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R ules and Discretion in M onetary Policy
Can N o m in a l G D P T a rg e tin g R ules Stabi
lize the Economy?
T he FOMC in 1992: A M onetary
C onundrum

FEDERAL
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Federal R eserve Bank of St. Louis
R eview
May/June 1993

In This Issue . . .
3

R ules and D iscretion in M onetary P olicy
Gerald P. D w yer Jr.
Should monetary policy be determined by a legislated rule or by a mone
tary authority’s discretion? Henry Simons first raised this issue in 1936 as
a choice between rules and authorities, terms little different from those
used in recent discussions. Proposed rules would restrict the Federal
Reserve's discretion in various ways. Simons argued that the Federal
Reserve should be required to keep the price level constant. Some other
proposed rules embody far more radical changes in the U.S. monetary
system.
This article provides an overview of the debate on rules vs. discretion.
Dwyer focuses on the following basic issue: Even if policy actions would
usually be the same with or without a rule, what are the benefits and
costs of a rule that commits policy? On the benefit side, rules make it
possible to have policies that are otherwise impossible. On the cost side,
rules can limit a monetary authority's responses to the economy’s recent
performance. As Dwyer indicates, though, such responses can actually be
destabilizing, and evidence that such responses have been stabilizing is
lacking.

Can N om inal GD P T argetin g R ules Stabilize the Economy?
Michael J. Dueker
Because the Federal Reserve has shown interest in making price stability
an explicit goal of monetary policy, examination of potential nominal an
chors has become particularly relevant. A target path for nominal gross
domestic product (GDP) growth is a possible nominal anchor that has
received considerable attention since Bennett McCallum proposed an implementable nominal GDP targeting rule. Numerous researchers have run
simulations of McCallum's rule and have generally concluded that ruleguided manipulation of the monetary base could greatly stabilize the
growth of nominal spending and could, by implication, be used to foster
price stability. Unfortunately, virtually all of these studies regarding the
stability of the velocity relationship between the monetary base and
nominal income have been too optimistic.
In this article, Michael Dueker tests and rejects the hypothesis that the
income velocity of the monetary base has been stable. He then estimates
a velocity model that has time-varying parameters to account for struc
tural change. Subsequent simulations of McCallum’s rule use a calibrated
version of the velocity model to generate data. In the simulations, McCal
lum’s rule is still able to stabilize nominal GDP growth, but less stringent-

MAY/JUNE 1993

ly than simulations using fixed-coefficient models have suggested. This
finding suggests that a nominal GDP target can serve as a long-run nomi
nal anchor so that prices might be predictable in the long run, but shortrun variability will persist.

The FOMC in 1992: A M onetary C o n u n d ru m
Joseph A. Ritter
The Federal Open Market Committee (FOMC) holds the primary responsi
bility for monetary policy. This article argues that in 1992, mixed signals
sent by M l, which grew rapidly, and M2, which grew slowly, were the
source of an important tension in monetary policymaking. In this article,
Joseph Ritter surveys hypotheses about the causes of slow M2 growth
and concludes that although the FOMC found none of them wholly per
suasive, the Committee gave less weight to movements in this
aggregate than in recent years.

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Gerald P. D w y er Jr.
Gerald P Dwyer Jr., a professor of economics at Clemson
.
University, was a visiting scholar at the Federal Reserve Bank
of St. Louis when this paper was started. The author would
like to thank his colleagues William R. Dougan, David B. Gordon
and Raymond D. Sauer. Richard I. Jako provided research
assistance.

Rules and Discretion in
Monetary Policy
l ^ n m H.n MONETARY POLICY be determined
by a legislated rule or by a monetary authority’s
discretion? Henry Simons (1936) first raised this
issue as a choice between rules and authorities,
terms little different than those used in recent
discussions. He stresses the value of a rule, such
as a law, instead of reliance on an authority’s
discretion because "definite, stable, legislative
rules o f the game as to money are of paramount
importance to the survival of a system based on
freedom of enterprise.”1 Though Simons men
tions that laws can change and therefore a rule
does not eliminate uncertainty about monetary
legislation, his principal focus is the undesirabili
ty o f delegating power to a monetary authority
with a mandate to pursue only very broad
goals. Others, for example Modigliani (1977),
have argued that monetary policy conducted by
just such an expert monetary authority will en
hance the economy’s performance.
Proposed rules would restrict the Federal
Reserve’s discretion in various ways. Simons ar
gued that the Federal Reserve be required to
keep the price level constant rather than be left
to pursue other possible goals. Some proposed
rules embody far more radical change in the

'See Simons (1936), p. 339.
2See Friedman (1959) and Lucas (1980).
3See Wallace (1977).
4The debate about rules vs. discretion in monetary policy
has a long and interesting history, summarized by Argy
(1988) and Carlson (1988). There is also substantial litera
ture on the implementation of monetary policy and the im

U.S. monetary system. One rule espoused by
some is a constant growth rate of the money
stock.2 With reserve requirements fixed and the
discount rate tied to open-market interest rates
by law, the only judgment necessary at the Fed
eral Reserve would be the open-market pur
chases of government securities necessary to
generate the mandated growth o f the money
stock. Another proposed rule would fix the level
of the monetary base.3 With this rule, it would
be possible to eliminate any discretion at the
Federal Reserve completely. What are the impli
cations of such radical changes?
The purpose of this article is to provide a
guide to the current state of the debate on
rules discretion. The focus of this article is the
basic issue: What are the implications of a rule
that commits future monetary policy, thereby
limiting the monetary authority's ability to
respond to changes in the economy?4

RULES VS. DISCRETION
Discussions of rules and discretion sometimes
use seemingly similar, but not identical, defini
tions of the terms. Any discussion of rules and

plications for rules, much of it in this Review. Goodhart
(1989) presents a detailed analysis of the implementation of
monetary policy. The long-standing contrast between the
monetarist case for rules and the alternative case for
stabilization policy is summarized in Mayer (1978).

MAY/JUNE 1993

discretion requires care in using these terms, as
well as other seemingly obvious terms such as
policy.

Policy and Its Instruments
What does the term policy mean? In this arti
cle, policy means a plan of action or a strategy.
A policy may either be the outcome of some
process or it may be a plan designed specifically
to further some goal. In either case, dynamic
aspects of the economy are sufficiently impor
tant that no sensible strategy can treat events
each day, month or year as independent. For
example, suppose that the goal is to have zero
inflation. The current inflation rate is affected
by expectations of future inflation, which in
turn depend on expectations of current and fu
ture policy actions. As this simple example illus
trates, any policy must consider current and
future implications of both current and future
actions.
A policy requires instruments to implement it.
Policy instruments are the tools manipulated to
produce the desired outcomes. The primary in
strument of monetary policy in the United
States today is open-market purchases and sales
of government securities. Additional instruments
include changes in required reserve ratios and
changes in the discount rate.
Any particular value of the instruments on
any particular date can be consistent with many
different policies. Only in the context of expect
ed future actions can the values of instruments
be considered part of a coherent policy. It is
common to refer to current monetary policy as
the values of indicators of the monetary
authority’s actions this week, perhaps the federal
funds rate or the growth o f the monetary base.
This usage is inconsistent with the definition of
policy as a plan though, because the current
and future implications of today’s values of in
struments or related indicators are clear only in
the context of some expected future actions.

Rules and Discretion
What is a discretionary monetary policy? Un
der discretion, a monetary authority is free to
act in accordance with its own judgment. For
example, if legislation directed the Federal
5This restriction to the monetary base as the single instru
ment could be accomplished by eliminating the discount
rate and changes in reserve requirements as instruments

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Reserve to do its best to improve the economy’s
performance and gave the monetary authority
the instruments that it has, the Federal Reserve
would have a discretionary monetary policy.
In the context of monetary policy, a rule is a
restriction on the monetary authority’s discre
tion. A rule involves the exercise of control over
the monetary authority in a way that restricts
the monetary authority’s actions. Rules can
directly limit the actions taken by a monetary
authority. For example, one simple possible rule
would be that the monetary authority hold the
monetary base constant. This clearly restricts
the use o f judgment. A rule need not be as sim
ple as that though. Rules can attempt to limit
the objectives pursued by the monetary authori
ty. For example, one possible rule would be that
the monetary authority announce a target for
monetary base growth over some period to fur
ther some well-defined goal and then to hit the
target unless predetermined exceptional circum
stances arise.
Though a rule imposed by legislation or even
constitutionally would be subject to revision, in
frequent changes in the rule relative to firms’
and households' expectations and decisions
make policy more predictable. This would be
true even if the application of the rule in a par
ticular instance were sometimes unclear be
cause of ambiguity about the state of the world.
The problem facing the monetary authority
would be to determine the particular state of
the world — for example, whether the economy
is in a recession. The rule then would deter
mine the particular choices of the values of the
instruments.
Most proposed rules restrict the monetary
authority’s discretion but do not eliminate it. Si
mons (1936) proposed a rule that the monetary
authority keep the price level constant. Though
this rule would restrict the monetary authority’s
discretion, the authority could still exercise sub
stantial discretion in pursuing this goal. Even
with the choice of the particular price index de
termined and even if the monetary authority
had only one possible instrument, perhaps the
monetary base, the authority would still have to
estimate the growth rate of the monetary base
consistent with a constant price level.5 This esti
mate requires a forecast of the demand for the
and making some technical changes in the relationship be
tween the Federal Reserve and the Treasury.

monetary base at zero inflation, which almost
inevitably requires judgment. Similarly, a rule
that the monetary authority keep the growth
rate of the money stock constant at, say, 4 per
cent per year can allow substantial judgment
about the way to hit the target. Even a rule re
quiring the monetary authority to keep the
growth rate of the monetary base constant at 4
percent could allow some choice of instruments
or of timing. Nonetheless, it is possible to have
rules that allow no discretion under any cir
cumstances. If the monetary authority has only
one instrument, a rule that the monetary base
grow at 4 percent per year can eliminate dis
cretion.

The Issues
There are two leading arguments concerning
the desirability of rules or discretion. The first
is the desirability of having elected representa
tives make choices. Simons’ (1936) choice was
for monetary policy largely determined by elect
ed representatives rather than by a monetary
authority. Part of this conclusion is based on a
particular set of values: a preference for mone
tary policy made by elected representatives
rather than by experts subject to looser control
by the electorate or their representatives.6 On
the other hand, others have argued that expert
economic judgment can contribute to better
policy.7
The other leading argument concerns the
economy's performance under rules and under
discretion — that is, the economic implications
of committing policy. This argument has two
components. The first component is whether,
even if policy actions usually would be the same
with or without a rule, there are benefits or
costs of committing policy. The second compo
nent is whether, given the current state of eco
nomic knowledge, policy actions that depend on
the current state of the economy are likely to
improve the economy’s performance. These two
components of the economic implications of
committing policy are closely related. If judg
ments based on the state of the economy are
unlikely to improve the economy’s performance,
there is little cost of committing policy.

6Simons (1936, p. 340) wanted to prevent “ discretionary (dic
tatorial, arbitrary) action by an independent monetary
authority.” Among others, Lucas (1980) indicates a prefer
ence for the electorate’s greater involvement in monetary
policy.

COMMITTING POLICY
A common observation 15 or so years ago
was that discretion could be used to produce
the same values of the policy instruments as
would be feasible with any restriction; hence a
rule could not improve on discretion. For exam
ple, if a constant growth rate o f the money
stock were desirable, as Friedman advocated, a
monetary authority exercising discretion could
produce this outcome.8 Furthermore, as Turnovsky (1977, p. 351) noted, “with one exception
... [a constant value of the instrument] is never
optimal; that is a judiciously chosen discretion
ary policy will always be superior.” According
to this view, because a discretionary policy can
produce the same values of the instruments as
a rule, a discretionary policy can be no worse
than a rule and in fact can even be better.

Time Consistency o f Policy
In their analyses of the “time consistency of
policy,” Kydland and Prescott (1977) and Calvo
(1978) show that this general argument against
rules is wrong. Consistent with Turnovsky’s
analysis, suppose that the monetary authority
sets the instrument each period based on what
seems like the best thing to do starting today.9
Kydland and Prescott (1977), Calvo (1978), and
Barro and Gordon (1983b) show that such a
policy can result in worse outcomes than will
result from a rule determining current and fu
ture monetary policy. That is, when the econo
my adjusts to this method of determining
monetary policy given the monetary authority’s
incentives, the economy’s actual performance
can be worse with discretion than with a rule.
There can be a positive return to committing
policy because committing future policy can
have substantial effects on the economy today.
Any economic policy implemented today takes
past expectations as given, which may seem
harmless and possibly even desirable. Suppose,
as seems safe, that people’s actions today de
pend on their expectations of the future. In any
model of the economy, doing the best that can
be done starting today yields a path of the in
struments for this period and the future. This
path starting from today takes past expecta-

7See Modigliani (1977).
8See Friedman (1959).
9Pindyck (1973) is one example of such sequential optimiza
tion with an estimated model.

MAY/JUNE 1993

the predictable component of y that is not as
sociated with past values of y or the policy in
strument. Even though the money stock is not a
policy instrument in the United States today, for
simplicity suppose that y is the growth rate of
nominal GDP and m is the growth rate o f the
money stock.
The economy, of course, is more complicated
than equation (1), but most of the arguments
for and against feedback policies can be ex
plained in the context of this equation. Equation
(1) includes only a single variable, but this is not
a real limitation: y can be interpreted as a set
of variables. Equation (1) is assumed to be linear
and to have constant coefficients, which are
possibly severe limitations largely shared by
current econometric models. A major limitation
of equation (1) is that expectations are not ex
plicitly included. One reason for the importance
of expectations, discussed previously, is their
importance for the incentives affecting policy.
Another reason for the importance o f expecta
tions, discussed later, is that the coefficients in
an equation such as (1) reflect households’ and
firms' expectations about policy. This depen
dence of the coefficients on expectations affects
the actual usefulness of an equation such as (1)
for policy. For illustrative purposes though,
equation (1) suffices.

