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82-3 c a E E o u TJ C Z a ; > a ) c * TH E FED’S PO ST-O C TO BER 1979 TEC H N IC A L O PERA TIN G PRO C ED U RES: RED U C ED A B ILITY TO C O N TR O L M O N EY George G. Kaufman m D m 70 > r — 70 m m co 70 < m 09 > Z * 0 ■n n i n > o o 82-3 The Fed's Post-October 1979 Technical Operating Procedures: Reduced Ability to Control Money by k George G. Kaufman Loyola University and Federal Reserve Bank of Chicago k The views expressed in this paper are solely those of the author and do not necessarily represent the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. May 1982 THE FED'S POST-OCTOBER 1979 TECHNICAL OPERATING PROCEDURES: REDUCED ABILITY TO CONTROL MONEY George G. Kaufman* On October 6 , 1979, the Federal Reserve changed its "open market operating procedures to place more emphasis on controlling reserves directly so as to provide more assurance of attaining basic money supply objectives."^ The change was widely expected to increase, at least in the near-term, volatility in short-term interest rates as the "new procedures entail greater freedom for interest rates to change over the short-run in response to market forces" and the Federal Open Market Committee widened the target intermeeting Federal funds range. it did. 2 And so The standard deviation in weekly percentage changes in the interest rates on three-month Treasury bills more than doubled from 2.4 percent to 5.3 percent between the four years before and the two years after October 1979. Less expected, however, was an increase in the short-term volatility of long-term rates. The standard deviation in weekly percentage changes in rates on 20-year Treasury bonds jumped from 0.8 percent in the four years before October 1979 to 2.5 percent in the two years after. These results are shown in Table 1. The standard deviations in daily changes in these rates show a similar pattern and are plotted in Figure 1. 3 *Loyola University of Chicago and Federal Reserve Bank of Chicago. Patricia Walker provided research assistance. The author benefited from discussions with and comments by Thomas Gittings, David Lindsey, Robert Laurent, Thomas Mayer, Harvey Rosenblum, Steve Strongin, Vefa Tarhan, Robert Weintraub and William Wilby. An earlier version of this paper was presented at the Midwest Finance Association meetings in Chicago, April 1-3, 1982. 2 Although the Fed warned that "even in evaluating money growth itself* which the Federal Open Market Committee sets as a target in the policy process, recognition has to be given to the likelihood that money growth can vary substantially on a month-to-month basis in view of inherently large and erratic money flows in as vast and complex an economy as ours," the new operating procedures were expected to decrease the short-and long-term volatility in monetary aggregates by reducing 4 the need for changes in reserves to stabilize interest rates. did not happen. But this Both short and long-term volatility in major monetary aggregate series increased after the change. For example, the standard deviation in weekly percentage changes in not seasonally adjusted M1B less currency rose from 1.90 percent in the period January 1975 October 6 , 1979 to 2.13 percent in the period October 6 , 1979 December 2, 1981 (Table 2). Similar results are obtained for alternative definitions of monetary aggregate, alternative sample periods, and seasonally adjusted data.^ Longer-term volatility in M1B has increased even more since October 1979 as is clearly evident in Figure 2. Thus, the Fed appears to have achieved the worst of both worlds. It has increased the volatility in both interest rates and money supply. This paper analyzes the new operating procedure to identify why this might have occured. The analysis suggests that, in the absence of deliberate Federal Reserve policy to permit greater short-run volatility in monetary aggregates, an important cause of the problem is the inappropriate grafting of a monetary aggregate target on a lagged reserve requirement accounting system. This alone increases the 3 complexity of controlling money supply. But, in addition, within this environment, the Fed has chosen to adopt technical operating procedures that reduce even further its ability to control the money supply. It would appear that at least in theory the operating procedures for controlling reserves directly would be straightforward. The FOMC could determine either a total reserve growth rate target or a monetary aggregate growth rate target. If the latter, the staff could translate the monetary aggregate target into a total reserve target by estimating the composition of deposits and thereby the appropriate multiplier. The total reserves target is then obtained by dividing the monetary aggregate target by the estimated multiplier. Money supply would respond directly and concurrently to changes in reserves. Because the Open Market Desk controls directly only the System's portfolio of securities, other factors that affect reserves, such as float and borrowing at the discount window, must be adjusted for. In the best of all worlds, these factors, including borrowing, could be predicted. But in reality it may be necessary to respond to them with a brief lag, e .g ., one day. Unfortunately, such a straightforward procedure is not possible under two week lagged reserves accounting, which separates the deposit accounting week from the reserve settlement week.