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A New Approach to Monetary Control by E. Gerald Corrigan, President Federal Reserve Bank of Minneapolis presented at the Financial Forum New York University Graduate School of Business Administration November 3, 1980 A New Approach to Monetary Control October 6, 1979, has become one of those dates which is instantly recognized as being associated with something important— and rightly so. After all, it was the day on which Pope John visit ed Washington, D.C. However, as you and I know, the Pope's visit was not the only extraordinary event occurring in Washington on that fall Sat urday morning. an The Federal Open Market Committee had assembled in extraordinary Saturday session, and at the conclusion of the meeting the Fed announced a series of policy changes which included some "conventional moves," and the Fed also announced a change the method used to conduct monetary policy. indicated its intent to "place greater Specifically, emphasis in in the Fed day-to-day operations on the supply of bank reserves and less emphasis on con fining short-term fluctuations in the federal funds rate." This change in operating procedures— or, to be more pre cise, the change in emphasis in operating procedures— was a recog nition that, because of sudden and unpredictable shifts, the rela tionship between the amount of money had weakened. Hitting a specified demanded funds and interest rate target, rates therefore, provided increasingly less assurances that the corresponding money targets would be hit— even over long periods of time. the technical issue as to how to best control money, procedures was also intended Aside from the change in to draw greater public attention to the notion that one necessary prerequisite to controlling inflation over time rests money and credit. in achieving disciplined and restrained growth in 2 - Now, more consider our than a year experience with - later, these it is appropriate new operating that we procedures, this forum can play a constructive role in that evaluation. ever, I cannot "Federal help Reserve but Policy note that Since the October ferent?"— seems a bit prejudicial. the financial press carefully title 1979: Indeed, and of as today's Is and How forum— It Really Dif as someone who reads someone who spends a fair amount of time talking with people in the markets, I am struck with the skepticism that still exists as to whether, has really changed. the extent in fact, anything By the same token, I am also struck at times by to which other observers, both in the markets academic circles, argue that too much has changed. of my remarks this afternoon will be on my and in Thus, the focus perceptions of the changes that have occurred in our operating techniques. From my vantage point, the fact that something has chang ed is clear. dispute. And I think I know that meetings of the FOMC; that from the evidence of change the nature of is beyond the discussions at the I know that from the language of the Commit tee's directives to the Manager of the System Open Market Account; I know that from the manner in which information is presented to the Committee by the staff and by the manner in which the Committee reacts to the information at its disposal. These inherently immeasurable indications of change are reinforced by indications of change in market variables. however, the evidence of change is, I believe, Here too, convincing. The daily movement in the funds rate was twice as large after October 1979 as it was in a comparable period before then. Likewise, the - monthly variability of the 3 funds after October 1979 than before. bility may dures. - rate was Of course, be due to factors other substantially larger this change in varia than our new operating proce There is, however, less ambiguous evidence of a change policy. in Our Research Department at the Minneapolis Fed developed mathematical characterizations of how the FOMC reacted to changes in the money supply, interest rates, and several other economic variables in two comparable periods before and after October 1979. To put it simply, mulas. They they expressed the Fed's decision rules as for found that, using standard statistical techniques, they could strongly reject the claim that there has been no change in the way the Fed reacts to developments interest rates. a new policy. in the money supply and They found that the Fed has indeed been following The result of this new policy is that the federal funds rate is more sensitive to changes in the growth of money; it responds both more quickly and more sharply. I do not mean to suggest that interest rates never enter into the Committee's deliberations. Committee's directives still You know, as I do, for consultations band limits By and large, the band is viewed by the Committee as a reference point operations rate the contain a band on the funds rate— a band that is typically 500 to 600 basis points wide. however, that for rather as it was a in the past. are looked at individual than in terms strict Also, constraint of day-to-day the limits on the funds of weekly days or points on averages rather time within days. than Here too, I believe the record confirms the fact that the Committee less concerned with interest rates than before. is For example, there 4 - were several occasions during - the period in question when market developments moved the funds rate to the point where the limits of the funds rate band could have been a constraint on operations. However, when this occurred, the funds rate band was altered by the Committee. There were also two occasions— one on the upside and one on the downside— in which market forces brought the funds rate into proximity with sharp shifts verse the the limits in economic direction of of and the funds financial interest rate rate band, conditions and money only to have emerge and re growth patterns before the Fed had to confront directly the question of whether to alter the funds rate limits. In these two instances, a case can perhaps be made that market forces intervened just in the nick of time, for in the circumstances that prevailed it would have been by no means clear to me that permitting a further rise (or fall) in the funds rate would have been