The Case f o r Feedback Policies
On the simplest level, the case for feedback
policies is transparent. Suppose that the coeffi
cients in equation (1), a, / and y, are constant
3
and policymakers know the values of these
coefficients. One policy without feedback would
be a constant growth rate of the money stock.
This and other policies without feedback permit
the effects of a shock, £t, to persist over time.
On the other hand, a feedback policy can
eliminate these persistent effects. If the mone
tary authority cannot predict the shocks to
nominal GDP growth, it is not possible for the
authority to offset the initial effect of a shock.
Nonetheless, a feedback policy can offset all
continuing effects of the shocks. Such a feed
back policy for equation (1) is
(2) m, =

y'-°-Py

rate of nominal GDP is, the higher is this peri
od’s growth rate of the money stock. There is
feedback from nominal GDP growth last period
to money growth this period.
Actually choosing an appropriate policy is
hardly so simple though, because among other
things any particular equation such as (2) as
sumes that much more is known about the econ
omy than is realistic. Few, if any, would argue
that knowledge about the economy is so advanced
that monetary authorities know the equations
that characterize the economy’s behavior over
time, let alone the values of the coefficients in
those equations. Suppose that the economy is
characterized by equation (1) and that monetary
policy is selected from feedback equations of
the general form of equation (2). With uncer
tainty about the particular equations that
characterize the economy, a monetary authority
might adopt such a feedback policy as follows:
(3) m,= m* + c5(y*-y, ,).
In this equation, m* is the constant growth of
the money stock that leads to nominal GDP
growth equal to the target growth rate in the
long run and 6 is a parameter characterizing
the response of money growth to deviations of
income growth from the target. If the economy
is governed by an equation something like (1), a
positive response to the observed deviation
from the target might seem likely to move the
economy toward the target more quickly than it
would get there otherwise.
An improvement in the economy’s perfor
mance with this simple feedback policy is possi
ble. Suppose that feedback equation (3) is
consistent with a target annual growth rate of
nominal GDP of 5 percent. Further suppose that
income growth initially is 5 percent and falls to
- 5 percent in period 0 because of a shock, that
is, £,= -1 0 in period t = G With substantial per
.
sistence in the economy (/ is 0.9) and constant
?
money growth (no feedback), the red line in
figure 1 shows that the economy only gradually
returns to growth of 5 percent after a shock. A
feedback policy using equation (3) can speed up
the convergence. For example, with 6 equal to
0.9, the rapid convergence shown by the black
line occurs.

y
where y* is the target growth rate of nominal
income. Equation (2) is an explicit example of a
feedback policy: the lower last period’s growth

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The usefulness of such feedback is the basis
of another argument against a rule. Mullineaux
(1985) and Lindsey (1986) suggest that actual
desirable policies are quite complex and that

Figure 1
Substantial Persistence in the Economy and Substantial Feedback
Percent

Beta = 0.9 and Delta = 0.9

Period

any desirable rule would be quite complex. If
this is true, any desirable rule might be so com
plex that writing it down would be much more
costly than any possible benefits of having it.
The only feasible rules may be simple ones that
restrict policymakers' responses to the econo
my's state, and these restrictions could worsen
the economy's performance.

The Case Against Feedback
Policies
One interpretation of arguments against rules
based on the complexity o f monetary policy
such as Mullineaux’s and Lindsey’s is that the
economy is too complex to specify a useful
model of the economy or a policy for the fu
ture. If the discussion is about unspecifiable
models, however, economic analysis has little,
or more likely, nothing to contribute—all is
guesswork. In this case, it is not obvious that
judgment uninformed by economic analysis has
more value than a rule; after all, the benefits of
13lndeed, this might be a major purpose of monetary policy,
a view suggested by Friedman (1959). Friedman’s more re
cent views are presented in Friedman and Schwartz (1986).

discretion are as speculative as the effects of
any rule.
The complexity of a desirable monetary rule
depends on what is expected of monetary poli
cy. One objective of monetary policy might be
to prevent runs on the banking system.1 Runs
3
on the banking system occurred at most once
every decade or two before the creation of the
Federal Reserve.1 This suggests a low frequen
4
cy of exceptional circumstances. Other possible
purposes o f monetary policy, such as stabilizing
interest rates on a daily basis, may provide
more exceptional circumstances and may be
more consistent with an argument that the cir
cumstances are so varied that a useful rule is
too complex to be worth trying to formulate it.
Whatever the frequency o f exceptional cir
cumstances, feedback policies are not necessarily
better than policies without feedback.1 Know
5
ing whether a particular feedback policy im
proves or worsens the actual behavior of the
15Phillips (1957) was the first to show this explicitly. In a
general context, Friedman (1953) shows the same propo
sition.

14See Dwyer and Gilbert (1989).

MAY/JUNE 1993

economy depends on detailed knowledge about
the response of the economy to different policies.
Suppose that the economy has little persistence,
for example ft is 0.1. Then with no feedback,
the red line in figure 2 shows that the economy
returns relatively quickly to 5 percent growth
of nominal GDP growth after the same shock as
in figure 1. If the monetary authority uses the
same feedback policy as in the example in
figure 1, the oscillations shown by the black
line in figure 2 result. If the economy has little
persistence, this feedback policy makes the
economy more variable after a shock than it
would be with a policy without feedback. Doing
something (a feedback policy) can be worse
than doing nothing (a policy with no feedback).
The importance of the possibility of worsen
ing the economy’s behavior is magnified by the
prospect that a monetary authority with a feed
back policy may never learn the structure of
the economy. If the economy's behavior could
be summarized by an equation such as (1) and
the monetary authority attempted to stabilize
the economy, the effects of the policy on nomi
nal GDP and expectations might make it impos
sible for the monetary authority ever to converge
to correct estimates of the economy’s responses
to different monetary policies.1 Some economists
6
believe that firms' and households’ ability to
converge to a reasonable working knowledge
about the economy is far from ensured. It is
not obvious that a monetary authority can con
verge to knowledge about the economy when
its learning has substantial effects on the econo
my’s behavior.1
7

Evidence on the Value o f Feed
back. Policy
What is the evidence concerning feedback
policies relative to policies without feedback? In

16This issue of convergence is similar to the issue of conver
gence of the economy to an equilibrium when firms’ and
households’ expectations influence the behavior of the
economy. More precisely, the issue is convergence of mar
kets to rational expectations equilibria. Bullard (1991)
sketches this research and provides references.
17Dwyer (1992) shows that a standard semi-logarithmic de
mand for money combined with equation (3) can generate
chaos, which suggests that nonconvergence can be dra
matic. Butler (1990) provides an introduction to the
mathematics of chaos in economics.
18Lindsey (1986) reviews earlier work.
19See Andersen and Jordan (1968) and Andersen and Carl
son (1970). Holbrook (1972) and Cooper and Fischer (1974),

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the context of simple equations such as (1),
some evidence about feedback policies has been
advanced recently.1 McCallum (1987) provides
8
some evidence that, since W orld W ar II, a sim
ple feedback rule for targeting nominal GDP
growth would have been better than either ac
tual policy or a constant growth rate of the
monetary base. This evidence is based on taking
an equation such as (1) and simulating it under
the alternative policies. Taylor (1985) has exa
mined the implications of targeting nominal
GDP for the behavior of real GDP. Perhaps his
major result is that targeting nominal GDP may
have undesirable implications for fluctuations of
real GDP. Both of these analyses are based on
very simple characterizations of the economy.
Whether they constitute more than preliminary
evidence is open to serious doubt.
Among other criticisms, these and other ana
lyses of alternative policies must deal with what
sometimes is called the Lucas critique. Lucas'
(1975) general point was that any evaluation of
alternative policies must carefully consider the
implications of changes in policy for expecta
tions. Changes in policy generally change expec
tations, and unless the changes in expectations
are handled very carefully, commonly estimated
economic models can be worse than useless in
predicting the effects of changes in policy. This
point can be illustrated in the context of equa
tion (1). With y interpreted as nominal GDP
growth and m interpreted as money stock
growth, the St. Louis equation and the St. Louis
model are examples of models such as equation
(1) that could be the basis o f a stabilization poli
cy such as equations (2) or (3).1 Some analyses
9
of the St. Louis equation correctly argued that
it is not structural in the sense that the equa
tion is likely to change if the monetary authori
ty’s behavior changes. The estimated equation at
least partly reflects the monetary authority’s be-

among others, analyzed the implications of the St. Louis
equation or model for alternative short-run stabilization poli
cy. This has seemed ironic to some because a common te
net of monetarism is that a rule without feedback would be
preferable to discretion or a rule with feedback. See Mayer
(1978). It is worth noting that forecasting the effects of
drastically different policies was not why the originators es
timated the model. The force of the observation that a
monetarist model could be used for stabilization is muted
but not eliminated by recent instability in this equation, in
stability that can be seen for example in Carlson (1986).
Variants of the St. Louis equation are not the only
representations of the economy that appear to have non
constant coefficients over time. This instability is a wellknown aspect of large econometric models.

Figure 2
Little Persistence in the Economy and Substantial Feedback
Beta = 0.1 and Delta = 0.9

Period

havior and households' expectations of policy.
That is, the values of the coefficients fi and y in
equation (1) reflect households' expectations of
monetary policy. If monetary policy changes,
the values of these coefficients are likely to
change, and before the new policy is imple
mented, it may be quite difficult to figure out
what the new values will be. Hence without large
amounts o f judgment, an equation such as (1)
cannot be used to estimate the effects of radi
cally different future policy or to formulate a
useful feedback policy.
Lucas’ point can be applied more generally
than just to simple equations such as (1). In
many so-called structural econometric models,
expected inflation appears in various equations
in the model and expected inflation itself is esti
mated by an equation relating inflation to past
values of inflation. Such simple expectations
equations generally will be different for differ
ent policies. This means that simple evaluations
of alternative policies using such structural
models are highly suspect. In any evaluation of
alternative policies, it is important to be clear
about what expectations of prior policy are built
into the model and how the model will change

with a new policy. In the current state of
knowledge, it is dubious whether such an exer
cise can be more than broadly suggestive and
even the suggestiveness is open to doubt.
An alternative and quite likely better way to
examine the effects of feedback policies is to
compare the U.S. economy's performance under
different government policies. It is commonly
thought that the government began systemati
cally using policy to stabilize the economy after
World W ar II and, at least to the same degree,
did not use such policies before then. Though
the conclusions are somewhat controversial, the
evidence presented by Romer and by Balke and
Gordon suggests that the economy has been no
more stable since World W ar II than it was in
prior years.2 The case has yet to be made that
0
stabilization policy in the postwar period has
improved the economy’s performance.

SUMMARY
In the last 20 years, the terms of the debate
about rules vs. discretion have shifted dramati
cally. At one time, it was widely believed that
discretion could accomplish anything that a rule

20See Romer (1989) and Balke and Gordon (1989).

MAY/JUNE 1993

could accomplish. The monetary authority could
exercise its judgment to produce whatever poli
cy a rule might specify in advance if the rule
were the best policy. If a deviation from the
policy that would be imposed by the rule were
desirable, the monetary authority’s hands would
not be tied if it had discretion. The following is
a more general but closely related line of argu
ment: A rule is a constraint, and, in general,
constraints make it impossible to accomplish
what could be done otherwise.
It now is understood that rules can have
benefits precisely because they restrict future
policy choices. The mere possibility that a mone
tary authority will take some action can affect
households’ expectations and the effects on ex
pectations can have negative effects on the econ
omy's performance. Furthermore, some policies
depend on committing future policy actions, and
leaving judgment in the monetary authority’s
hands restricts the monetary authority’s ability
to pursue policies that require commitment.
A judgment about the desirability of rules or
discretion hinges in part on judgments about
how much control over monetary policy should
be given to appointed officials and their ad
visers. Some proposed rules for the monetary
authority leave some discretion. For example,
with a rule that the monetary authority keep
the price level constant, the monetary authority
could exercise substantial judgment about the
best means of reaching this end. Nonetheless,
even if some discretion remains, there can be a
positive return from committing policy. The size
of the actual gain in any particular country
from committing monetary policy by a law, a
constitutional restriction or a similar device de
pends fundamentally on how much incentive a
monetary authority has to generate surprise in
flation and how much commitment is implicit in
the country’s political process.
Judgments about rules vs. discretion and
whether a monetary authority should respond
to the state of the economy also hinge on what
can reasonably be expected from monetary poli
cy given current knowledge about the economy.
Responding to the state of the economy can be
destabilizing; doing something can indeed be
worse than doing nothing. Though many at
tempts have been made to estimate the effects
of feedback polices and rules, estimating the ef
fects of monetary policy on an economy’s actual
behavior is tricky. Besides the difficulties as
sociated with attempting to specify a model of

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the economy adequately, estimates of expecta
tions in a very different environment are re
quired. It is dubious whether the effects of
feedback policies and various rules estimated to
date provide more than broadly suggestive
evidence.

REFERENCES
Andersen, Leonall C., and Keith M. Carlson. “A Monetarist
Model for Economic Stabilization,” this Review (April 1970),
pp. 7-25.
_______ , and Jerry L. Jordan. “ Monetary and Fiscal Actions:
A Test of Their Relative Importance in Economic Stabiliza
tion,” this Review (November 1968), pp. 11-24.
Argy, Victor. “A Post-War History of the Rules vs. Discretion
Debate,” Banca Nazionale del Lavoro Quarterly Review
(June 1988), pp. 147-77.
Balke, Nathan S., and Robert J. Gordon. “ The Estimation of
Prewar Gross National Product: Methodology and New Evi
dence,” Journal of Political Economy (February 1989),
pp. 38-92.
Barro, Robert J., and David B. Gordon. “ Rules, Discretion
and Reputation in a Model of Monetary Policy,” Journal of
Monetary Economics (July 1983a), pp. 101-21.
_______ ,. “A Positive Theory of Monetary Policy in a Natural
Rate Model,” Journal of Political Economy (August 1983b),
pp. 589-610.
Bullard, James B. “ Learning, Rational Expectations and Poli
cy: A Summary of Recent Research,” this Review (Janu
ary/February 1991), pp. 50-60.
Butler, Alison. “A Methodological Approach to Chaos: Are
Economists Missing the Point?” this Review (March/April
1990), pp. 36-48.
Calvo, Guillermo A. “ On the Time Consistency of Optimal
Policy in a Monetary Economy,” Econometrica (November
1978), pp. 1411-28.

Carlson, John B. “ Rules Versus Discretion: Making a Mone
tary Rule Operational,” Federal Reserve Bank of Cleveland
Economic Review (Quarter 3, 1988), pp. 2-13.
Carlson, Keith M. “A Monetarist Model for Economic Stabili
zation: Review and Update,” this Review (October 1986),
pp. 18-28.
Cooper, J. Phillip, and Stanley Fischer. “ Monetary and Fiscal
Policy in the Fully Stochastic St. Louis Econometric
Model,” Journal of Money, Credit and Banking (February
1974), pp. 1-22.
Dwyer, Jr., Gerald P “ Stabilization Policy Can Lead to
.
Chaos,” Economic Inquiry (January 1992), pp. 40-46.
_______ , and R. Alton Gilbert. “ Bank Runs and Private
Remedies,” this Review (May/June 1989), pp. 43-61.
Friedman, Milton. Essays in Positive Economics (University of
Chicago Press, 1953).
_______ . A Program for Monetary Stability (Fordham Universi
ty Press, 1959).
_______ , and Anna J. Schwartz. “ Has Government Any Role
in Money?” Journal of Monetary Economics (January 1986),
pp. 37-62.
Goodhart, Charles. “ The Conduct of Monetary Policy,” Eco
nomic Journal (June 1989), pp. 293-346.

Holbrook, Robert S. “ Optimal Economic Policy and the
Problem of Instrument Instability,” American Economic
Review (March 1972), pp. 57-65.
Kydland, Finn E., and Edward C. Prescott. “ Rules Rather
than Discretion: The Inconsistency of Optimal Plans,” Jour
nal of Political Economy (June 1977), pp. 473-91.
Lindsey, David E. “ The Monetary Regime of the Federal
Reserve System,” in Campbell and Dougan, eds., Alterna
tive Monetary Regimes (Johns Hopkins University Press,
1986), pp. 168-208.
Lucas, Jr., Robert E. “ Econometric Policy Evaluation: A Cri
tique,” Carnegie-Rochester Conference Series on Public
Policy (vol. 1, 1975), pp. 19-46.
________“ Rules, Discretion, and the Role of the Economic
Advisor,” in Stanley Fischer, ed., Rational Expectations and
Economic Policy (University of Chicago Press, 1980),
pp. 199-210.