^ Although any individual bank may obtain its necessary reserves in the reserve settlement week from a variety of sources, for the banking system as a whole, the Fed has to provide all the reserves required by the dollar amount of total deposits established two weeks earlier in the deposit accounting week. Thus, the minimum amount of total reserves in any settlement period is predetermined by events two weeks earlier and is 4 beyond Fed control in that period. Lagged reserves do not merely delay bank response by two weeks; they alter the bank decision making process. To influence the amount of deposits and thereby the money supply in the deposit accounting week, the Fed has to influence bank deposit decisions two weeks before the settlement week when it provides the reserves for that week. Short of rewriting history, this may be achieved in a number of ways that affect the cost of reserves either or both in the current g deposit week or in the reserve settlement week two weeks later. The Fed has chosen to do so by affecting the mix of reserves between borrowed and unborrowed reserves. 9 The strategy is based on the assumption that a dollar of borrowed reserves affects banks differently than a dollar of unborrowed reserves either directly by changing the pressures to repay or indirectly by changing the Fed funds rate as banks are "forced” into or out of the discount window. In the words of the Fed: Suppose that the demand for money ran stronger than was being targeted...The increased demand for money and also for bank re serves to support the money would in the first instance be ac companied by more intensive efforts on the part of banks to obtain reserves in the Federal funds market, thereby tending to bid up the Federal funds rate, and by increased borrowing at the Federal Reserve discount window. As a result..emerging market conditions reflect or induce adjustments on the part of banks and the public. These responses on the part of banks, for example, could induce sales of securities to the public (thejgby extin guishing deposits) and changes in lending policies. Likewise, Chairman Paul Volcker has testified in 1980 that: As soon as monetary growth picked up, our operating techniques ’automatically’ began to bring bank reserve positions under mild pressure as use of the discount window increased. The pressure was reinforced on several occasions by reducing the provision of nonborrowed reserves. Total bank reserves have, to be sure, expanded sharply— a mechanical concomitant of the rise in Ml— but banks have had to borrow those reserves from the Federal Reserve; we have^ijiot supplied them on our own initiative through the open market. 5 Borrowed reserves are thus the key variable in affecting bank decisions on deposits determination. The higher are borrowed reserves, the lower is the tendency to create deposits, and conversely. 12 The FOMC assigns the Open Market Desk the task of achieving a specified target growth in unborrowed reserves. As unborrowed reserves are total reserves minus borrowings, this requires that the committee first establish a target or initially assumed level of borrowed reserves that it believes will provide the degree of bank restraint that is consistent with achieving the previously established target money growth. Given the initial amount of unborrowed reserves so determined, the desk operates to increase or decrease the amount from this initial level at some target rate until the next meeting of the FOMC. If during this intermeeting period, banks demand more reserves than are consistent with the sum of the target change in unborrowed reserves and the initially assumed amount of borrowed reserves, the necessary reserves are provided through the discount window. This temporarily increases borrowings above the initially assumed level and increases the degree of restraint, encouraging banks to slow their deposit growth. Conversely, if banks demand fewer reserves than are provided by the sum of the target change in unborrowed reserves and the initially assumed borrowed reserves, the amount of borrowings will decline below the initially assumed level. This will reduce the restraint pressures on the banks and encourage them to speed up their loan and deposits expansion. In the words of Peter Sternlight, Manager of the Fed’s Open Market Account: Under this approach monetary growth in excess of path causes increases in borrowings from the Fed, which would be associated with higher interest rates and pressure on the banking system that would, over time, tend to return growth of money supply and reserves toward the desired path. Shortfalls in growth would have 6 the opposite effect, reducing the need for borrowings and thus encour ' lower interest rates and more vigorous monetary expans-Luu. How is the initial borrowing target (assumption) established? At first, the FOMC did so by fassuming a level of borrowing near that , prevailing in the most recent period.” 