the "right" decision. Fortunately, per haps, we will never know! The particulars of individual episodes aside, I know that some would argue that rate band— no the Committee to alter the limits of the band— constitutes prima facie evidence that no matter thing how wide and no matter has changed. believe that there even the mere presence of a funds I also is, daily movements views, nor totally do indifferent know that in some sense, in I accept how willing the the about funds view some observers interest to a de facto narrow limit on rate. that continue I do monetary rates. not accept policy Whatever those should one be claims about the role of interest rates in the process of monetary policy 5 - formulation, they are and will - remain vehicle around which households, businesses, decisions. Those portfolio decisions have implications for econ omic activity, and and financial the they may have institutions make portfolio important implications for the size of the reserves multiplier. These considerations insure that interest rates in deliberations policy. However, will play a role neither this inevitability nor about monetary the Committee's practice of establishing large ranges for federal funds rate move ments is incompatible with the followed since last October. to the But, total clearly, exclusion of changed policy that the Fed has In short, policy has changed, but not any consideration of interest rates. interest rates rank lower— much lower— in the hier archy of things than they did prior to October 6, 1979. The results of the change in policy emphasis course, more important than the changes themselves. are, of In looking at those results, I would have to concede that we have a little bit of the "good forms: news," "bad news" syndrome. The good news takes two first, the objective of calling increased public attention to the need for restrained growth in money and credit over time has been eminently successful— at times I think almost too successful! Second, looked strained. at over time, the growth of money has been re For example, since October 1979, MIA and M1B have grown at annual rates of about 5 and 6 3/4 percent, the growth of M2 has been at 9 1/2 percent. respectively, while For 1980 to date, MIA is comfortably within its target range, and M1B and M2 are current ly running slightly above the targets for the year, burst of money growth experienced in recent months— a money growth that is not all that easy to understand. following the surge in - In considering 6 - those ranges and actual money growth for 1980, I would also note that when those ranges were announced last February, they were universally viewed as rigorous and demanding— indeed to some, virtually unattainable. Thus, at this point, and looked at in the perspective of appropriately long time frames, I have to conclude that we have had a measure of success in keeping the growth of money in line with intentions and in line with a pat tern of growth that should be compatible with a reduction in infla tion over time. The bad news, of course, is that over the period in ques tion we have had considerably more variability in both money growth and in interest rates than we might have hoped for. That varia bility is troubling in part because it complicates decision making and financial planning, and also because it tends to feed upon itself, particularly in markets that are as sensitized as ours seem to be. Thus, I think it is important that we seek to understand the reasons for this variability and seek to find ways to minimize it in the future. As I see it, technical— contributed a variety of factors— some "real," others to the variability we have witnessed. On the "real" side, I am convinced that the sudden imposition and then removal of credit counter-shift controls in the demand did produce for money a significant balances shift and which contributed importantly to the sharp drop and subsequent rebound in the growth of money. Similarly, the pattern of growth in nominal income must also be recognized as having had a major impact on the variability of both money and interest rates. Indeed, I would guess that the - amplitude April of the swing in 7 the - growth of nominal income between and September-October of this year must rank as one of the sharpest such swings over such a short interval in our recent econ omic history. Surely, the amplitude of that swing in nominal come contributed directly and importantly in to the fall and subse quent rise in money and interest rates. To the extent that these judgments are correct, the horns of the dilemma facing the Fed become more evident. The amplitude of the swing in money could, perhaps, have been moderated, the expense of a still sharper swing in interest rates. but at As I see it, there is no other set of circumstances that could have produced less variability in money in those circumstances, but I have to ask myself whether swing rates, in money it would have been prudent to seek to moderate the by producing particularly since still there larger are lags variations between in changes interest in Fed actions and changes in the growth in money. On more technical grounds, there are at least three sets of factors which have contributed to the variability we have seen. First, there are lags in the adjustment process between the growth of reserves and the growth in money. When the Fed sets or adjusts a reserve path, or when market rates rise or fall sharply in response to changes in the demand for credit, the adjustments and portfolio shifts that ultimately reflect themselves in money take time. in altered growth rates The length and stability of these lags are open to some debate, but their presence is beyond dispute. Thus, if the money supply and interest rates drop sharply— say, for a quarter— with a given reserve path, the drop itself tends to set into play 8 - corrective the drop forces - in the opposite direction. in money growth, the Fed raises its If, in response to reserve path, its action might not have any effect until the correcting move has al ready begun. Then, the correcting move in the opposite direction would be amplified— just the opposite of the intended result. The presence of these lags ready complex question of what ments should money