Mullineaux, Donald J. “ Monetary Rules and Contracts: Why
Theory Loses to Practice,” Federal Reserve Bank of
Philadelphia Business Review (March/April 1985), pp. 13-19.
Phillips, A. W. “ Stabilisation Policies and the Time-Forms of
Lagged Responses,” Economic Journal (June 1957), pp.
265-77.
Pindyck, Robert S. “ Optimal Policies for Economic Stabiliza
tion,” Econometrica (May 1973), pp. 529-60.
Romer, Christina. “ The Prewar Business Cycle Reconsidered:
New Estimates of Gross National Product, 1869-1908,” Jour
nal of Political Economy (February 1989), pp. 1-37.
Simons, Henry C. “ Rules versus Authorities in Monetary Poli
cy,” Journal of Political Economy (February 1936), pp. 1-30.
Reprinted in Friedrich A. Lutz and Lloyd W. Mints, eds.,
Readings in Monetary Theory (Richard D. Irwin, Inc., 1951).

Mayer, Thomas. The Structure of Monetarism (W. W. Norton &
Company, 1978).

Taylor, John B. “ What Would Nominal GNP Targeting Do to
the Business Cycle?” Carnegie-Rochester Conference Ser
ies on Public Policy (vol. 22, Spring 1985), pp. 61-84.

McCallum, Bennett T. "The Case for Rules in the Conduct of
Monetary Policy: A Concrete Example,” Federal Reserve
Bank of Richmond Economic Review (September/October
1987), pp. 10-18.

Turnovsky, Stephen J. Macroeconomic Analysis and Stabiliza
tion Policies (Cambridge: Cambridge University Press,
1977).

Modigliani, Franco. “ The Monetarist Controversy, or, Should
We Forsake Stabilization Policy?” American Economic
Review (March 1977), pp. 1-19.

Wallace, Neil. “ Why the Fed Should Consider Holding M0
Constant,” Federal Reserve Bank of Minneapolis Quarterly
Review (Summer 1977), pp. 2-10.

MAY/JUNE 1993

Michael J. Dueker
Michael J. Dueker is an economist at the Federal Reserve
Bank of St. Louis. Richard I. Jako provided research
assistance.

Can Nominal G D P Targeting
Rules Stabilize the Econom y?

'M . HK FEDERAL RESERVE HAS SHOWN that it
would support making price stability the explicit
goal of monetary policy.1 How to accomplish
this, however, is a matter of considerable dis
cussion. Some economists have suggested that
the best way to ensure that price stability is the
foremost goal of monetary policy is to adopt a
monetary policy rule. Such a rule would be a
verifiable program of action designed to maintain
price stability without constricting long-term
economic growth. As long as the Federal Reserve
faithfully implemented the rule’s prescriptions,
the public would have cause to believe that
prices, once stabilized, would remain stable.
One way to achieve price stability in a growing
economy is to have nominal gross domestic
product (GDP) grow at the same rate as potential
output.2 One monetary policy rule, proposed by
McCallum (1987), provides a systematic way for
the Federal Reserve to adjust the monetary base
as nominal GDP deviates from desired levels.3
Simulations of this rule, presented in McCallum
(1987, 1988) and Judd and Motley (1991), appear
to suggest that the monetary base can be manip
ulated to keep nominal GDP close to a path con
sistent with price stability. In these simulations
1See Chairman Alan Greenspan’s statement to Congress
[Greenspan (1989)].
2Because of difficulties in allowing for quality changes and
other imperfections in currently available price indices,
many economists believe that 1 or 2 percent annual infla
tion in a measure like the consumer price index is actually

McCallum's rule proves to be robust to a variety
of empirical models that relate changes in the
monetary base to resulting changes in nominal
GDP: Keynesian, Real Business Cycle and atheoretical vector autoregression models. Each em
pirical specification, however, confronts
McCallum's rule with a world in which the
structure of the economy is stable: the model’s
coefficients are held constant.
This article broadens the set of empirical
models used to evaluate McCallum’s rule to in
clude one in which the relationship between
base growth and nominal GDP growth is subject
to structural change that takes the form of
stochastic changes in the model’s coefficients.
Such a time-varying parameter (TVP) model
presents a new environment in which the
properties of McCallum’s rule have not yet been
examined. Simulation results from the TVP model
indicate that McCallum’s rule is more prone to
the problem of instrument instability than simu
lations from constant-coefficient models have
suggested. The instrument instability can be
remedied, however, by targeting nominal GDP
less stringently than McCallum’s original rule
had specified.4
consistent with price stability. In this case nominal GDP
should grow slightly faster than potential output.
3Bradley and Jansen (1989) discuss possible rationale for
nominal GDP targeting.
4See McCallum (1987).

MAY/JUNE 1993

THE ROLE OF VELOCITY IN
SIMULATIONS OF RULES

ROLE OF VELOCITY IN NOMINAL
GDP FEEDBACK RULES

Simulations present an opportunity to learn
how closely nominal GDP can be expected to
adhere to its target level and how variable the
monetary base will have to be under McCallum’s
rule. As we will see, McCallum’s rule specifies a
rate of growth for the monetary base, given the
level of nominal GDP relative to its target. Simu
lations of McCallum’s rule require a model of
how the monetary base is related to nominal
GDP, which can be summarized by the income
velocity of the monetary base. McCallum (1987)
provides a simple model relating changes in the
base to nominal income, where MB is the mone
tary base and e is a mean-zero random distur
bance with variance a2
e:

McCallum’s Rule
McCallum (1987) proposes a monetary policy
rule that uses the monetary base to target nomi
nal GDP. The rule employs a four-year moving
average of past growth in base velocity to fore
cast its growth in the coming quarter. Based on
this forecast, the rule then specifies the percen
tage of the gap between target and actual levels
of nominal GDP that policymakers should try to
close in the coming quarter.
Specifically McCallum’s rule takes the follow
ing form:

(3) AInMI, = A0- ^
(1) AlnGDPx = a + pAlnGDPl t + bA/nMBt+ et,

(/nVt l -/nV117)

+ A1 (InGDP -lnG D P)l t
(4) AlnGDP, = A0 Vf

or, restating the model in terms of velocity
growth,

(2) MnGDPt-M n M B t =
a + pAlnGDPt + (b - 1)AlnMBx+ et.

This model illustrates the way in which veloci
ty is generally modeled in simulations of McCal
lum’s rule: the percentage change in the velocity
of the monetary base is modeled as a function
of time t - 1 variables, base growth at time f and
a random disturbance. The model also raises
questions about the constancy of the parameters
in the model of velocity growth: cr,p,b,ol. Simu
lations using a calibrated version of a constantcoefficient model will represent the economy's
behavior under the rule only to the extent that
the coefficients do not change in the long time
span the rule is to be in effect. As an alternative,
this article posits a simple short-run forecasting
model of velocity with time-varying parameters
and tests the restriction that the coefficients are
constant over the sample period. Then simula
tions o f McCallum’s rule are run using a cali
brated time-varying parameter model of velocity
growth. The article next discusses the role of
velocity forecasts in formulating McCallum’s
rule, in contrast to the foregoing paragraphs
which discussed their role in simulating the rule.

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where MI is the monetary instrument, V is the^
income velocity of the monetary instrument, GDPt
is the target level of nominal GDP at time t, and
GDP, is the actual level of GDP at time t. Also,
A0 > 0 and A1 > 0. The second term on the
right-hand side of equation (3) is the average ve
locity growth in the previous 16 quarters. The
rule calls for the monetary authority to adjust
the growth in the monetary instrument accord
ing to this velocity forecast. The third term
represents the percentage gap between target
and actual nominal GDP and thereby provides
the feedback. When the gap is positive, the rule
seeks but does not guarantee (because of sur
prise changes in velocity) GDP growth greater
than the growth rate of target GDP (A0
).
McCallum uses average velocity growth be
cause trends in velocity growth can shift over
time, but not every change in base velocity
represents a long-lasting shift in the trend.
McCallum’s velocity forecast, however, uses only
the past 16 values of velocity. In the next section
an alternative monetary rule is described. This
rule differs from McCallum’s in that it uses ex
planatory variables to help forecast velocity; it
also uses a time-varying parameter model. By al
lowing for time-varying coefficients, the fore
casting model will be less prone than fixedcoefficient models to breaking down as time
passes.

Figure 1
Squares of Deviations in Base Velocity Growth from Its Mean
0.00125

0.001

0.00075 -

0.0005-

0.00025 -

n rrn i n i r ir m
1959 61

63 65 67 69 71

A Forecasting-Based M onetary
Rule
A short-run velocity forecasting model with
time-varying parameters offers a possible source
of one-step-ahead velocity forecasts required by
a monetary rule such as McCallum's. This type
of model would adapt in a systematic way to
structural changes, that is, to changes in the
relationships between velocity and the variables
used to forecast velocity, such as interest rates.
The forecast-based feedback rule considered
in this paper takes the form
(5) A/nM7( = A0-(A/nV)t| t _ i + X1
(lnGDP - lnGDP)t ^
(6) AlnGDPt = A(J Vf
where the variables are as defined in equations
(3) and (4), and the second term on the righthand side of equation (5) is the forecast of ve
locity growth for period t based on information
available through period t- 1 . This rule differs
from McCallum's rule in that it uses an explicit
ly derived forecast of velocity growth, rather
than an average of past velocity growth. The
next section details the velocity forecasting
model.

n i n i rrTT f r n

73 75 77 79 81 83 85 87 891991

A Forecasting Equation
This article reports results on one of many
possible velocity forecasting equations. The ve
locity forecasting model employed here allows
for time-varying coefficients on the explanatory
variables, which are the lagged change in the
three-month Treasury bill rate and lagged growth
in the monetary instrument. Velocity growth
should be positively related to the lagged change
in the Treasury bill rate, because this short
term interest rate indicates the opportunity cost
of money; velocity growth should be negatively
related to lagged growth in the monetary instru
ment, because if nominal GDP is somewhat slug
gish, part of additional money growth will lead
to decreased velocity in the short run. The ve
locity forecasting equation employed here uses
the Kalman filter and generalizes Bomhoff’s
(1991) velocity forecasting equation in three
ways: it includes lagged money growth, lets the
interest elasticity vary over time, and allows the
variance of the error term to change.
Figure 1 shows squared deviations from the
mean in the quarterly percentage change in the
velocity of the St. Louis monetary base. The
figure suggests that the volatility of velocity is
not constant. This is not too surprising: econo

MAY/JUNE 1993

mists believe that velocity is related to interest
rates and expected inflation. Research has found
that interest rates and inflation do not have
constant volatilities, so we might expect velocity
to share this property.5
The particular specification used to generate
short-run forecasts is
(7) A/nVt = po + PltATB3t_1+pztAlnMIl_i + e<
t
et~ Normal (0, ft)
\ = ° l+

S,e (0, 1)
o\ >o\

sumed to be uncorrelated, so the covariance
matrix Q is diagonal. Kim (forthcoming, b) dis
cusses the specific form the Kalman filtering
takes for this model and the evaluation of the
likelihood function, which is maximized with
respect to (o2,o\ ,p,q,Q), where Q u = oj,, i =
1,2,3. The appendix also includes a summary of
the filtering algorithm used in simulations.
By construction, this model allows for two
sources of forecast error: error in predicting
the value o f the coefficients and the heteroscedastic random disturbance. In general, in a
model with time-varying coefficients
(9) yt = X,_jft + e„

Probability(St = 1 |St l = l ) = p

the one-step-ahead forecasts are

Probability(St = 0 j St l = 0) = q

(10) y, = X , - A |t-r

where V stands for the velocity of the monetary
instrument, MI, and TB3 is the three-month
Treasury bill rate.6 The errors in equation (7), et,
have time-varying volatilities in that their vari
ance is assumed to switch between a low and
high level according to a first-order Markov
process.7

Thus the forecast errors have two components
which equal Xt^ (f t - ft ^ _ 1 + et. If the variance of
)
(ft —
ft|t-i) s
and var(et) - o2, the onestep-ahead forecast error variance is

With time-varying coefficients, equation (7)
will be estimated using the Kalman filter under
the assumption that the state variables, ft, follow
random walks:8
(8) ft = ft j + V,
V j'N orm al (0, Q)
In a short-run forecasting context, the assump
tion that the coefficients follow random walks
suggests that people need new information be
fore changing their views about the relation
ships among variables. This is essentially why
Engle and Watson (1985) advocate the view that
time-varying coefficients should have unit roots.
The innovations to the coefficients, v, are as

References are Bollerslev (1986) for inflation and Engle,
Lilien and Robins (1987) for interest rates.
6Only one lag of each explanatory variable appears in equa
tion (5), but, unlike a constant-coefficient model, the timevarying parameter model uses past values of the explana
tory variables and forecast errors in generating its forecast.
The appendix describes how the inferred coefficients em
body past information.
7The combination of time-varying parameters and this type
of heteroscedasticity was introduced by Kim (forthcoming,
b). Kim (forthcoming, b) also illustrates that this model of
heteroscedasticity is quite similar in practice to the well-

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(11)

= Xl. 1
Rt|t. X , +

The first component (Hlt) is called the variance
due to time-varying parameters (TVP); the se
cond (H,t) is simply the variance of the random
disturbance e. Inferences about the relative
sizes of the two sources o f forecast error vari
ance play an important role in updating the
coefficients. Using the Kalman filtering equa
tions in the appendix, one can write the fore
cast yt+1|t as
<
12> y,+i|, =

+ Z A | t-i

where Xt are the explanatory variables,
is
last period's forecast error (and is thus the new
information available), and Zt is proportional to

known autoregressive conditional heteroscedastic (ARCH)
model of Engle (1982). Basically, the Markov model tries to
match the persistence of periods of high and low volatility
in the data, where persistence of high and low volatility
states is increasing in p and q, respectively.
eBomhoff (1991) and Hein and Veugelers (1983) also use the
Kalman filter to forecast velocity. Bomhoff (1991) holds the
interest elasticity (/31t) constant and restricts /?2t to equal
zero, so past money growth is not included in the set of in
formation used in his forecasts; Hein and Veugelers (1983)
restrict both /51t and
to equal zero, further restricting the
information set used for forecasting.

Table 1
Quarterly Growth in Velocity of St. Louis Base
Variable

Parameter

Parameter
value

Standard
error

0.643

°2
o

.125

1.230

Low variance
High variance

.262

Constant

°5i

0.019

.051

ATB3

0.533

.268

AlnMI

°v3

0.027

.022

Probability(S, = 1 | St_, = 1)

0.781

.203

Probability(S, = 0 | St_, = 0)

<
7

0.869

.123

-167.800

Log-likelihood
Q-statistic (24 lags)

21.000

Q2-statistic (24 lags)

22.700

Table 2
Quarterly Growth in Velocity of Board Base
Variable

Parameter

Low variance

Parameter
value

Standard
error

0.694

.125

High variance

1.260

.328

Constant

0.044

.043

°o

ATB3

0.604

.275

AlnMI

°v3

0.023

.034

Probability(S( = 1 | S(_t = 1)

0.760

.237

ProbabilityfS, = 0 | St1 = 0)

<
7

0.892

.124

Log-likelihood

-168.700

Q-statistic (24 lags)

17.800

Q2-statistic (24 lags)

21.500

If H2 is large relative to Hlt, observers would at
t
tribute less of a forecast error to a change in
coefficients; instead, they would believe that it
was probably an outlier. A large value of H,t
then implies that last period’s forecast error
would play a relatively small role in determining
next period’s forecast.