14 But this restricted the FOMC’s freedom to change the target money growth. To exert greater control over money growth within the FOMC’s framework, it was necessary to estimate the amount of borrowed reserves consistent with the desired target growth rate in money supply. Then the level of borrowing ncould be set higher or lower if it were desired to impart some initial thrust toward some greater or lesser pressures on bank reserve positions".^ Ceteris paribus, borrowings are generally viewed as being determined by the spread between the Fed funds rate and the discount rate. 16 If the discount rate is set, the level of borrowed reserves depends on the Fed funds rate. Thus, in principle if not in practice, determination of the target borrowed reserves that will achieve the target money growth requires that the Fed funds rate that is consistent with the target money growth be estimated first. But this Fed funds rate was the basic rate that was estimated (and targeted) under the old operating procedures. The new procedures in effect use the same underlying system of equations as the old procedures plus one additional equation. Greatly abbreviated versions of the two systems of equations are shown in Table 3 . ^ Before October 1979, the near-term target money supply was believed to be attainable by achieving the target Federal funds rate; after October 1979, the target money supply was believed to be attainable by achieving the target aggregate borrowed reserves. The target Fed funds rate is established by 7 transposing and solving a demand for money type equation containing target values of money supply and predicted values of nominal income for the Treasury bill rate. Money and income are assumed independent of each other in the short-term. The Fed funds rate is then obtained through a term structure equation. The new procedures use the Fed funds rate solution from this equation as an independent variable in the borrowed reserves equation. But it was in large measure because the appropriate Fed funds rate could not be reliably estimated that the old procedures were abandoned in October 1979. In explaining the changes in procedures to Congress, Chairman Volcker stated that: Translation of money stock objectives into day-to-day management of the federal funds rate is effective if the relationship between the public’s demand for cash balances and short-term market interest rates is ef fectively stable and predictable. But in an environ ment of high and volatile inflation rates the relation ship between^nterest rates and money...is more difficult to appraise. Likewise, in its directive adopted at the special meeting on October 6 , 1979, the FOMC stated: The principal reason advanced for shifting to an operating procedure aimed at controlling the supply of reserves more directly was that it would provide greater assurance that the Committee’s objectives for monetary growth can be achieved. In the present environment of rapid inflation, estimates of interest rates, monetary growth, < i d economic j^ activity had become less reliable than before. Empirically, the new aggregate borrowing equation specifying primarily the Fed funds-discount rate spread as an independent variable appears to be even less reliable than the other equations in the system for a number of reasons. One, the effective discount rate charged banks is not the nominal discount rate posted. The Fed administers the window 8 to ration credit more directly and the degree and quality of administration varies from Fed district to Fed district and even from district home office to district branch. Two, the Fed has periodically imposed a surcharge on borrowings by larger banks in excess of a designated minimum dollar amount and frequency of usage per period. Both the magnitude of the surcharge and the minimum number of times per period borrowings are not subject to the surcharge have been changed. Three, the decision to borrow is likely to be a function of more than the Fed funds rate, and it is unlikely that the Fed funds rate is an appropriate proxy at all times for the spectrum of all other interest rates no less all nonrate forces. Lastly, under a system of lagged reserve accounting and strict unborrowed reserves targeting, the aggregate dollar amount of borrowing in a reserve settlement week is effectively determined by aggregate