and with that the Fed some react initial desired greatly complicates kinds of to, given growth rate in money. al information and develop targets path of reserves the for the growth in thought to be compatible Suppose, for example, operations remain right on path, but for a week, a month, or even a quarter, money growth is faster than expected or desired. Do you adjust the path, or do you assume that the money growth pattern is simply an aberration that will work out over time? These decisions are never easy, but in an environment in which there are lags, they become even more difficult, because if an adjustment in the reserve path is made, that very adjustment may produce conditions in the future that will ultimately require offsetting actions in the oppo site direction. A second "technical" source of the variability in money and interest rates that we have witnessed can be traced to lagged reserve accounting. Lagged reserve accounting was not a problem in the context of the old operating procedures and, in most weeks, it is not a major problem under the new operating procedures. How ever, on those few occasions in which there are large and unexpect ed deviations in deposit does add to our problems. growth, the presence of lagged reserves For example, absent lagged reserves, the 9 - funds market would provide - a tip-off of a sudden surge in money growth, and the resulting transitory run-up in the funds rate might help to blunt would the surge certainly know in money growth. more sooner. At Thus, the very least, contemporaneous least more contemporaneous reserve accounting might help. even here there are sharply differing viewpoints as or we at However, to just how much help would be forthcoming. Finally, and still on the technical side, we are be deviled by a whole range of definitional and measurement problems. The disparity between the growth of MIA and M1B which has emerged during 1980 as a result of shifts point. into ATS accounts is a case in The still somewhat mysterious growth in money by $10 bil lion in the single week of August 6 is another case in point. In this regard, I wish I could tell you that these kinds of data prob lems were a thing of the past. case— at least for a while. Unfortunately, that will not be the For example, the introduction of NOW accounts nationwide beginning in January 1981 will surely bloat the growth of M1B in a wholly artificial way for some time. as thousands with of institutions the Fed and maintaining begin filing "reports of Similarly, deposits" reserves with the Fed for the first time as required by the Monetary Control Act, there is sure to be a period other both of at least operating reserve several problems and money months will produce numbers. problems should be transitory, in which errors While they will reporting and both of errors distortions and in these particular almost certainly produce some confusion and some doubt as to the underlying intent and per formance of Fed policy. 10 - - Against the backdrop of the good news and the bad news, the obvious question that arises is: What is the bottom line— are the post-October 6 techniques an improvement over the pre-October 6 procedures? My answer is "yes." I reach that conclusion not sim ply because the evidence of what, in fact, has occurred since Octo ber 6 is, on balance, compatible with that conclusion. to ask myself change the question of what in policy not occurred. would have I also have occurred That question, had to be sure, hypothetical one that is open to considerable debate. the is a However, my own view is that, whatever the problems with the new procedures, I, at least, am willing to speculate that the growth of money for the period as a whole would not have been as restrained as it has been were it not for the change. Having said that, I would hasten to add that I believe that we can improve these techniques and procedures. term, definitional In the near and data problems— in part associated with the implementation of the Monetary Control Act— will further complicate matters. behind help, However, once the crunch associated with that process is us, as universal should the major serve requirements. us, we can reserves reporting of deposits simplification of the structure of re and unencumbered look at lagged considerable analysis of grist for experience with the analytical in itself, pro mill. the new procedures will, dent, generate ideas for enhancement and improvement. reserve More fundamentally, perhaps, we now have more than a year of experience with the new procedures which, vides should Similarly, once that initial crunch is behind take a fresh requirements. and That ongoing I am confi 11 - Whatever enhancements - or modifications may grow out of that evaluation and out of the continued evolution of events, even assuming the best and in terms of transitional problems such as the introduction of NOW accounts nationwide, we still, in my mind, have to come to better grips with the question information we react to and how we react. of what kinds of Even in a highly simpli fied world in which we know exactly what "money" is and can measure it precisely from week to week, there will be deviations from tar gets, there will be aberrations, there will be external shocks, and there will be uncertainty. in this context, it seems to me that there is a wide and growing body of knowledge in the area of deci sion rules and information filtering which may be relevant to the task of more systematically determining what is "noise" and what is "real." In summary, there has been a change in the way we conduct monetary policy. certainly hurdles the in The change has not been without its problems, and task the year of monetary ahead. control faces those hurdles, But some very the tough inevitable short-run blips in the money supply, the inevitable second guessing as to why the Fed entered the market at 11:07 a.m. instead of 11:30 a.m., should not be misconstrued. and the dialogue aside, has been rates and, the underlying from where of growth in money I stand, that, will over sustained reduction in inflation. The technicalities, objective of continue time, are the debate the exercise to be achieving compatible with a
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