FORECAST RESULTS
The forecasting model was estimated for
quarterly data from III/1959 to 11/1992 on the

velocities o f the following monetary aggregates:
the St. Louis measure of the monetary base, the
Board of Governors monetary base, M l and M2.
The latter three measures are included to pro
vide some context for the St. Louis base results.
Tables 1 through 4 contain parameter estimates
of the forecasting model of equations (7) and (8)
for each monetary aggregate.
For the two measures of the monetary base
and M l, the coefficient with the most significant
variation is the interest rate elasticity. Because

MAY/JUNE 1993

Table 3
Quarterly Growth in Velocity of M1
Variable

Parameter

Low variance

Standard
error

0.680

°o
A

High variance

Parameter
value

.189

1.160

.322

0.018

Constant

.053
.350

ATB3

°V2

0.905

Ain Ml

°?
3

0.054

.023

Probability(S, = 1 | S,_1 = 1)

0.580

.392

Probability(S, = 0 | St_, = 0)

<
7

0.723

.425

Log-likelihood

-173.600

Q-statistic (24 lags)

27.100

Q2-statistic (24 lags)

21.600

Table 4
Quarterly Growth in Velocity of M2
Variable

Parameter

Low variance

Parameter
value

Standard
error

°o

0.729
1.370

.217

Constant

°h

0.033

.043

ATB3

°v2

0.001

.183

Ain Ml

0.004

.096

= 1)

0.955

.039

Probability(S, = 0 | S,_1 = 0)

0.898

.091

High variance

Probability(St = 1 | S,

Log-likelihood

.071

-171.400

Q-statistic (24 lags)

16.100

Q2-statistic (24 lags)

27.100

McCallum's rule is written for the St. Louis base,
specification tests are done for the St. Louis
base. The log-likelihood for the TVP model with
Markov switching is -167.8. The log-likelihood
with Markov switching and constant coefficients
is -175.1. This implies a likelihood-ratio statistic
of 14.6, which is rejected as a xl variable at the
99 percent confidence level. Thus, while the

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variance due to time-varying parameters in
figure 2 appears to account for a relatively
small portion of the overall forecast error vari
ance for St. Louis base velocity, the model’s
parameters exhibit statistically significant varia
tion. The log-likelihood for OLS is -184.4, so
we can similarly reject homoscedasticity in the
error term in an OLS regression. This means

Table 5
Velocity Forecast Error Variances
St. Louis Base

0.992
0.831
0.161

1.050
0.813
0.236

1.040
0.945
0.098

Total forecast error variance H,
Variance due to disturbance term H2t
Variance due to TVP H1
t

that o2does not remain constant throughout the
sample period.
The Q-statistics test for serial correlation, and
all are insignificant as are the Q2
-statistics, which
test for serial correlation in the squared fore
cast errors. (The distribution of the Q- and Q2
statistics is
under the null hypothesis of no
serial correlation; the 5 percent critical value is
36.4.) The lack of serial correlation indicates
that the model avoids making persistent errors
in its forecasts. Significant Q2
-statistics would in
dicate that the Markov model of heteroscedasticity is an inadequate model of the persistence in
the variance of the error terms. The sum p + q
indicates the persistence of the volatility of the
error term. If p + q > 1, the Markov process
is called persistent. Interestingly, M2 has the
most persistent volatility states with p + q =
1.85, which is not far from the upper bound of
2. This finding suggests that when policymakers
are finding relatively large forecast errors in M2
velocity, they will likely continue to be plagued
with large forecast errors (in either direction) in
the near term.
Table 5 compares the relative importance of
the two sources o f forecast uncertainty: the var
iance due to coefficient variation and the vari
ance of the disturbance term, et. (Because of the
great similarity between the results for the two
measures of the monetary base in tables 1 and
2, only results for the St. Louis monetary base
will be presented hereafter.)
Even though the numbers in table 5 cannot
be directly compared across monetary instru
ments, they do illustrate that M2 has the most
stable coefficients among the three monetary
aggregates, measured as a percentage of total
forecast variance. By this measure, M l has less
stable coefficients than the monetary base, so
the narrowness of the monetary aggregates is
not necessarily inversely related with coefficient
stability.

Figures 2 through 5 divide the conditional
forecast error variance into its two components,
Hlt and H,t, for the four monetary aggregates
examined in this paper. As the figures show,
the relative sizes of Hlt and H2 are not constant
t
over time. One should point out that, if the
magnitude of the variance of the random distur
bances, H,t, is generally large relative to the var
iance caused by time-varying coefficients, Hlt, it
does not mean that Hlt is too close to zero to be
important: the likelihood-ratio test reported
previously rejects the hypothesis that the fore
cast error variance due to time-varying param
eters is equal to zero for the velocity of the St.
Louis base. The velocities of all four aggregates
show heightened forecast error variance due to
time-varying coefficients from 1979 to 1982, the
period of nonborrowed reserves targeting and
financial deregulation. For reference the timevarying coefficients for St. Louis base velocity
are shown in figures 6 through 8. The estimated
coefficients generally have their expected signs:
a positive interest rate elasticity and a negative
money growth elasticity. Dickey-Fuller unit root
tests do not reject the hypothesis that each of
these three coefficients follows a random walk;
thus the inferred coefficient values do not con
tradict the assumed random walk specification.
Given that two monetary rules, which differ
only in their velocity forecasts, will be simulat
ed, it is useful to compare the forecast errors
from the forecasting equation with time-varying
parameters and McCallum’s 16-quarter moving
average. As table 6 shows, the 16-quarter mov
ing average is close to the TVP model in mean
squared forecast error only for the velocity of
the St. Louis base. For the broader aggregates,
the mean squared errors are at least 33 percent
higher for the moving-average forecast than for
the TVP model. If the forecast errors are persis
tent, they can compound errors in targeting
nominal GDP. Thus, we also report Q-statistics
which test for serial correlation in the forecast

MAY/JUNE 1993

Figure 2
Variance Decomposition of St. Louis Base Velocity Growth
Forecast Error Variance

Figure 3
Variance Decomposition of BOG Base Velocity Growth
Forecast Error Variance

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Figure 4
Variance Decomposition of M1 Velocity Growth
Forecast Error Variance

Figure 5
Variance Decomposition of M2 Velocity Growth
Forecast Error Variance

Total variance

Variance caused by
error term

Variance caused by TVP

i r
1960 62

i i i i i i i i i i 11 i r i i i i i i i i i i i i i i i i i
64

90 1992

MAY/JUNE 1993

Figure 6
Intercept for St. Louis Base Velocity Growth
Coefficient Value

Figure 7
Effect of Lagged Base Growth on Growth of St. Louis Base Velocity
Coefficient Value

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Figure 8
Effect of Lagged Change in the Three-Month T-Bill Rate on Growth of
St. Louis Base Velocity
Coefficient Value

Table 6
Velocity Forecast Error Comparison
St. Louis Base

Mean squared forecast error TVP model
Q-statistic (24 lags) for TVP model

.981
21.0

1.03
27.1

.994
16.1

MSFE from McCallum’s 16-quarter moving average
Q-statistic (24 lags) for 16-quarter moving average

1.08
36.5

1.62
59.6

1.34
44.6

errors. With a x;4critical value of 36.4 at the 5
percent significance level for the Q-statistics,
the 16-quarter moving average forecast errors
are significantly serially correlated for all three
monetary aggregates.

Estimating a velocity forecasting equation with
time-varying coefficients (equations (7) and (8))
not only provides a way to modify McCallum’s

rule (equation (5)), it also provides estimates of
the variances of the coefficients that can be
used to calibrate a data-generating process for
velocity to be used in simulations of McCallum’s
rule. We also run simulations on the forecastbased rule to learn about its properties. The ob
ject here is to learn something about the feasi
bility o f nominal GDP targeting when velocity's
relationship with other variables is subject to
structural change.

MAY/JUNE 1993

Without interest rates in the forecasting
equation, the actual increase in the forecast
error variance is less than 7 percent, so the
quantitative effect of this change should be
small.

Table 7
Simulation Results for ForecastBased Rule (Averages across 200
simulations)

2. The error term et is assumed to be homoscedastic for simplicity. This allows us to
drop Markov switching from the simulations.

Forecasting Rule: A0 = .00985; A1 = .25
Mean value of !nGDPx - lnGDPt

-.0 1 7 4

Mean square error of /nGDP, - lnGDPt

.0007

High value of lnGDPt - lnGDPt

.025

Low value of lnGDP{ - lnGDP{

-.0 6 0

Mean annual growth rate of monetary base

4.66

Standard deviation of annual base growth

2.89

High value of annual base growth

15.70

Low value of annual base growth

-2 .1 9

SIMULATIONS OF THE RULES
All o f the velocity models employed in simula
tions of McCallum's rule in McCallum (1987,
1988), Judd and Motley (1991, 1992), Rasche
(1993) and Thornton (forthcoming) have assumed
constant coefficients. This paper takes a different
tack by estimating time-varying parameter
models of velocity growth. A data-generating
process with stochastic coefficients is then used
to generate data in simulations. In this way, we
attempt to study how a monetary rule would
perform when the velocity relationship is sub
ject to unpredictable structural change.
Simulations were run for a data-generating
process calibrated to the velocity growth of the
St. Louis base. The modifications to the forecast
ing model of equations (7) and (8) are the fol
lowing:
1. Short-term interest rates are dropped as an
explanatory variable and the model is then
re-estimated. This approach is adopted be
cause we have no good way to determine in
terest rates using any of the equations we
have estimated. In effect, we are forecasting
with a smaller information set, which will
make the forecast error variance larger.
9This is somewhat analogous to models of nominal interest
rates that assume unit roots. Random walk behavior might
provide a very close approximation to interest rate behavior
in the short run, but long-run simulations cannot plausibly
assume a unit root, or negative nominal interest rates
would eventually result.

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3. The coefficient on lagged base growth, /2 is
? t,
no longer assumed to have a unit root; in
stead it is modeled as an autoregressive
process with a near-unit root: [)2 = ,95/3211 +
I
v3t. When running the simulation for 400
quarters, it is not realistic to allow /2 to be
3t
come less than negative one indefinitely,
though it is allowed to do so for lengthy
periods.9
4. The starting values for /t_0 are randomized
?
from their calibrated values to reduce depen
dence on a particular choice o f starting values.
Details on this simulation are in the appendix.
The other choices to be made in the simulation
are the parameters in the monetary rule of
equation (7). The target for quarterly nominal
GDP growth was set to A0 = .00985, which cor
responds with 4 percent annual growth. The
value of Aj determines how much of the gap be
tween the target and actual levels of nominal
GDP policymakers should try to eliminate in the
coming quarter. For Ai; we follow McCallum's
(1987) suggestion by setting it equal to 0.25.
The exercise consists of simulating particular
monetary rules 200 times for periods of 400
quarters each. To reiterate, the important point
of this exercise is to study the performance of a
monetary policy rule under a data-generating
process for velocity that includes unpredictable
structural change. The desired information is
how closely nominal GDP might be kept to its
target path and how variable the growth rate of
the monetary instrument would have to be. The
numbers in table 7 represent averages across
the 200 simulated 400-quarter periods for the
forecast-based rule.
The results in table 7 show that simulated
nominal GDP in levels is on average 1.7 percent
below its target, with extreme deviations of 2.5

Table 8
Simulation Results for McCallum’s
Rule (Averages across 200 simuForecasting Rule: A0 = .00985; A, = .10
Mean value of tnGDP{ - lnGDP{

.038

Mean square error of lnGDPx - lnGDPt

.009

High value of lnGDPt - lnGDPt

reduced: the average gap in levels between ac
tual and target nominal GDP is 3.8 percent. The
mean square error o f the gap between actual
and target nominal GDP is higher than that of
the forecast-based rule, however. Nevertheless,
McCallum’s rule appears to be robust to a world
in which the growth rate o f base velocity is
subject to structural change, albeit with a lower
value on the feedback parameter, A,, which
means that nominal GDP cannot be targeted as
stringently period-by-period as it can with the
forecast-based rule.

.108

Low value of lnGDPx - lnGDPt

-.057

Mean annual growth rate of monetary base

1.92

Standard deviation of annual base growth

1.20

High value of annual base growth

6.20

Low value of annual base growth

-0.827

percent above and 6 percent below the target.
Considering that the simulations ran for 400
quarters, the differences between target and ac
tual GDP are small. The simulated rate of base
growth averages 4.7 percent per year across the
200 replications, with extremes of 15.7 percent
and -2.2 percent annual growth. The latter
figure should be small in absolute value, be
cause of the political difficulty in selling a mone
tary rule that would potentially call for
substantial decreases in the monetary base for
as long as a year. The former figure suggests
that double-digit base growth would occasionally
occur under a policy of nominal GDP targeting.
In contrast, McCallum’s rule, which uses
moving-average forecasts of velocity growth,
proved to be unstable with A[ equal to 0.25.
(Average base growth was negative 6 percent
per year.) The results for McCallum’s rule
presented in table 8 are for simulations run
with A, equal to 0.10, so the rule attempts to
close gaps between target and actual nominal
GDP more slowly to prevent instrument insta
bility.
McCallum’s rule no longer displays instrument
instability once the feedback parameter, A]; is

CONCLUSIONS
This paper confronts McCallum's nominal GDP
targeting rule in simulations with a world in
which coefficients in the velocity equation for
the monetary instrument are subject to unpre
dictable stochastic change. Hypothesis tests on
the estimated model of the velocity of the St.
Louis base reject coefficient stability. To ac
count for unstable coefficients, a time-varying
parameter model of velocity is estimated and
used to calibrate the data-generating process
used in simulations. These simulations suggest
that McCallum’s rule can stabilize nominal GDP
growth in a time-varying parameter framework.
Nominal GDP cannot be targeted as closely as
when an alternative forecast-based monetary
rule is used, however. In addition, nominal GDP
cannot be targeted as closely as previous studies
that simulated McCallum’s rule using constantcoefficient models of velocity have suggested.
Overall, McCallum’s approach to nominal GDP
targeting proves to be simple yet robust to ve
locity behavior that is quite complex. The alter
native forecast-based rule performed somewhat
better in simulations in which velocity was
generated in a time-varying parameter model,
but it has the disadvantage of being more
difficult for the public to verify.1 Given that it
0
would be easier for the public to verify that the
Fed is following McCallum’s rule, relative to the
forecast-based rule, the former may garner the
Fed more credibility, even though it is technical
ly less able to stabilize nominal GDP growth.

10Until the public was able to observe low inflation and rela
tively stable nominal GDP growth for a considerable length
of time, the credibility of a rule-based policy would likely
depend on the public’s ability to verify that the monetary
authority was actually following the rule when setting tar
gets for money growth.