deposits and required reserves two weeks earlier. Only the indentities of the individual banks tapping the discount window and for how much is determined by interest rates in that week. The aggregate amount of borrowing by the banking system is determined by its estimates of the Fed funds and discount rates in the reserve settlement week during the deposit accounting week two weeks earlier. The equation, of course, also entails considerable simultaneity between the dollar amount of borrowings and the Fed funds rate. Do higher borrowings raise the Fed funds rate or do higher Fed funds rates increase borrowings? As a result, internal Federal Reserve studies by Levin, Goodfriend, and Kasriel and Merris find the aggregate borrowing equation to have low and unstable explanatory power. 20 Likewise, Judd and Throop find that 1the average absolute deviation of 1 borrowed reserves from projected levels was...twice as large as either 9 of the other two types of operating errors,1 namely, errors in hitting 1 the statistically projected multiplier and the level of nonborrowed reserves. 21 Thus, the new procedures use the statisticaly unreliable output of the system of equations underlying the old procedure as input for an even less reliable equation underlying the new procedure. It follows that the bottom line money supply growth-target borrowings equations is unreliable and entails significant slippage. 22 Moreover, the money supply-borrowing relationship is asymmetical. Increases in target borrowings, ceteris paribus, are associated with slower monetary growth over the entire range, although the relationship is unlikely to be linear. On the other hand, decreases in target borrowings are associated with faster monetary growth only to the point where borrowing is zero or at a minimum frictional level. At that point, a wide range of faster money growth rates can be associated with the same initial level of borrowings depending on the Fed funds rate. Borrowings becomes a poor target. It was primarily for this reason that the Fed abandoned its borrowing target in the 1930s, when borrowings dropped to near zero, in favor of free reserves (excess reservesborrowed reserves), which are not restricted to positive values. From this line of reasoning, one would expect that: 1. Short-run (weekly) money supply growth will be more variable for a given borrowings assumption than for a given Fed funds target as the slippage is greater, 2. Money supply will be procyclical if changes in the state of the economy are underpredicted as they often are in periods of strong economic swings because the "correct" initial borrowing assumption 10 is likely to be mis-estimated at least to the same degree that the Fed funds rate target was under the old system, 3. 23 and Acceleration in money growth in periods of weak economic activity will be delayed. Without specific guidance by the FOMC, when assumed and actual borrowings are close to zero, the desk is likely to lower the Fed funds rate only cautiously in progressive steps. Additionally, although the Fed funds rate is permitted to vary over a wider range, it is unlikely that for a given borrowing target it will vary greatly and that it will remain particularly steady once it hits an upper or lower boundary. At this point, if past performance is a guide, it is unlikely that the borrowing target will be changed consistently by enough to moderate the ongoing monetary growth to target rates. An examination of the use of borrowing targets (initial assumptions) in 1980 in Table 4 and the actual pattern of money change in Figure 2 confirms this interpretation. Money growth declined sharply in the second quarter of the year at the same time that the initial borrowing target was lowered from $2,750 million to $75 million and increased even more sharply in the third quarter as the initial borrowing target was increased again to $1,300 million. This suggests that the behavior of money supply within that year would have been little different if a Fed funds target had been used consistent with the old procedure. Indeed, because of the inability to lower the borrowing target below zero in the spring of 1980, the dramatic procyclical swing in money is likely to have been greater than under the old procedure. A more direct test of the ability of the new procedures to control the money supply accurately is to compare the short-run money growth targets (tolerance ranges) specified by the FOMC at every meeting with 11 the actual changes in money supply in the same period. the Fed has made this difficult to do. Unfortunately, Before October 1979, the FOMC established clear, unchanged two-month targets for Ml and M2 that held for the entire period. Shortly after October 1979, however, the FOMC switched over to longer three- to six-month targets that could be and often were modified at least once during the period. Thus, it is difficult to identify the