rates or a weak economy. The directive did not incor
porate any presum ption, however, about the likely
direction of any interm eeting adjustm ent in policy.5
7

D ecem ber M eeting
The data reviewed at the Committee’s Decem ber
meeting showed that employment growth, industrial
production and consum er spending had strength
ened in recent m onths. Sluggishness in business
spending and the housing sector were elem ents of
concern, however, and the balance of trade showed no
convincing signs of improvement. To a considerable
extent, the discussion focused on downside risks to
econom ic growth, particularly for the early part of
1987. The earlier decline of the dollar had enhanced
the international competitiveness of many U.S. firms,

5 The Committee approved a temporary increase from $6 billion to $7
7
billion in the limit on changes in System Account holdings of govern
ment securities during the next intermeeting period, effective De
cember 3. Outright purchases through December 1 had left insuffi
cient leeway for additional purchases that would be necessary to
provide for seasonal increases in required reserves and currency in
circulation.

FEBRUARY 1987

FEDERAL RESERVE BANK OF ST. LOUIS

but a num ber of m em bers expected only m inor im
provement in foreign trade over the quarters ahead.
The growth of consum er debt was viewed as a factor
that might inhibit dom estic dem and in 1987. More
over, consum ers and businesses were thought to have
shifted some purchases originally planned for 1987
into 1986 to take advantage of certain provisions of the
tax code that were scheduled for rescission under the
new tax legislation.5 While the reduction in personal
8
tax rates for 1987 was good news for consum ers, the
new tax code along with high vacancy rates had nega
tive im plications for spending on multifamily housing
and nonresidential construction.
In their discussion of policy im plem entation, the
m em bers noted that the broader m onetaiy aggregates,
w hose growth had slowed in November, were within
their target ranges for the year. On the other hand, the
growth of M l had accelerated in November. Some
m em bers felt that a continuation of the rapid growth
of that aggregate, and the reserves needed to support
it, carried an inflationary risk. There was a strong
likelihood, however, that M l velocity would continue
to decline even with some slowing in M l growth. Once
again, the Com m ittee agreed that the growth of M l
would be appraised in the context of the growth of the
broader aggregates and other developments.
Given the econom ic outlook and the fact that M2
and M3 were w ithin their long-run ranges, the Com
mittee directed the desk “to m aintain the existing
degree of pressure on reserve positions.”5 In light of
9
the downside risks to the economy, severed m em bers
em phasized that in subsequent weeks, developments
might call for some easing of reserve conditions. These
m em bers noted that flexibility in the direction of ease
was afforded by the recent firming of the dollar’s value.
M embers recognized, however, that circum stances
might call for a small adjustm ent in either direction.
The Com m ittee’s deem phasis of M l as an interm e
diate target and guide for policy was underscored at
the Decem ber meeting. A tentative range of 3 to 8
percent for M l growth in 1987 had been reported to
Congress in July as more tentative than usual. In
December, a m ajority of the Com m ittee indicated that
they opposed “establishing a formal target range for
M l growth in 1987.” Many of those m em bers believed,
however, that M l growth “should continue to be m on
itored or evaluated in light of information about the
economy, prices, and the broad m onetaiy aggregates
and other financial variables.”6
0

CONCLUSION
The FOMC deem phasized M l and placed relatively
more weight on the broader m onetaiy aggregates and
various econom ic and financial indicators in estab
lishing its overall approach to policy and in guiding
short-run policy im plem entation during 1986. A state
m ent typical of the 1986 directives issued by the Com
m ittee was that changes in the direction of policy
im plem entation would depend “on the behavior of
the aggregates, taking into account the strength of the
business expansion, developments in foreign ex
change markets, progress against inflation, and condi
tions in dom estic and international credit m arkets.”6
1
The lengthy list of factors guiding policy underscored
the Com m ittee’s desire to take a flexible approach in
providing reserves in what it viewed as a highly u n cer
tain econom ic environment.
The recent changes in the relative weights attached
to various policy guides have reflected the Commit
tee’s evaluation of the im portance and reliability of
these variables in influencing real growth and in
flation. The accom modative thrust of policy was m oti
vated by sluggish econom ic growth and a num ber of
risks to sustained expansion. While the Committee
was wary of inflationary risks in the outlook, price
p ressu res over the co u rse of 1986 w ere w ellcontained. W hether m onetary policy can continue to
provide sufficient liquidity to sustain econ om ic
growth without an acceleration in the rate of inflation
is a m ajor issue confronting the Federal Reserve in
1987.

REFERENCES
Broaddus, Alfred, and Marvin Goodfriend. “Base Drift and the
Longer-Run Growth of M1: Experience from a Decade of Monetary
Targeting,” Federal Reserve Bank of Richmond Economic Review
(November/December 1984), pp. 3-14.
Gilbert, R. Alton. “Operating Procedures for Conducting Monetary
Policy,” this Review (February 1985), pp. 13-21.
________ _ “Requiem for Regulation Q: What It Did and Why It
Passed Away,” this Review (February 1986), pp. 22-37.
Hafer, R. W. “Much Ado About M2,” this Review (October 1981),
pp. 13-18.
_________ “The FOMC in 1985: Reacting to Declining M1 Veloc
ity," this Review (February 1986), pp. 5-21.
Keeley, Michael C., and Gary C. Zimmerman. “Deposit Rate Dereg
ulation and the Demand for Transactions Media," Federal Reserve
Bank of San Francisco Economic Review (Summer 1986), pp. 4 7 62.
Lawler, Patrick J.

“The Large Monetary Aggregates as Intermediate

“ See Tax Reform Act of 1986.

“ Ibid., p. 302.

“ Record (April 1987), p. 304.

6 Record (February 1987), p. 122.
1

FEDERAL RESERVE BANK OF ST. LOUIS
Policy Targets,” Voice of the Federal Reserve Bank of Dallas
(November 1981), pp. 1-13.
Mann, Catherine L. “Prices, Profit Margins, and Exchange Rates,”
Federal Reserve Bulletin (June 1986), pp. 366-79.

FEBRUARY 1987
Tax Reform Act of 1986.
1986).

H. Rept. 99-841, 99 Cong. 2 Sess. (GPO,

Volcker, Paul A. Statement before the Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, July 23, 1986, Federal
Reserve Bulletin (September 1986), pp. 635-42.

Mehra, Yash. “The Recent Financial Deregulation and the Interest
Elasticity of the Simple M1 Demand Function: An Empirical Note,”
Federal Reserve Bank of Richmond, Working Paper No. 85-3
(1985).

Walsh, Carl E. “In Defense of Base Drift," American Economic
Review (September 1986), pp. 692-700.

Roth, Howard. “Effects of Financial Deregulation on Monetary Pol
icy,” Federal Reserve Bank of Kansas City Economic Review
(March 1985), pp. 17-29.

Wenninger, John. “Responsiveness of Interest Rate Spreads and
Deposit Flows to Changes in Market Rates," Federal Reserve
Bank of New York Quarterly Review (Autumn 1986), pp. 1-10.

Full text of Review (Federal Reserve Bank of St. Louis) : February 1987

FRASER