MAY/JUNE 1993

REFERENCES
Barro, Robert J., and David B. Gordon. “A Positive Theory of
Monetary Policy in a Natural Rate Model,” Journal of Politi
cal Economy (August 1983), pp. 589-610.
Bean, Charles R. “ Targeting Nominal Income: An Appraisal,”
The Economic Journal (December 1983), pp. 806-19.
Bollerslev, Tim. “ Generalized Autoregressive Conditional Heteroskedasticity,” Journal of Econometrics (April 1986), pp.
307-27.
Bomhoff, Eduard J. “ Predicting the Income Velocity of
Money: A Kalman Filter Approach,” unpublished
manuscript, Erasmus University, Netherlands (June 1991).
Bradley, Michael D., and Dennis W. Jansen. “ Understanding
Nominal GNP Targeting,” this Review (November/December
1989), pp. 31-40.
Dickey, David A., Dennis W. Jansen and Daniel L. Thornton.
“A Primer on Cointegration with an Application to Money
and Income,” this Review (March/April 1991), pp. 58-78.
Engle, Robert F. “Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Infla
tion,” Econometrica (July 1982), pp. 987-1007.
_______ , David M. Lilien and Russell P. Robins. “ Estimating
Time-Varying Risk Premia in the Term Structure: The
ARCH-M Model,” Econometrica (March 1987), pp. 391-407.
_______ , and Mark Watson. “ Kalman Filter: Applications to
Forecasting and Rational Expectations Models,” Advances
in Econometrics, Fifth World Congress (Volume 1, 1985),
pp. 245-81.
Garbade, Kenneth. “ Two Methods for Examining the Stability
of Regression Coefficients,” Journal of the American
Statistical Association (March 1977), pp. 54-63.
Greenspan, Alan. “A Statement before the Subcommittee on
Domestic Monetary Policy of the Committee on Banking,
Finance and Urban Affairs, U.S. House of Representatives,
October 25, 1989,” Federal Reserve Bulletin (December
1989), pp. 795-803.
Hein, Scott E., and Paul T.W.M. Veugelers. “ Predicting Veloci
ty Growth: A Time Series Perspective,” this Review (Oc
tober 1983), pp. 34-43.
Judd, John P., and Brian Motley. “ Controlling Inflation with an
Interest Rate Instrument,” Federal Reserve Bank of San
Francisco Economic Review (Number 3, 1992), pp. 3-22.
_______ . “ Nominal Feedback Rules for Monetary Policy,”
Federal Reserve Bank of San Francisco Economic Review
(Summer 1991), pp. 3-17.
Kim, Chang-Jin. “ Dynamic Linear Models with Markov
Switching,” Journal of Econometrics (forthcoming, a).
________“ Sources of Monetary Growth Uncertainty and Eco
nomic Activity: The Time-Varying Parameter Model with
Heteroscedastic Disturbances,” The Review of Economics
and Statistics (forthcoming, b).
Koenig, Evan F. “ Nominal Feedback Rules for Monetary Poli
cy: Some Comments,” Federal Reserve Bank of Dallas,
Working Paper No. 9211 (July 1992).
Kydland, Finn E., and Edward C. Prescott. “ Rules Rather
than Discretion: The Inconsistency of Optimal Plans,” Jour
nal of Political Economy (June 1977), pp. 473-91.
McCallum, Bennett T. “ The Case for Rules in the Conduct of
Monetary Policy: A Concrete Example,” Federal Reserve
Bank of Richmond Economic Review (September/October
1987), pp. 10-18.

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________“ Robustness Properties of a Rule for Monetary
Policy,” Carnegie-Rochester Conference Series on Public
Policy (Autumn 1988), pp. 173-203.
Mehra, Yash P. “ In Search of a Stable, Short-Run M1 De
mand Function,” Federal Reserve Bank of Richmond Eco
nomic Review (May/June 1992), pp. 9-23.
Poole, William. “ Monetary Policy Lessons of Recent Inflation
and Disinflation,” The Journal of Economic Perspectives
(Summer 1988), pp. 73-100.
Rasche, Robert H. “ Monetary Aggregates, Monetary Policy
and Economic Activity,” this Review (March/April 1993),
pp. 1-35.
Stone, Courtenay C., and Daniel L. Thornton. “ Solving the
1980s’ Velocity Puzzle: A Progress Report,” this Review
(August/September 1987), pp. 5-23.
Taylor, John B. “ What Would Nominal GNP Targeting Do to
the Business Cycle?” Carnegie-Rochester Conference Ser
ies on Public Policy (Spring 1985), pp. 61-84.
Thornton, Saranna R. “ Can Forecast-Based Monetary Policy
Be More Successful than a Rule?” Journal of Economics
and Business (forthcoming).

Appendix
Kalman Filtering
The Kalman filter is a set of recursive equa
tions that determine how the inferred regression
coefficients are updated as new observations
are added. The Kalman filtering without Markov
switching used in the simulations consists of the
following equations:
(13)
(14)

= Gflt-it|t-iG +

(15)

*itit-i — yt —

(16)

H, = Hu + H2 =
t

(17)

K =

(18)

ft | = ft | 1+K,»It|t. 1
.
t.

(19)

fi,|t = (I -

The term Kt, called the Kalman gain, determines
how much new information, summarized by the
latest forecast error
(t_,, is allowed to affect
the inferred ft coefficients. Equation (18) shows
that the inferred coefficients are updated using
the product of the Kalman gain and the latest
forecast error. Thus the inferred coefficients
themselves are functions of past values of the
explanatory variables and the dependent varia

ble. In this way the current forecasts in a timevarying parameter model that uses the Kalman
filter are based on a larger information set than
just last period’s values of the explanatory
variables.
Combining the equations for Kt and /t,t and
3
multiplying through by Xt l shows how new in
formation, rj, | , is used in updating forecasts of
,_1
the dependent variable:
( 20 )

This relation demonstrates the assertion that
the relative sizes of Hlt and H,t determine the
weight put on new information when updating
the inferred coefficient values.

Calibrating the Simulations
As discussed in the text, the forecasting equa
tions were estimated for base growth without
interest rates as an explanatory variable. The

only explanatory variables with time-varying
coefficients were the intercept and lagged base
growth. In the simulations we need to specify
starting values for the true parameter values,
the inferred parameter values and the variances
o f vt, where fix = G J , + vt. G is a (2 x 2) di
/t
agonal matrix with Gn = 1 and G2 = .95. The
2
coefficient variances were set to IE-05 for the
intercept and .05 for lagged base growth. The
variance o f et, the disturbance term, was set to
1.08. These values come from the estimated
forecasting model, where the value of o2is placed
e
near the value of the estimated unconditional
value between oft and a]. Finally the starting
values for the inferred coefficient values were
randomized by adding noise to the true starting
values. This was done to reduce dependence on
particular initial values in the Kalman filter and
also to mimic uncertainty that would pertain to
the initiation of a new monetary policy regime,
the rule. Thus the simulations should roughly
resemble the data-generating process governing
the growth of base velocity, including changes
in the structural coefficients.

MAY/JUNE 1993

Joseph A. Ritter
Joseph A. Ritter is an economist at the Federal Reserve Bank
of St. Louis. Leslie Sanazaro provided research assistance.

The FO M C in 1992: A Monetary
Conundrum

WEAK, HESITANT AND protracted recov
ery was under way during 1992. Real gross
domestic product (GDP) did not regain its
prerecession level until third quarter 1992, a
year and a half after the recession’s trough. On
the whole, however, incoming data were less
negative during 1992 than in 1991 and the Fed
eral Open Market Committee (FOMC) generally
displayed more confidence that the economy
was growing in 1992.1 As concern about a fur
ther economic downturn receded, troubling
aspects of the monetary aggregates’ behavior
became more prominent in FOMC deliberations.
Since mid-1991, an unusual combination of
very slow M2 growth and rapid growth of
reserves and M l has drawn considerable atten
tion.2 The juxtaposition of fast M l and reserve
growth and slow M2 growth was an important
conundrum for policymakers in 1992: Was slow
M2 growth constricting economic recovery
(though slowing inflation at the same time), or
was rapid M l growth a signal of future infla
tionary pressure (though perhaps supporting
rapid recovery)? These worst-case interpreta

tions highlight the range of uncertainty raised
by anomalous behavior of an important set of
indicators.
The article begins with an outline of major
economic developments in 1992 followed by an
examination of the aforementioned monetary
conundrum. These first two sections provide a
backdrop for more detailed discussion in the
third section of the eight FOMC meetings and
policy actions taken between meetings. Because
discussion of monetary policy often uses poten
tially ambiguous terms such as easing, I have in
cluded a shaded insert, “Translating the FOMC
Policy Directives,” which explains how some of
these terms are used in FOMC directives and in
discussions of monetary policy.

ECONOMIC DEVELOPMENTS IN
1992
A month-by-month account of economic de
velopments makes it is easy to lose sight of
broader patterns. Figure 1 illustrates some of
these patterns. A wide-angle view reveals that

1The FOMC comprises the seven governors of the Federal
Reserve System, the president of the Federal Reserve
Bank of New York, and, on a rotating basis, the presidents
of four of the other 11 regional Federal Reserve Banks.
The seven remaining presidents attend the meetings and
present their views but do not vote.
2M1 comprises currency, traveler’s checks and checkable
deposits. M2 combines M1 with savings deposits, money
market mutual funds, small time deposits, and some
smaller items.

MAY/JUNE 1993

Translating the FOMC Policy Directives
The domestic policy directives issued by the
FOMC in recent years have contained two
parts. The first part summarizes available in
formation about the economy that provides a
context for the actions taken. The second
part is a discussion o f policy and the actual
directive. In 1992 the directive used the fol
lowing wording:
In the implementation of policy for the im
mediate future, the Committee seeks to
__________ the existing degree of pressure
on reserve positions. In the context of the
Committee’s long-run objectives for price sta
bility and sustainable economic growth, and
giving careful consideration to economic,
financial, and monetary developments, slight
ly greater reserve restraint__________ or
slightly lesser reserve restraint__________
be acceptable in the intermeeting period.
The words that fill in the blanks are the keys
to translating the directive. The first blank
gives the main thrust of the directive. The
choices here are decrease (known as easing),
increase (known as tightening) and maintain.
Interpretation of the first two choices is
straightforward, but they were not used in
1992.
The second two blanks determine the socalled bias o f the directive and are particular-

the 1991-92 recovery was the slowest since
W orld W ar II, with growth below the long-run
average for several quarters and little employ
ment growth. A narrower focus highlights the
fact that the economy was substantially stronger
in 1992 than in 1991 and that the second half
of 1992 was substantially stronger than the first
half, despite pessimistic expectations from
midyear onward. An important feature of 1991
and 1992 was the dramatic fall of interest rates
(see figure 2). A notable aspect of this decline
was the sharp steepening of the yield curve;
short-term interest rates fell much more than
long-term rates. The increase in the rate spread
between 10-year and three-month Treasury
rates following the business cycle trough in
^Throughout this article the terms ease and easing used in
connection with specific policy actions have a narrow
meaning that is spelled out in the shaded insert “ Translat
ing the FOMC Policy Directives.” In other instances, easy

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ly important when the main thrust is main
tain. The choices for both the second and
third blank are the words would and might.
The key insight is that would is stronger than
might. If the main thrust o f the directive is
maintain and the directive says that “slightly
greater reserve restraint might or slightly
lesser reserve restraint would be acceptable,”
the directive is referred to as biased or asym
metric toward ease. Pairing might with might
or would with would gives a symmetric direc
tive. Pairing would and might, is known as bi
ased or asymmetric toward restraint. A direc
tive that is biased toward ease is intended to
give the Chairman somewhat more leeway in
the direction of ease in the day-to-day im
plementation of policy between meetings. On
some occasions there is an unusually strong
presumption that the Chairman will act on
the bias toward ease. See, for example, the
discussion of the October 6 meeting in the
text. This understanding is not included in
the directive itself but is clearly stated in the
record of Committee discussions.
The FOMC directives do not state how
these somewhat imprecise words are translat
ed into specific dollar sales or purchases of
government securities, but in recent years,
outside observers have regularly focused at-

March 1991, for example, is larger than that in
any postwar recovery period.
The U.S. economy ended 1991 with a whim
per: GDP grew at an annual rate of less than
0.6 percent in the fourth quarter. The FOMC
ended the year with a significant easing that
coincided with a 1 percentage point cut in the
discount rate.3 The federal funds rate then
hovered around 4 percent until April (see figure
2). During the first months of 1992 new eco
nomic data suggested that the risk of sliding
back into recession had receded; indeed it
turned out that the economy grew at a 3 per
cent rate in the first quarter.
M2 started the year with a month of strong
and tight are used in a more general way to refer to the
overall stance of monetary policy, a much less well-defined
concept.

tention on a federal funds rate target, or an
expected federal funds rate, that helps the
New York Bank implement the directive on a
day-to-day basis.1 An easing (tightening) action
is taken relative to a particular reserve base
line (and the implied federal funds rate) settled
on at an earlier date. The easing (tightening)
action itself is a purchase (sale) o f more
Treasury securities than envisioned in the
baseline and tends to decrease (increase) the
federal funds rate.2
Whether monetary policy is easy or easier
in a broader sense following an easing action
is a complex issue. For example, despite 10
easing actions during 1991, 1992 still present
ed the monetary conundrum described in

1 more comprehensive discussion of the relationship
A
between the expected federal funds rate and other
aspects of Federal Reserve operating procedures can
be found in Sternlight et at. (1992).
2Banks and other depository institutions in the United
States are required to keep reserves against certain
kinds of deposits. The reserves can be in the form of
vault cash or deposits with the Federal Reserve. When
a bank finds itself short of reserves, it can borrow from
the Federal Reserve at the discount window or from
other banks in the federal funds market. The federal
funds rate is determined by supply and demand in this
market for reserves. Open market operations conducted
by the Federal Reserve System change the supply

growth but then began to decline. In April, fall
ing M2, together with "indications that the eco
nomic expansion was not as strong as its pace
early in the year,” prompted an easing action.4
Immediately following this action, the federal
funds rate fell substantially but then stabilized
around 3.75 percent until the end of June.
Data for April and May were more positive,
but many indicators for June (released around
the beginning of July) led to a swing toward
pessimism. Industrial production, employment,
retail sales, M l and M2 all tilted down. The
4See Federal Reserve press release July 2, 1992, p. 4. The
press releases referred to in the remainder of this article
are dated March 29, 1991; April 3, 1992; May 22, 1992; July
2, 1992; August 21, 1992; October 9, 1992; November 20,
1992; December 24, 1992; and February 5, 1993. All press
releases will be referred to by date. Reserve requirements
on transactions deposits were reduced from 12 percent to
10 percent on April 2. The reduction was intended to
“ strengthen the financial condition of banks and thereby

this paper-was M2 growth sufficient?3
In the last two years the tilt of the directive
has been important. As table 1 on p. 42 indi
cates, there has been only one easing direct
ed by the main thrust wording, but under
language asymmetric toward ease, the federal
funds rate has fallen by several percentage
points (figure 2). Several times in the last two
years, significant changes in the federal funds
rate have been associated with changes in the
discount rate voted by the Board of Gover
nors (the FOMC comprises the Board plus
five of the presidents of the regional Federal
Reserve Banks). See, for example, the discus
sion in the text of the easing action taken in
early July.

of reserves available to the market. When the System
sells Treasury securities, it effectively takes reserves out
of the system, decreasing supply. This tends to cause
the federal funds rate to rise.
3The issue of judging the overall stance of monetary
policy is discussed in Bullard (1992), p. 44.

growth of real GDP had fallen to only 1.5 per
cent in the second quarter. Both the Board staff
and private forecasters became more pessimistic
about growth prospects for the second half of
the year. The private sector Blue Chip consen
sus forecasts for GDP growth in the second half
of the year made in June, July and August
were 3.2 percent, 3.0 percent and 2.8 percent,
respectively.5
At the beginning of July the Board o f Gover
nors cut the discount rate from 3.5 percent to
3.0 percent. This was accompanied by open
improve their access to capital markets, thus putting them
in a better position to extend credit” (Federal Reserve
Bulletin, April 1992, p. 272). The change apparently had no
significant effect on monetary aggregates and no bearing
on the decision to ease later in the month.
5See Eggert (1992).