target against which the actual money change for a period should be compared. The target moves and is frequently revised during the period to correspond more closely to the developing actual rates of money growth. For example, as can be seen from Table 4, on January 9, 1980, the FOMC set targets for the first quarter of the year. It revised these targets at its next meeting on February 5. On March 18, targets were changed and set for the first half of the year, including the first quarter that had almost ended. These targets were revised on April 22, and on May 20 the committee set targets for the last two months of this period, May and June. 24 Thus, the target periods overlap and the evaluation problem is analagous to that of base drift that plagues attempts to measure meaningfully the Fed’s ability to meet its longer-term targets. 25 That lagged reserve accounting has significant unfavorable implications for short-term monetary control is denied by the Federal Reserve. In November 1981, the Board requested public comment on a proposal to introduce more contemporaneous reserve accounting. In its announcement, the Board stated that: Contemporaneous reserve requirements (CRR) have some potential for improving the implementation of monetary policy by strengthening the linkage between the reserves held by depository institutions and the money supply. There is some question, however, whether such potential gains would increase short-run volatility in the money market. The Board noted that any potential 12 gains in monetary control should not be exaggerated, in view of the sizable remaining slippages between reserves and mon^, and in view of the inherent volatility of short-run money flows. In sum, to the extent the post-October 1979 operating procedure differs from the pre-October 1979 operating procedure, it has increased the difficulty of attaining the Fed’s money supply objectives and has increased the short-term volatility in both interest rates and money supply and the cyclical volatility in money supply. These results are, of course, either accidently or by design, contrary to the Fed’s announced intentions. Because the peculiarities of the technical aspects of the new procedures reflect the need to operate in a lagged reserve accounting world, greater control over both interest rates and money supply is best guaranteed by abandoning lagged reserves ac counting. Although, as noted in footnote 8 , there are alternative ways of influencing deposits under lagged reserves, these means appear considerably less efficient than those that are possible under concurrent reserves accounting. There are at least some officials within the Federal Reserve who remain unconvinced that greater short-run control of the money supply is either desirable or necessary. For example, Governor Lyle Gramley testified in March 1982 that: However, several implications for monetary targeting that can be drawn from the experience of recent years. First, short-run movements of the money stock have even less meaning than they once did as indicators of monetary policy. What happens to money growth over longer periods is what counts. Second, monetary targets should be expressed in rather wide ranges; the present ranges of three percentage points are certainly not too wide. Third, we need to continue to use multiple targets, rather than to focus on any single measure of money. Indeed, somewhat greater weight may need to be given to the broader monetary aggregates in the future as a consequence of the relative instability of the demand for Ml. Finally, we need to stand ready to accept growth of money outside our target ranges— or even to modify t ^ ranges— if changes in the public’s asset preferences warrant it. 13 To the extent that this view is representative, the much heralded October 1979 change represents still another "self-fulfilling Fed prophecy," but one less immediately visible and more difficult for the outsider and even many insiders to recognize. 28 14 FOOTNOTES ^Board of Governors of the Federal Reserve System, nThe New Federal Reserve Technical Procedures for Controlling Money," January 30, 1980, p. 1. 2 Board of Governors, p. 1. 3 Paul L. Kasriel, "Interest Rate Volatility in 1980," Economic Perspectives (Federal Reserve Bank of Chicago), January/February 1981, p. 10. 