MAY/JUNE 1993

Figure 1
Growth of Real GDP During Recoveries
Seasonally Adjusted Annual Rates (in Percent)
8-

-6

-5

-3

-2

-1

' 91Q2

'91Q3

' 91Q4

'92Q1

' 92Q2

' 92Q3

' 92Q4

-1

□

-3

91Q1

1991-92

■

-2H

Average

—2
—3

-4

4
3
4
5
Quarters After NBER Troughs

Growth of Nonfarm Payroll Employment During Recoveries
Seasonally Adjusted Annual Rates (in Percent)

-5

-4

-3

-2

-1

0
91Q3

91Q4

92Q1

92Q2

r
92Q3

r
92Q4

0
1

-1

91Q2

■

91Q1
-3H

1991-92

--2

■

-2

Average

—3
4

-4
0

3
4
5
Quarters After NBER Troughs

Note: Average includes all postwar recessions before 1991 except the 1980 recession.

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Figure 2
Interest Rates
Percent

Percent

10~year
Treasury Bond

7.5

-7 .5

7.0

8.0

-7 .0
-6 .5

6.5
Federal Funds

6.0

5.5

6.0

-5 .5

5.0

3-month Treasury Bill

-5 .0

4.5
4 .0 -

-4 .0

3.5

- 3 .5

3 .0 -

i—
J

i— i— i— i— i— i— i— i— i— i— i— — i— — r-n — — r

F M A M J J
1991

A S O N D J

F M A M J J
1992

Note: Vertical lines mark FOMC meeting dates.

market operations “directed at allowing the full
amount of the reduction to be reflected in money
market rates."6 The federal funds rate then fell
about a 0.5 percentage point. The federal funds
rate subsequently averaged about 3.25 percent
until September. These two actions constituted
the most significant policy move of the year.
Though many indicators turned up in July
(and down again in August), M2 continued to
fall despite the actions taken at the beginning of
July. In response to the flagging M2 growth and
to continuing signs o f sluggish economic growth,
another easing action was implemented in early
September.7 The federal funds rate remained
higher than expected following this action but
settled down to around 3.0 percent by the end
of October and remained there for the re
mainder of the year.8 Positive M2 growth re
sumed during the second half o f the year,
supported by rapid growth of reserves, but
6October 9, 1992 press release, p. 4.
7November 20, 1992 press release, p. 4.
8November 20, 1992 press release, p. 4.
9This issue is treated extensively in Bullard (1992).

turned negative again in December and into 1993.
The second half of 1992 is a case study in the
difficulty of making policy on the basis of fore
casts and month-by-month changes in economic
data.9 The downturn that threatened at midyear
never materialized; the economy grew at a 3.4
percent rate in the third quarter and 4.7 percent
in the fourth. This was not apparent during the
third quarter, however, and in fact private fore
casters remained pessimistic until late in the
year. The July and September easing actions
were taken partly on the premise that the econ
omy was weakening (and partly in response to
flagging M2 growth), yet economic growth in
the second half of the year ended up much
stronger than during the first half of the year.1
0

THE MONETARY CONUNDRUM
During the past two years, M2 has grown
slowly by past standards and has frequently
10Most estimates indicate that it takes at least six months for
any effects of monetary policy actions to be apparent in the
level of real output, so it is unlikely that strong growth in
the second half of 1992 was the result of the July policy
actions.

MAY/JUNE 1993

Figure 3
M2 and M2 Growth Ranges
Billions of Dollars, Seasonally Adjusted

1991

1992

Note: Vertical lines mark FOMC meeting dates. Pre-benchmark data.

been near or below the growth ranges set by
the FOMC (see figure 3).1 The slow overall
1
growth of M2 has been accompanied by rapid
growth of M l and reserves (see figure 4).
Reserve growth follows a pattern similar to M l,
though at higher levels. From December 1991 to
December 1992 M2 grew by 1.8 percent, M l
grew by 14.1 percent, and total reserves grew
by 19.6 percent. Much of the difference be
tween M l and M2 growth rates can be traced
to money market mutual funds and small time
deposits (components of M2 but not of M l),
which fell substantially during this period.
The FOMC's stated policy objectives are to
"foster price stability and promote sustainable
growth in output.” Monetary aggregates, partic
ularly M2, are closely monitored by the FOMC
1 Data on the monetary aggregates were benchmarked at
1
the end of 1992. All monetary data in both text and charts
of this article are pre-benchmark data.
12Economists who agree with this statement as a theoretical
proposition can be subdivided into those who think that
monetary policy can help stabilize real GDP and those who
think that the attempt is likely to be counterproductive in
practice, even if it is possible in principle.

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partly because of their historically close rela
tionship (by macroeconomic standards) with
nominal GDP. The growth rate of nominal GDP
is approximately equal to the growth of real
GDP plus the inflation rate. Nearly all macroeconomists agree that money’s long-run effect is
almost entirely on the price level; that is, the
only thing a central bank can do for the econo
my in the long run is to keep the inflation rate
low. Though many macroeconomists argue that
short-run economic growth can be bought at
the expense o f future inflation, almost all agree
that higher growth induced in this way cannot
be sustained in the long run.1 The records of
2
FOMC meetings indicate that Committee discus
sions take for granted that monetary policy has
an effect on real economic activity in the short
run.1
3
13The April 3 press release, for example, states, “ The mem
bers generally agreed that enough monetary stimulus prob
ably had been implemented to foster the desired upturn in
economic activity ... ” (p. 16).

Figure 4
Growth of M1 and M2
Seasonally Adjusted Annual Rates
35

3530-

-3 0

25-

-2 5

20 -

-2 0

15-

-1 5

10 -

-10
-5

r t

u i

w r
-5

-5J

F M A M J J
1991

A S O N D J

F M A M J

J
1992

A S O N D

Note: Horizontal bars indicate FOMC meetings (right end) and last available data
(left end). Pre-benchmark data.

In recent years many economists and policy
makers have agreed that it is desirable to use a
monetary aggregate as an intermediate indicator
of the thrust of monetary policy. Unfortunately,
the economic theory underlying these conclu
sions is not specific enough to recommend the
use of any particular monetary aggregate. An
ideal monetary aggregate has a strong connec
tion with policymakers' goals but is also closely
related to their actions, primarily open market
operations. No single aggregate has met both
criteria consistently over time. For several years

the FOMC has paid closer attention to M2 be
cause it has been a somewhat better indicator
of the long-run growth of nominal income.1
4
The Federal Reserve has more direct influence
over M l, however, because its checkable
deposit component is closely tied to the level of
reserves.1 That there is a tighter link between
5
Federal Reserve actions and narrower aggregates
such as M l has persuaded some economists and
policymakers to give relatively more weight to
narrower aggregates in evaluating the stance of
monetary policy.1
6

14During the early 1980s the FOMC paid close attention to
M1. In 1982, they began to place more emphasis on M2
but still set M1 growth ranges. In 1987 they decided to quit
setting M1 targets, citing “ uncertainties about its underly
ing relationship to the behavior of the economy and its
sensitivity to a variety of economic and financial circum
stances.” See Federal Reserve Board of Governors (1987).

16Members of the Shadow Open Market Committee (a group
of academic and business economists not affiliated with
the Federal Reserve System) have often expressed these
views in their critiques of FOMC policy.

15lt should be noted, however, that one of the factors that
led the FOMC to begin to de-emphasize M1 in the early
1980s was the difficulty in controlling the aggregate during
a period of rapid deregulation and financial innovation.

MAY/JUNE 1993

The juxtaposition of rapid growth of M l and
reserves with the slow growth o f M2 was the
monetary conundrum policymakers faced in
1992. Though the Committee no longer sets a
target range for M l, this is more than an arcane
technical issue: If the relationship between M2
and nominal GDP had broken down, the slow
growth of M2 might be misleading, and the
rapid growth of reserves and M l might signal
increasing future inflation. If not, the slowdown
o f M2 might reliably signal slow growth of
nominal income that could endanger the eco
nomic recovery in the short run and cause
deflation in the long run.
An observer who was convinced that the rela
tionship between M2 and nominal GDP had not
broken down, even temporarily, might argue
that, though the growth of M l and reserves was
high by historical standards, it was inadequate
and that monetary policy was not sufficiently
expansionary. Another observer, convinced that
there had been a breakdown of the link between
M2 and nominal GDP, might argue that slow M2
growth was not a cause for concern, but that
rapid M l growth signaled future inflation. Most
observers saw more uncertainty and found their
own views somewhere between these extremes.

Why Did M2 Slow Dramatically?
Most hypotheses about the proximate causes
of the slowdown in M2 growth point to changes
in relative returns on M2 assets. Interest rates
on assets included in the M2 aggregate but not
in M l fell relative to interest rates on other as
sets, and the public therefore preferred to hold
these other assets. Portfolios were adjusted in
two directions. Because the opportunity cost of
holding transactions balances (mostly M l assets)
relative to other M2 assets had declined, the
public could afford the convenience o f larger
transactions balances, thus increasing M l while
the non-Ml components of M2 declined. Perhaps
most important was the movement in the other
direction, from M2 assets, such as small time
deposits, to higher-yielding alternatives not in
cluded in the M2 aggregate.1
7
The movement of interest rates on non-Ml
components of M2 relative to other assets was
caused partly by the sharp widening of the
spread between short- and long-term interest
rates (M2 assets tend to have relatively short
17One such high-yield alternative for many firms and con
sumers was to pay off or avoid debt.

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maturities) and partly by various factors that
depressed M2 interest rates relative to those on
other assets of comparable maturities. One of
these factors may have been slack demand for
bank loans. Firms and consumers faced with
uncertain demand and income appeared reluc
tant to borrow at current interest rates. Banks,
seeing the return on new loans little above
Treasury yields, were unwilling to bid up
deposit rates. The slack demand for bank loans
may also reflect a long-run decline in depository
institutions’ share of total intermediation.
It has also been argued that various regulato
ry changes, including higher capital require
ments, higher deposit insurance premiums and
closer regulatory scrutiny o f portfolios, have in
creased the cost o f bank intermediation, driving
a larger wedge between the rates charged and
the rates paid by depository institutions.
Though the relevance of many of these factors
has been apparent for several years, the lack of
historical precedent has made it extremely
difficult to predict the magnitude and duration
of their influence on M2.

Did the Relationship betw een M2
and Nominal G D P Change?
The relationship between M2 and nominal
GDP is summarized by M2 velocity, the ratio of
nominal GDP to M2. If nominal GDP grows at
the same rate as M2, velocity is constant. When
nominal GDP grows more quickly (slowly) than
M2, velocity increases (decreases). Historically
M2 and nominal GDP have grown at approxi
mately the same rate when averaged over long
intervals. In the short run, when nominal GDP
and M2 growth rates often differ, M2 velocity
has usually moved in the same direction as the
opportunity cost of holding M2 assets, as shown
in figure 5. The opportunity cost measure shown
is the difference between the three-month
Treasury bill rate (representing assets not in
cluded in M2) and a weighted average of the in
terest rates paid on M2 assets. Simple economic
reasoning suggests that, all else equal, as the
true opportunity cost rises, consumers and busi
nesses should decrease the quantity of M2 assets
they hold. They may, for example, substitute
Treasury bills, which are not in M2, for small
time deposits, which are in M2. This substitution
causes M2 to fall and M2 velocity to rise.

Figure 5
M2 Velocity and Opportunity Cost
Log Scale

Quarterly Averages

Figure 5 shows a substantial rise in M2 veloci
ty during 1991 and 1992. This would not be
particularly remarkable (several similar episodes
are shown) except that the opportunity cost
measure moved in the opposite direction. The
unprecedented size and duration of the diver
gence of these variables have been interpreted
as evidence that the relationship between M2
and nominal GDP may have changed. If this
were true, it would then be difficult to discern
the implications of the slow growth of M2. This
uncertainty about the link between M2 and
nominal GDP led some observers and policy
makers to give added weight to other variables
in assessing the stance of monetary policy. Con
cerns about rapid M l and reserve growth were
reinforced by the general steepening of the
yield curve during the year, which appeared to
indicate market expectations of rising short-term
interest rates. The expected increases could
mean that the investors required a premium to

Log Scale

compensate for rising expected inflation or that
economic recovery was expected to drive real
interest rates higher. Either interpretation would
imply that monetary policy had been sufficiently
expansionary despite the evidence of slow M2
growth.
A different interpretation of the divergence
between M2 velocity and opportunity cost is
that the relationship has always been more
complicated than figure 5 implies, but only re
cently has this become important.1 The break
8
down in the relationship might be only an
artifact of mismeasurement of the opportunity
cost variable and does not necessarily imply a
break between M2 and nominal GDP.
The argument starts by observing that in
principle the entire spectrum o f interest rates is
germane to an individual's decision to hold a
particular M2 asset. In the opportunity cost
measure shown in figure 5 the three-month

18Feinman and Porter (1992) develop this argument in
depth.

MAY/JUNE 1993

Treasury bill rate represents yields on all nonM2 assets. For the three-month rate to capture
all of the relevant movements in these yields, in
terest rates on all non-M2 assets must move in
parallel with it. Figure 5 shows that this ap
proach has worked well historically, but changes
in returns on non-M2 assets in recent years
may no longer be summarized by movements in
the Treasury bill rate. On this view the diver
gence between M2 velocity and the measure of
opportunity cost shown in figure 5 does not in
dicate a breakdown in the long-run relationship
between M2 and nominal GDP. Rather this im
plies that the recent rise in velocity-like previ
ous episodes-is temporary, induced largely by
the widening of the difference in yields on
short- and long-term assets and the consequent
failure o f this measure to capture the true op
portunity cost of M2. If so, M2 velocity may fall
and M2 growth may accelerate when the differ
ence narrows. However, wariness about shortrun growth of M2 as an indicator of nominal
GDP growth is still warranted.
One effort to implement this line of reasoning
empirically by estimating an opportunity cost
using a broader set o f non-M2 yields concludes
that “ seen against the background of a more
complete accounting of relevant interest rate
margins, the recent behavior of M2 is not near
ly as anomalous as suggested by the standard
model.”1 The authors note, however, that their
9
study does not entirely resolve the puzzle.
The FOMC did not take a radical position on
the question of whether M2 was growing too
slowly. Though the record of every 1992 meet
ing indicates substantial concern over this issue,
every 1992 policy directive called for maintain
ing the “existing degree of pressure on reserve
positions” (see table 1). On the other hand, the
largest move toward ease occurred in early July
after M2 fell below the lower bound of its
growth range. Moreover, every easing action
followed a period in which M2 declined or its
growth fell significantly below expected levels.
Members of the FOMC expressed a range of
views about whether the Fed should ease enough
to ensure that M2 growth rebounded to the bot
tom of its growth range. Jerry Jordan, president
of the Federal Reserve Bank of Cleveland, main
tained that it is particularly important to
19Feinman and Porter (1992), p. 21.
20When such consultations take place, they are noted in the
record of the next meeting. Less formal consultations may
take place, but not be noted in the record.

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achieve M2 growth in the target range and voted
against the proposed directive at two meetings
for this reason. Governor Lawrence Lindsey
joined him once in his dissent.
At the other end o f the spectrum Governor
John LaWare and the president of the Federal
Reserve Bank of St. Louis, Thomas Melzer, vot
ed against policy directives on four occasions
because they felt that a bias toward ease was
inappropriate during the second half of the
year. They believed that slow M2 growth was
sending a misleading signal and that earlier eas
ing actions by the FOMC would be sufficient to
support economic recovery, despite slow M2
growth.

DETAILED CHRONOLOGY OF
FOMC ACTIVITY
The FOMC meets eight times each year. At
the end of each meeting the Committee issues a
directive to the Federal Reserve Bank of New
York to guide open market operations until the
next meeting. The Committee typically gives the
Chairman some flexibility to initiate policy ac
tions between meetings (during 1992 all actions
were taken between meetings). These actions
are sometimes agreed on during a conference
call among the members, but this was not done
during 1992.2
0
A summary of each meeting, the record of
policy actions, is released to the public shortly
after the next meeting. The record is also pub
lished in the Federal Reserve Bulletin. The shad
ed insert explains some of the language used in
the monetary policy directives and discussions
o f monetary policy.
The following summaries of FOMC meetings
and policy actions between the meetings are in
tended to give a sense of the main concerns of
the Committee and the information available at
the time. In general the most recent economic
information available to the FOMC is for a peri
od that ended at least one month before the
meeting. The main exceptions to this are in
terest rates, which can be observed daily, and
some data that are collected and assembled by
the Federal Reserve System-for example, com
ponents of the industrial production index and
the monetary aggregates. Figure 6 shows some

Table 1
FOMC Directives and Measures of Monetary Policy Stance
Intermeeting
Stance toward
Meeting

Main
Thrust'

Ease2

Restraint3

maintain
maintain
maintain
maintain
maintain
maintain
decrease
maintain

would
might
might
might
would
would
would
would

might
might
might
might
might
might
might
might

maintain
maintain
maintain
maintain
maintain
maintain
maintain
maintain

would
would
might
would
would
would
would
would

might
might
might
might
might
might
might
would

Change in
Discount
Rate

Change in
Expected
Fed Funds
Rate4

-0 .5

-0.25
-0.25

Growth5
of M2

Growth*
of M1

1991
February 5 - 6
March 26
May 14
July 2-3
August 20
October 1
November 5
December 17

-0 .5
-0.5
-1.0

-0 .2 5
-0.25
-0 .2 5
-0 .5
-0 .5

6.46
4.62
1.30
-0.51
-1.66
3.56
5.44
4.73

8.39
5.67
9.10
4.94
6.66
13.68
10.53
23.78

-1.13
0.37
-2.79
2.35
4.93
2.10
0.52
-6 .6 8 7

6.93
12.22
-2.38
14.80
27.69
13.58
8.48
5.067

1992
February 4-5
March 31
May 19
June 30-July 16
August 186
October 66
November 176
December 22
'Directive says, ‘

-0 .2 5
-0.5

-0.5
-0 .2 5

existing degree of pressure on reserve positions.”

d ire c tiv e says, “ slightly/somewhat lesser reserve restraint
3Directive says, “ slightly/somewhat greater reserve restraint

be acceptable .
... be acceptable ...”

41991 data from table 3 of Sternlight et. al. 1992 data from table 3 of McDonough et al.
5Percent change at an annual rate from week of meeting to week before the following meeting.
6Some members voted against this directive. For details, see the discussion of this meeting in the text or the appendix.
7Based on post-benchmark data.

of the monthly economic data regularly consi
dered by the Committee. Short horizontal lines
in each chart illustrate the data lags faced by
the Committee. (This device is used in figure 4
as well.) The right end indicates the meeting
date and the left end shows last data available
to the Committee at the time of the meeting. In
addition to this delay, most data series are sub
ject to revision after their initial release. Figure
6 plots the current revisions of the data, but
significant inconsistencies between the original
release and the revised data are noted below.
Table 1 provides an overview o f the direction of
monetary policy during 1991 and 1992.

February 4 -5 , 1992, Meeting
The Committee’s first task of the year was to
set growth ranges for the monetary aggregates.

A growth range of 2.5 percent to 6.5 percent
for M2 had been tentatively set in July 1991.
For several years before 1991 the FOMC had
been gradually lowering the range toward a lev
el consistent with price stability. Several mem
bers expressed a preference for resuming this
trend as a signal of the Committee’s commit
ment to price level stability, though all found
the current range acceptable. Because of puz
zling recent behavior of M2 (discussed above),
uncertainty was expressed over how monetary
growth in these target ranges would affect eco
nomic activity and inflation. The members
judged, however, that the 2.5 percent to 6.5
percent range would "provide adequate leeway
and operational flexibility to accommodate a
satisfactory economic performance.”2 They not
1
ed, however, that “the substantial uncertainties

2 April 3, 1992 press release, p. 12.
1

MAY/JUNE 1993

Figure 6
Monthly Economic Indicators
Growth of Nonfarm Payroll Employment
Seasonally Adjusted Annual Rates
32-

I ------1
I ------ 1
-

-4 -

J F M A M J

J A S O N D J
1991

F M A M J J A S O N D
1992

Growth of Industrial Production
Seasonally Adjusted Annual Rates
18
I ----1

-15

F M A M J

”

J A S O N D J
1991

F M A M J

J A S O N D
1992

Consumer Price Index Inflation
Seasonally Adjusted Annual Rates
8
6

4
2

-2

J F M A M J J A S O
1991

D J

M J J A S O N D
1992

Note: Horizontal bars indicate FOMC meetings (right end) and last available data (left end).

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surrounding the outlook for M2 suggested that
the Committee would have to approach mone
tary developments with a great deal of flexibili
ty over the year ahead.”2 Growth ranges of 2.5
2
percent to 6.5 percent for M2 and 1 percent to
5 percent for M3 were approved unanimously.
In setting policy for the weeks until the next
meeting, there was clear consensus that no dra
matic action should be taken, particularly since
significant easing had been undertaken late in
1991. Nonetheless, the Committee expressed
concern about the uncertain state of the econo
my. Though there w ere some positive signals,
nonfarm payroll employment had been flat in
December, and both retail sales and industrial
production had fallen slightly in November and
December.2 The pace of inflation had continued
3
to decline. The economic projection prepared by
the Board staff predicted “a recovery of eco
nomic activity.”2
4
Some members expressed concern about the
recent erratic behavior of M2. A staff analysis
indicated that M2 could be expected to grow
more rapidly given current conditions.
H ow ever, ex p an sio n o f M 2 p ro b a b ly w ould
c o n tin u e to b e re s tra in e d b y th e ag g ressiv e
re d u c tio n s b y d ep o sito ry in stitu tio n s in th e ir
o ffe rin g ra te s o n d ep o sit co m p o n e n ts o f th is ag
g re g a te an d th e co n tin u a tio n o f re la te d sh ifts o f
M 2 fu n d s in to h ig h er-y ield in g cap ital m a r k e t in
stru m en ts. In ad dition, th e e x p e c te d p ick u p in
th e p ace o f RTC re so lu tio n s o v e r th e b a la n c e o f
th e fir s t q u a r te r w o u ld te n d to m o d e ra te th e
g r o w th o f M 2 and e sp ecially M 3. T o th e e x te n t
th a t su b d u ed g ro w th o f th e b r o a d e r ag g reg ates
w e re to r e fle c t su ch sp ecial in flu e n c e s, th e re
w ould n o t b e sig n ifican t ad v e rse im p lication s
fo r th e o v era ll p e rfo rm a n c e o f th e e co n o m y .25

The Committee voted to maintain existing con
ditions in reserve markets but, with the possibil
ity o f deteriorating economic conditions in
mind, voted for a bias toward easing.

March 31, 1992, Meeting
New economic data did not clarify the eco
nomic situation following the February 4-5
meeting. Nonfarm payroll employment dropped
slightly in January but reversed itself in Febru

ary. Industrial production followed a similar but
more pronounced pattern. Strong retail sales
and shipments of nondefense capital goods
provided some bright spots in the January and
February data. Prices were increasing at about
the same rate as a year earlier. The economic
projection prepared by the Board staff predicted
“continued recovery in economic activity.”2
6
Reports on economic conditions in the 12 dis
tricts tended to support this point of view.
While short-term rates had held steady since
the last meeting, longer-term rates jumped sub
stantially, particularly at intermediate maturities
(figure 2). In the apparent absence of an intend
ed or unintended action raising short-term rates,
the Committee viewed the jump as a sign that
markets w ere interpreting other economic news
as evidence of growing economic momentum.2
7
The Committee was troubled by the renewal
of weak M2 growth. After significant easing late
in 1991, M2 growth was relatively robust in
January and February, but it appeared that M2
had quit growing or possibly declined in March
(data for the end of March were not yet availa
ble), contrary to expectations at the previous
meeting. Some members were concerned that
slow growth o f M2, should it continue, “could
signal that monetary policy was not positioned
to support a satisfactory expansion.”2 Some ob
8
served that it was the behavior of M2 and M3
rather than economic conditions that persuaded
them in favor of bias toward ease in the direc
tive.2
9
The Committee unanimously adopted another
directive biased toward ease, though a minority
of members would have favored a symmetric
directive in view of evidence of a strengthening
economy. The majority, however, "remained
concerned about the vulnerability of the expan
sion to a variety of risks.”3
0

April Easing
In early April it became clear that M2 had in
fact begun to decline during March. Together
with "indications that the economic expansion
was not as strong as its pace early in the year”
this led to a decision to ease monetary condi-

22April 3, 1992 press release, p. 13.

27May 22, 1992 press release, p. 4.

23Later revisions indicate a slight increase in retail sales.

28May 22, 1992 press release, p. 12.

24April 3, 1992 press release, p. 6.

29May 22, 1992 press release, p. 13.

25April 3, 1992 press release, p. 18.

30May 22, 1992 press release, p. 11.

26May 22, 1992 press release, p. 5.

MAY/JUNE 1993

tions in early April.3 Besides M2, retail sales
1
was the only prominent economic indicator that
turned down. Employment and industrial pro
duction both rose during March. After this eas
ing action the federal funds rate fell more than
0.5 percentage points from around 4.0 percent,
but it eventually stabilized around 3.75 percent.

M ay 19, 1992, Meeting
Payroll employment and industrial production
increased through April, continuing the trend
started at the beginning of the year. Retail sales
rebounded from a March drop, and there was
evidence that fixed investment was picking up
after an April drop in shipments.3 The staff pro
2
jection was again “continuing recovery.”3 Over
3
all, the evidence suggested a modest recovery
with a broad base across regions and industries.
Once again the behavior of the monetary ag
gregates was a central focus of concern. Both
M2 and M3 contracted during March and from
March to April, leaving them below the levels
expected by the Committee at its March 31
meeting.3 Though many thought that tem
4
porary technical considerations accounted for
part of this decline, some Committee members
regarded the weakness of M2 and M3 as “in
dicative of an increase in the downside risks to
the expansion.”3 Others felt instead that “a vari
3
ety of developments ... seemed to have altered
previous relationships between M2 and M3 and
measures of spending and income.”3 Therefore
6
"satisfactory economic expansion would tend to
be consistent with weaker growth and a higher
velocity of M2 than would be suggested by
historical relationships.”3 Some members felt in
7
addition that “the strength of M l and reserves
... could raise questions about the consistency of
current monetary policy with progress toward
price stability.”3
8
Though some members would have preferred
bias toward ease, whereas others preferred to
tilt the directive toward restraint, the Committee
agreed unanimously on a policy of unchanged
pressure in reserve markets with symmetric
language.

June 3 0 -July 1, 1992, Meeting
Through May, payroll employment and indus
trial production continued the weak upward
trend started at the beginning o f the year, sug
gesting that expansion continued at a very
modest pace. However, "recent information sug
gested some weakening in the expansion."3
9
Growth of consumption expenditures in particu
lar had slowed significantly. The staff projection
predicted a "modest pickup in economic growth
over the second half of the year.”4 Members
0
reported that the expansion continued to be ge
ographically broadly based, though there were
significant exceptions, notably California.
The growth of M2 and M3 was still weak in
May, and available information for June indicat
ed contraction, leaving the aggregates below the
lower end of the growth ranges.
The policy record indicates that at the June
30-July 1 meeting, FOMC members had more
diverse opinions about policy for the immediate
future than at the May meeting. Some members
preferred an immediate easing o f policy. Of
those who preferred easing, some emphasized
"the recent indications of some slowing in the
expansion and the already considerable slack in
the economy,” whereas others highlighted "the
desirability of taking relatively prompt action to
foster growth in the broad measures of money
within the Committee’s ranges for the year.”4
1
The Committee voted to return to a directive bi
ased toward ease. John LaWare and Thomas
Melzer objected to the asymmetric directive be
cause "the current stance of monetary policy
was not impeding an expansion consistent with
the economy’s long-run potential”4 and because
2
in the context of the previous symmetric direc
tive it "suggested an excessive emphasis on
short-term economic developments that might
undermine the credibility of the System’s longrun policies.”4
3
The Committee also reaffirmed the 1992
growth ranges for M2, M3 and total domestic
nonfinancial debt and tentatively decided to
maintain the same growth ranges for 1993.

31July 2, 1992 press release, p. 4.

38July 2, 1992 press release, p. 12.

32Revised retail sales data show a slight decline in April.

39August 21, 1992 press release, p. 7.

33July 2, 1992 press release, p. 6.

“ August 21, 1992 press release, p. 5.

34July 2, 1992 press release, p. 6.

41August 21, 1992 press release, p. 17.

35July 2, 1992 press release, p. 11.

42August 21, 1992 press release, p. 21.

36July 2, 1992 press release, p. 11.

43August 21, 1992 press release, p. 21.

37July 2, 1992 press release, p. 12.

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July Easing
The day after the FOMC meeting (July 2) the
Department of Labor reported that payroll em
ployment had fallen by 117,000 (1.3 percent at
an annual rate) in June after four months of
slow growth.4 Also on July 2 the Board of
4
Governors voted to lower the discount rate
from 3.5 percent to 3.0 percent, and open mar
ket operations were implemented to let the fed
eral funds rate fall by a comparable amount.4
5
Figure 2 shows that the federal funds rate,
which had hovered around 3.75 percent, fell
sharply to about 3.25 percent. There was no tel
ephone conference regarding this change in the
intermeeting policy.