4 Board of Governors, p. 8 . ^The results are also unchanged by omitting the period March 15 to December 31, 1980 when credit controls may have affected the behavior pattern of financial variables and by omitting January 1981 when the maximum shifting of deposits in response to the nationwide introduction of NOW accounts occured. In addition, variability was estimated in demand deposits at member banks only because a change in reporting series on deposits from nonmember banks at yearend 1979 may have increased the reported volatility in these deposits from before that date. The results are not altered materially. g It is evident that, unless the different monetary aggregate measures are perfectly correlated, each will require a different reserve path to achieve. Thus, this procedure requires use of either a single money measure or explicit weights for a composite measure. ^It is not clear that the Fed was fully aware of the implications of lagged reserves accounting for money control when it abruptly changed pro cedures in October 1979 in the midst of a "financial crisis." Discussions of lagged reserves appear in Warren L. Coats, "Lagged Reserve Accounting and The Money Supply Process," Journal of Money, Credit and Banking, May 1976, pp. 167-180; Daniel E. Laufenberg, "Contemporaneous Versus Lagged Reserve Accounting," Journal of Money, Credit and Banking, May 1976, pp. 239-246; Robert D. Laurent, "Reserve Requirements: Are They Lagged in the Wrong Direction?" Journal of Money Credit and Banking, August 1979, pp. 301-310; and George G. Kaufman, "Report of the Ad Hoc Subcommittee on Reserve Proposals" (Memorandum, Federal Reserve Bank of Chicago, June 13, 1966). See also Milton Friedman, "Monetary Policy: Theory and Practice", Journal of Money, Credit and Banking, February 1982, pp. 98-118. g These alternatives are discussed in Robert Laurent, "A Critique of the Federal Reserve’s New Operating Procedure" (Staff Memorandum 81-4, Federal Reserve Bank of Chicago, 1981) and George G. Kaufman, Money, The Financial System and the Economy (3rd ed.) (Houghton-Mifflin, 1981), pp. 527-529. 9 A complete discussion of the operating procedures is provided in Peter Sternlight, et. al., "Monetary Policy and Open Market Operations in 1980," Quarterly Review (Federal Reserve Bank of New York), Summer 1981, pp. 1-20. ^Board of Governors, pp. 4-5. ^Paul A. Volcker. "Statement Before the Subcommittee on Domestic Monetary Policy," House of Representatives, November 19, 1980. 12 R. Alton Gilbert Reserves Targeting" December 1980). Fed in the Rates Brothers, strategy described (New York: 1930). also Role (Working Paper, "Consequences Reserves" Federal (Paper Harper in the Prepared Kaufman, Borrowing Bank of Federal St. The that Chicago, the Economic by the Banks and W. of Federal February Under Riefler, Harper the Reserve" 1965) R e s e r v e ’s R e - a t t a c h m e n t for W e s t e r n used and Winfield (New York: from Policy Louis, Reserve "A Reexamination Bank Reserve of 1927) States of from Burgess, Brothers, G. of M o n e t a r y Bank different Randolph the U n ited George "Conduct Reserve greatly i n W. of M e m b e r Meltzer, Resler, Federal is n o t Markets See and H. Paper, and and Money Significance David The 1920s the M o n e y M a r k e t Money and (Working and to Allan H. Free Association Meeting, July 1981). 13 Peter D. Sternlight, "Is The Misdirected?" Journal of M o n e y , See Lindsey and also David Operating Procedures" P r o c e d u r e s , Vol. II, in others, Federal February Federal Credit, R e s e r v e ’s M o n e t a r y and Banking, February "Monetary Reserve Control Staff Control 1982, Experience Study, Under New Monetary Policy p. 126. the New Control 1981. 14 Board are not FOMC of Governors, released summary Reserve Bank footnote publicly minutes. of 9). 1981 ^Sternlight, ^See, Operating Staff York, February ^For targets the summer were 1981 Fred Levin and level They first of yet Paul not reserves reported published by Quarterly its been of b o r r o w e d are the Review in the Federal (see reported. 125. The View from Control on Demand the Meek, Trading "Implementing Desk" P r o c e d u r e s , Vol. for Borrowing" I, in (February (Federal the Federal Reserve New Reserve 1981) Bank and of Fred New 1981). a more complete and Review basis. not Lombra E. Economic 11, F e d ’s t a r g e t have New Monetary Work The regular 1980 in example, "Further Raymond pp . for p. 3. a targets Procedures: Study, Levin, The New York The p. on description Raymond (Federal G. of Torto, Reserve Bank the "The of old system Strategy Richmond), of equations of M o n e t a r y see Policy" September-October 1975, 3-14. 18 Paul A. Volcker, "Statement to Congress" Federal Reserve Bulletin (December 1 9 7 9 ) , pp. 9 5 9 - 9 6 0 . 19 "Record Federal 20 Levin Borrowing, Operating 1981). (February Monetary 1981); an Discount possible decision Determinants by D.H. For of M e m b e r are Bank 1966. see J.R. Paper, modeling Stephen Borrowing: C. (Federal Changing An 6, Committee," "Discount 1979 Reserve Randall obtained Resler, detailed Open Market 974.2 0 Goodfriend, Federal and Working example p. Post-October Target" Estimating Federal Marvin Paper, results through more Finance, September and the 1979), the Paul Kasriel Borrowing Borrowings" process. 1981); and (Working techniques Window of (December 11, better "Detecting Actions Policy and Initial Somewhat estimation be Policy Bulletin Procedure" September Choosing Davis, of Reserve Bank Merris, Reserve using Barth, more of of Swamy Relationships: Improved of individual Goldfeld and Econometric in Chicago, August sophisticated 1981. the Reserve Richmond, "Difficulties Bank P.A.V.B. Economic Window Federal and W.D. The estimates bank "The Journal of of also borrowing Edward Kane, Study," case may 16 21 ■ John Letter 22 is In a less that P. recent shifts in short-term are created shift in in greater the borrowed argues than for m o ney function direction rates nonborrowed however, under tended out the new that are to m o v e automatically in Thus, the same target operating supply procedures than the reserve old target target and accommodated "money (as) the function (p. be smaller as may be weekly volatility reserves reserves target "Nonborrowed Conference of St. so on same See target that in m o n e y is less, the m o n e y Reserve also, and Washington conclusion is under not supply Targeting Improving Monetary Louis The 9). for seen a If given from the new procedures flexible function Control by St. Gilbert by the (Paper Federal October that nonborrowed frequently. Louis, and suggests the Control" sponsored of than shifts and Monetary University reached the more, David presented Reserve 30, 1981) . Resler. 24 Report FOMC St. by and direction supply procedure" should I , " Weekly 1981. reserve sloping money in m o n e y Rate: 30, the b o r r o w e d reserves. an upward reserves changes Discount the nonborrowed in b o r r o w e d have tracing Lindsey, Bank Lindsey demand the demand Penalty Francisco), October below: The at David Throop," San short-run same the so, of the interest by Bank paper essentially this w e r e figure in the a n d A d r i a n W. Reserve inflexible changes data Judd (Federal Board of Governors 198 0 , p p . 87-125, in 1980: Louis), A Year and of R. Reserve August/September of Alton Policy," L. Journal 26 Board November Pierce, 1 9 8 1 v pp. 9, of "The Myth of M o n e t a r y .: . . G o v e r n o r s of 1981, pp. Federal Targeting", 25 James the Gilbert of Review System, E. (Federal Annual Trebing, Reserve "The Bank of 2-16. !' Congressional Economics, November the Reserve and Michael Federal Reserve Supervision 1978, pp. System, of M o n e t a r y 363-376. "Press Release," 1-2. 27 Lyle E. Gr a m l e y , ’ tatement ’S Monetary Policy of the Committee House of Representatives, 1982, p. Before the Banking, Subcommittee 3,. 1 9 8 2 , " Finance Federal and on Domestic 177 . March on Reserve Urban Affairs, U.S. Bulletin, March 28 For Kaufman, previous "The Self-Fulfilling examples Federal of Fed self-fulfilling R e s e r v e ’s I n a b i l i t y Prophecy," Financial to Analysts Control prophecies the M o n e y see George Supply: A Journal, September/October, 17 1972. A similar view In my how opinion, to produce service to Committee are Friedman Street the real "The problem objective, the than expressed by Milton stabler monetary that of control important Milton been Fed unreconstructed regard Wall has of regard Keynesians " c r e d i t 1 or 1 Federal Reserve 1, that growth, the members do n ot or it of as p. the Fed that, the does despite Open Market important classical central to 16. do not know lip Investment so. Most bankers who conditions" growth. and Monetary 1982, but "credit market steady monetary Journal, February is n o t Friedman: Instability", as far m ore 18 Table 1 Percentage Change in W e e k l y Pre-and Variability Post-October Pre-October in Selected Interest Rates 1979 1979 Post-October 1979 70:1- 75:53- 79:41- 79:41- 79:41 79:41 79:41 81:48 81:48 81:48 Standard Deviation Fed funds 3-month 5-year 3.719 Treasury Treasury bill security 1.903 6.130 5.257 5.309 3.371 2.387 5.323 4.543 4.577 1.788 1.407 3.278 2.979 3.052 10-year Treasury security 1.328 1.027 2.683 2.552 2.619 20-year Treasury security 1.184 0.828 2.495 2.391 2.444 *0mitted 3/15/80 - 1/1/81 Omitted 3/15/80 - 1/31/81 19 Table 2 Percentage Change in W e e k l y Pre-and Variability Post-October Pre-October in M o n e y Stock 1979 Post-October 1979 70:1- 75:53- 79:41- 79:41 79:41 81:48 79:41* -81:48 1979 79:41** -81:48 Standard Deviation M1B M1B 1.288 Less Currency **0mitted Omitted 3/15/80-1/1/81 3/15/80-1/31/81 1.539 1.729 1.771 1.741 1.557 1.896 2.132 2.168 2.135 20 Table 3 Comparison of Abbreviated Pre-and Underlying Post-October 1979 S y s t e m of Operating Equations Pre Basic Operating Relationship: for Procedures H r= f ( F R T ) Establish Target: *1 Post MT*f(BT) “r Solve for for Consistent TR=f(MT>Y p ) FRt : Consistent Monetary FR^Target Fed TR=Treasury Aggregate Funds Bill Rate B^,=Borrowed R e s e r v e DR=Discount Rate Target p=Predicted Value Target Complex Y p=Predicted Nominal T=Fed Rate GNP FR=f(TR) B T= f ( F R , D R ) Bp K ex M^=Target T R = f ( M x ,Yp ) FRT =f(TR) Solve Growth 21 Table 4 Specifications from Directives of the Federal Open Market Committee, 1980 Date of meeting 1/9/80 2 /5 /8 0 ............... Initial assumption for borrowed reserves (millions of dollars) Discount rate on day of meeting and subsequent changes (percent) 1 1 12 - 151 / /2 1,000 12 6 V2 1112 - 1512 / / 1,250 12 13 on 2/15 + 3 percent sur charge on 3/17 December to June 41 2 / 5 73 A (or somewhat slower) 13-20 2.750 13 + 3 December to June 412 / 5 63 A (or somewhat slower) 13-19 1,375 13 + 3 Specified short-term annualized rates of growth for period mentioned (percent) M-1 A M-1 B M-2 December to March 4- 5 * 7* December to March 41 /2 3 /1 8 /8 0 ............. 