August 18, 1992, Meeting
At its August 18 meeting, the Committee con
cluded that though expansion continued, its
pace had slowed.4 July payroll employment had
6
reversed the June decline, but both numbers
were propped up by temporary hiring in a new
federally sponsored summer jobs program. In
dustrial production followed the same patternrecovery in July from a June drop. Retail sales
increased moderately in July following a secondquarter slowing, while shipments o f nondefense
capital goods rose sharply in June. Market in
terest rates at all maturities fell substantially
during July following the easing action but
probably also reflected the sluggishness of the
expansion. The staff projection pointed to a con
tinuing pattern of "subdued economic expan
sion.’’4 Some members noted that "they could
7
not identify any sector of the economy that
seemed primed to provide the impetus needed
for a vigorous expansion,” though they noted
"considerable progress ... toward redressing
earlier over-expansion and credit excesses.”4
8
Members expressed considerable optimism
about the inflation outlook, citing “increasingly
persuasive evidence of slower rates of increase
in wages and prices.”4
9
The monetary aggregates remained an impor
tant concern. M2 and M3 contracted further in
July and continued below the lower end o f the
44See U.S. Department of Labor (1992). Revised data show a
less substantial fall of 0.18 percent.
45October 9, 1992 press release, p. 4.
46October 9, 1992 press release, p. 1.
47October 9, 1992 press release, p. 6.
‘“ October 9, 1992 press release, p. 8.

growth ranges. Following the easing in early
July, M l (which had fallen during June) began a
period of rapid growth in July.
Some members felt further easing was in ord
er, but a majority favored an unchanged policy
that recognized the potential for conditions war
ranting easing. The behavior of the broad mone
tary aggregates was regarded as a significant
factor “in favor of careful consideration of” fur
ther easing.5
0
A directive biased toward ease was adopted
with support from some members who favored
a symmetric directive. John LaWare and Thomas
Melzer voted against this action citing reasons
similar to those mentioned in their previous
dissent.

Septem ber Easing
In early September, after slower-than-expected
response o f M2 to the July easing and economic
data (including a sharp increase in initial unem
ployment insurance claims) that continued to in
dicate sluggish economic growth, an easing
action was implemented. For technical reasons
the federal funds rate remained higher than ex
pected following this action, but it settled to
around 3.0 percent by the end of October.5
1

O ctober 6, 1992, Meeting
The policy record for the October meeting
gives a picture of economic developments very
similar to that from the previous meeting"economic activity was expanding at a subdued
pace.”5 Nonfarm payroll employment fell slight
2
ly in August and again in September, though
the latter partly reflected the end of the sum
mer jobs program mentioned above.5 Industrial
3
production fell in August and partial informa
tion for September "suggested further weak
ness.” Consumption seemed to have slowed
through August after a period of robust growth.
Shipments of nondefense capital goods slowed
during July and August, a sign of possible
renewed weakness in investment. The staff
projection "indicated that economic activity
would expand at a slow pace in the current
^O ctober 9, 1992 press release, p. 12.
5 November 20, 1992 press release, p. 4.
1
52November 20, 1992 press release, p. 1.
“ Subsequent revision to the employment data made the
September drop into a slight rise as shown in Figure 6.
November 20, 1992 press release, p. 1.

49October 9, 1992 press release, p. 10.

MAY/JUNE 1993

quarter” but would pick up gradually in 1993.5
4
Many members again worried that, "No impor
tant sector of the economy seemed poised to
provide much impetus to business activity ...”5
5
Several members felt that recent volatility in
some asset markets, particularly the foreign ex
change market, underscored the risks o f poten
tially adverse developments.5 On the plus side
6
they noted that declines in the dollar and
domestic interest rates "suggested improved
conditions for greater expansion.”5 The infla
7
tion outlook continued to be favorable.
M2 and M3 began to grow again in August,
but only slowly. The weak growth appeared to
have continued into September, and both ag
gregates w ere expected to finish September be
low the bottom end of the growth range.
The same range of opinions on policy for the
immediate future was expressed. The policy
record, however, indicates a clear shift toward
ease in the balance of members' opinions. Though
the policy directive contains exactly the same
wording stating a bias toward ease, the record
indicates that a majority of the Committee sup
ported a directive "strongly” biased toward pos
sible ease, with "a decided presumption o f some
easing,” and with “a marked bias toward possi
ble easing.”5 Four members voted against the
8
directive. John LaWare and Thomas Melzer fa
vored a symmetric directive for the reasons
stated at previous meetings, adding their con
cern that an easing action might destabilize the
dollar.5 Mr. Melzer was also concerned that
9
continued rapid M l growth might jeopardize
progress toward price stability. Two other Com
mittee members, Jerry Jordan and Governor
Lawrence Lindsey, favored immediate easing
sufficient to "achieve the Committee’s pre
announced target growth for M2.”6 They indi
0
cated that this action should be accompanied by
an announcement that the growth range would
be lowered in 1993 to signal that the easing did
not indicate a discounting of the FOMC's goal of
price stability.

N o v em b er 17, 1992, Meeting
More optimism about the pace of economic
activity was evident at this meeting: “economic
activity had been expanding at a moderate
pace.”6 Nonfarm payroll employment had risen
1
slightly in October following two months of
declines. Industrial production rose in October
“following a modest increase in the third quart
er.”6 (The July increase had offset slight declines
2
in August and September.) Stronger retail sales
in September and October, stronger housing
sales and starts, and anecdotal evidence all sug
gested stronger overall consumption spending.
Another strong increase in outlays for producers’
durable equipment in the third quarter implied
renewed strength in investment. Increasing in
terest rates, particularly at intermediate maturi
ties, suggested that the more optimistic outlook
was shared by financial markets. The staff
projection “suggested a continuing expansion in
economic activity.”6 In discussion “the members
3
indicated that they w ere encouraged by the
somewhat more positive tone in the latest eco
nomic reports and by the signs of improving
business and consumer confidence.”6
4
M2 growth picked up in October. Combined
with the more favorable economic reports, this
had deterred a move toward ease despite the
strong presumption in favor o f ease at the Oc
tober meeting. Further easing had been expected
by financial markets, and correction of this ex
pectation was regarded as partly responsible for
the rise in interest rates.
Many members preferred a symmetric policy
for the upcoming weeks, believing that "risks to
the expansion were now fairly evenly balanced.”6
5
Others still preferred a bias toward ease, but
without the strong presumption understood at
the previous meeting. The Committee once
again adopted a directive biased toward ease.
Jordan, LaWare and Melzer voted against this
action for reasons similar to those expressed at
the previous meeting.

54November 20, 1992 press release, p. 6.

61December 24, 1992 press release, p. 1.

55November 20, 1992 press release, p. 7.

62December 24, 1992 press release, p. 1.

56The European Exchange Rate Mechanism collapsed on
September 16.

63December 24, 1992 press release, p. 6.

57November 20, 1992 press release, p. 7.
“ November 20, 1992 press release, pp. 10, 11 and 13.
59November 20, 1992 press release, p. 16.
“ November 20, 1992 press release, p. 15.

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Federal Reserve Bank of St. Louis

64December 24, 1992 press release, p. 7.
65December 24, 1992 press release, p. 13.

D ecem ber 22, 1992, Meeting
As figure 1 indicates, real GDP rose signifi
cantly in the third quarter and the available evi
dence for the fourth quarter indicated that this
pattern was continuing. Nonfarm payroll em
ployment again rose slightly in November. In
dustrial production also increased. Retail sales
rose sharply through November, and sales and
starts o f single-family homes showed sizable
growth.6 Shipments of nondefense capital goods
6
continued to expand. Yields on long-term bonds
fell, but this was attributed to favorable market
reaction to "indications that the incoming Ad
ministration would give emphasis to reducing
the federal budget deficit over time,” rather
than to the weakening recovery.6 The staff
7
projection "suggested a continuing expansion in
economic activity” but also indicated that the
momentum of the expansion would be partly
offset by weaker export demand.6 Reports
8
from most regions reinforced a picture of "in
creasingly robust business conditions,” though
there were notable exceptions, again including
California.
M2 slowed once again in November, and this
weakness appeared to continue into December.
A staff analysis pointed to sluggish growth of
M2 and M3 and substantial slowing in the
growth of M l during the coming months.

tember, combinations of faltering M2 growth
and possibly slowing economic activity prompt
ed easing actions. The July action accompanied
a half-point discount rate reduction. The econo
my was growing fairly quickly by the end of
the year, despite forecasters’ midyear pes
simism.
Although the FOMC devoted a good deal of at
tention to anomalous behavior of M2, the ag
gregate ended the year slightly below the lower
end of its growth range. Various factors led to
doubt about the reliability of M2 as an indicator
of economic activity and inflation, but the impli
cations of slow M2 growth combined with rapid
growth of reserves and M l during 1992 are not
yet known.

REFERENCES
Bullard, James B. “ The FOMC in 1991: An Elusive Recovery,”
this Review (March-April 1992), pp. 41-61.
Eggert, Robert J. (ed.). Blue Chip Economic Indicators,
Capitol Publications, Inc., Vol. 17 (June/August 1992).
Federal Reserve Board of Governors. “ Monetary Policy
Report to the Congress,” Federal Reserve Bulletin (April
1987), pp. 239-54.
Federal Reserve press releases, “ Record of Policy Actions of
the Federal Open Market Committee,” (March 29, 1991;
April 3, 1992; May 22, 1992; July 2, 1992; August 21, 1992;
October 9, 1992; November 20, 1992; December 24, 1992;
and February 5, 1993).

The Committee felt that recent positive de
velopments warranted "a shift toward a more
balanced approach to possible intermeeting
changes in policy.”6 Though noting considerable
9
uncertainty about the future course of the
economy, "members observed that the next poli
cy move might be in either direction.”™ Despite
the slower M2 growth, a symmetric directive
was unanimously adopted.7
1

Feinman, Joshua N., and Richard D. Porter. “ The Continuing
Weakness in M2,” Finance and Economics Discussion Ser
ies working paper 209 (Board of Governors of the Federal
Reserve System, September 1992).

SUMMARY

Sternlight, Peter D., Cheryl Edwards and R. Spence Hilton.
“ Monetary Policy and Open Market Operations during
1991,” Federal Reserve Bank of New York Quarterly Review
(Spring 1992), pp. 72-95.

For much of 1992, stronger economic perfor
mance seemed just around the corner. Three
times during the year, in April, July, and Sep

McDonough, William J., Spence Hilton and Peter Kretzmer.
“ Monetary Policy and Open Market Operations during
1992,” Federal Reserve Bank of New York Quarterly Review
(Spring 1993), pp. 89-114.

U.S. Department of Labor, Bureau of Labor Statistics. “ The
Employment Situation: June 1992,” News (July 2, 1992),
p. 1.

66A later revision of the data shows a fall in retail sales in
November.
67February 5, 1993 press release, p. 10.
68February 5, 1993 press release, p. 6.
69February 5, 1993 press release, p. 12.
70February 5, 1993 press release, p. 12.
71The language of the directive differed slightly from the May
directive. See table 1.

MAY/JUNE 1993

Appendix
FOMC Dissents
This appendix contains the exact text of mem
bers reasons for voting against FOMC directives.

February 4 -5 , 1992
No dissents.

March 31, 1992
No dissents.

M ay 19, 1992
No dissents.

June 3 0 -July 1, 1992
Messrs. LaWare and Melzer dissented because
they judged an asymmetric directive, with a
bias toward easing, as being inappropriate at
this time. In their view, the current stance of
monetary policy was not impeding an expansion
consistent with the economy’s long-run poten
tial. In addition, a bias toward ease, especially in
the context of the Committee’s decision at the
May meeting to adopt a symmetrical directive,
suggested an excessive emphasis on short-term
economic developments that might undermine
the credibility of the System’s long-run policies.
They were concerned that such a loss of credi
bility could have adverse effects on the dollar in
foreign exchange markets and on long-term in
terest rates in domestic markets. Mr. Melzer
also believed that, if additional easing w ere un
dertaken, a greater policy reversal ultimately
would be necessary, making the attainment of
sustainable economic growth more difficult in
the long run.

August 18, 1992
Messrs. LaWare and Melzer dissented because
they did not favor a directive that was biased
toward possible easing during the intermeeting
period. In their view, monetary policy already
was appropriately stimulative, as evidenced in
part by the low level of short-term interest
rates and by the rapid growth in reserves since
early this year, and was consistent with the pro
motion of economic growth in line with the
economy's long-run potential. Business and con
sumer confidence were in fact at low levels, but
they reflected a variety of problems facing the
economy that were unrelated to the stance of
monetary policy. Accordingly, what was needed

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at this point was a more patient monetary
policy—one that was less predisposed to react to
near-term weakness in economic data and that
allowed more time for the effects of earlier eas
ing actions to be reflected in the economy. In
deed, an easing move in present circumstances
might well stimulate inflationary concerns by
reducing confidence in the System’s willingness
to pursue an anti-inflationary policy and thus
could have adverse repercussions on domestic
bond markets and further damaging effects on
the dollar in foreign exchange markets.

O ctober 6, 1992
Messrs. Jordan and Lindsey preferred immedi
ate action by the Committee to increase the
availability of bank reserves sufficiently to
achieve the Committee’s pre-announced target
growth for M2 in 1992. Such reserve provision
would likely be associated with further declines
in short-term market interest rates. They be
lieved that this policy action by the Committee
should be accompanied by an announcement of
reductions of the upper and lower limits o f the
range for M2 growth in 1993. They felt that it
was important to make clear that near-term ac
tion to increase M2 expansion was not an aban
donment of the long-term objective of
non-inflationary monetary growth.
Messrs. LaWare and Melzer dissented because
they did not want to bias the directive toward
possible easing during the intermeeting period.
In their view, a variety of indicators, including
the level of short-term interest rates and the
growth of reserves, suggested that monetary
policy already was positioned to foster an ex
pansion in economic activity consistent with the
economy’s long-run potential. Moreover, further
easing at this time would incur a substantial
risk of destabilizing the dollar in the foreign ex
change markets. In these circumstances, they
favored a steady monetary policy that was not
disposed to react to near-term weakness in eco
nomic data and that allowed more time for the
effects of earlier easing actions to be felt in the
economy. Mr. Melzer also expressed concern
that the progress already made toward achiev
ing price stability might be jeopardized if very
rapid growth in M l were to continue.

N o v em b er 17, 1992
Mr. Jordan dissented because he preferred
taking immediate action to increase the availabil
ity of bank reserves sufficiently to raise M2

growth to a pace more consistent with the Com
mittee’s annual range. Because desirable M2 ex
pansion in line with the Committee’s objectives
would be likely to fall within a lower range
next year, he would announce concurrently a
reduction in the 1993 range to make clear that
near-term action to increase M2 expansion was
not an abandonment of the long-term objective
of non-inflationary monetary growth.
Messrs. LaWare and Melzer dissented because
they did not want to bias the directive toward
possible easing during the intermeeting period.
In their view, recent developments pointed to a
strengthening economy, and they favored a
steady policy that was not predisposed to react
to near-term weakness in economic or monetary
data. More time was needed to evaluate the ef
fects of prior monetary policy actions, and they

were concerned that the adoption of a more
stimulative policy over the near term might well
establish a basis for greater inflation later. Mr.
Melzer was concerned that rapid growth in to
tal bank reserves, the monetary base, and M l
over the last two years might already have laid
a foundation for accelerating nominal GDP
growth and a reversal of the disinflationary
trend. In addition, he noted that policy errors
can easily be made at this stage of the business
cycle. In an economic expansion, efforts to
resist increases in the federal funds rate
through large reserve injections eventually lead
to higher inflation and higher nominal interest
rates.

D ecem ber 22, 1992
No dissents.

MAY/JUNE 1993

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St. Louis, Missouri 63166

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Full text of Review (Federal Reserve Bank of St. Louis) : May/June 1993

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