4 /2 2 /8 0 ............. Range for Federal funds rate (percent) 5 * Rates for M-1 and old definition for M-2 . Source: FRBNY Quarterly Review . Summer 1981, pp 68-69 Notes The Committee’s objectives were set in terms of M-1 and the old definitions of M-2 and M-3. In July 1979, the Committee had set growth of objectives for M-1, M-2, and M-3 from the fourth quarter of 1978 to the fourth quarter of 1979 of 3 to 6, 5 to 8, and 6 to 9 percent, respectively. (The M-1 objective incorporated later revisions in assumptions about the growth of NOW and ATS accounts.) The Committee antici pated growth in 1980 within those ranges. FOMC indicated its objectives would be furthered by growth of M-1 A, M-1 B, M-2, and M-3 from the fourth quarter of 1979 to the fourth quarter of 1980 within ranges of 3 1 2 to 6, 4 to 6 1 2 , / / 6 to 9, and 61 to 9 1 2 per /2 / cent, respectively. The associ ated range for bank credit was 6 to 9 percent. On February 22, the upper limit of the range for Federal funds rate was raised to I 6 V percent. On March 6, 1980 2 the upper limit of the range for Federal funds was raised to 171/2 percent. The next day the Com mittee further modified the domestic policy directive to raise the upper limit of the range for Federal funds to 18 percent. On May 6 the lower limit of the range for Federal funds rate was reduced to 1 0 1/2 percent. The 3 percent surcharge was removed effective May 7. 22 Table 4 (con't) Specifications from Directives of the Federal Open Market Committee1 0 Range for Federal funds rate (percent) Initial assump tion for borrowed reserves (millions of dollars) 81 /2-14 100 13 12 on 5/30 11 on 6/13 June to September 7 8 8 81 /2-14 75 11 10 on 7/28 June to September 61/2 9 12 8-14 75 10 August to December 4 61 /2 81 /2 8-14 750 10 11 on 9/26 September to December 212 / 5 71 A 9-15 1,300 11 12 + 2 on 11/17 September to December 2 1 /2 5 7% (or somewhat less) 13-17 1,500 12 + 2 13 + 3 on 12/5 December to March 4Va 4 3/4 7 (or somewhat less) 15-20 1,500 13 + 3 Specified short-term annualized rates of growth for period mentioned (percent) M-1A M-1B M-2 Date of meeting 5 /2 0 /8 0 ............. April to June 7-7 V z 7V ,2-8 8 (or moderately faster) 7 /9 /8 0 ............... 8 /1 2 /8 0 ............. 9 /1 6 /8 0 ............. 1 0 /21 /8 0 ........... 11/18 /8 0 ........... 1 2 /19 /8 0 ........... Discount rate on day of meeting and subsequent changes (percent) Notes Objectives for 1980 remained the same. In addition, on July 29 the Committee agreed that, for the period from the fourth quarter of 1980 to the fourth quarter of 1981, it looked for a reduction of the ranges for growth of Vz per centage point from the ranges adopted for 1980, abstracting from institutional influences affecting the behavior of the aggregates. On November 26 the Committee raised the upper limit of the range for the Federal funds rate to 18 percent. On December 5 the Committee modified the directive by providing leeway for pursuit of the Committee’s short-run objectives for the behavior of reserve aggregates without operations being pre cisely constrained by the inter meeting range for the Federal funds rate for one week, and then extended it to the meeting on December 18-19, 1981. The objectives abstracted from the effects of deposit shifts connected with the introduction of NOW accounts on a nationwide basis. It was recognized that the introduction of NOW accounts nationwide at the beginning of 1981 could widen the discrepancy between growth of M-1 A and M-1B. 23 Figure 1 Daily percentage changes in selected interest rates federal funds rate three-month Treasury bill rate Source: Paul L. Kasriel "Interest Rate Volatility in 1980," Economic Perspectives (Federal Reserve Bank of Chicago), (January/February 1981), pp. 17. Figure 2 Variability in M l B and M2 SEASONALLY ADJUSTED, ANNUAL RATES, MONTHLY PERCENT rmn i in) in i mil m M1-B CURRENCY, DEMAND OEPOSITS, AN OTHER CHECKABLE O DEPOSITS AT BANKS AND THRIFT INSTITUTIONS 20 10 ♦ 0 3-MONTH M OVIN AVERAGE G CENTERED 10 October 1979-^ 20 30 M2 M1-B PLUS CONSUMER-TYPE TIME AND SAVINGS DEPOSITS AT BANKS AND THRIFT INSTITUTIONS, OVERNIGHT RPa AND EURODOLLARS, AND MONEY MARKET MUTUAL FUNO SHARES 3-MONTH M OVIN AVERAGE G 20 CENTERED 10 IO+ - Source: 1977 1975 1973 Board of Governors of the F ederal Reserve System, 1979 Federal Reserve Chart 1981 Book (February 1982), p..6
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