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Working Paper Series Interest Rates and the Conduct of Monetary Policy WP 90-06 This paper can be downloaded without charge from: http://www.richmondfed.org/publications/ Marvin Goodfriend University of Chicago Federal Reserve Bank of Richmond Working Paper 90-6 INTEREST RATES AND THE CONDUCT OF MONETARY POLICY Marvin Goodfriend* University of Chicago and Federal Reserve Bank of Richmond August 1990 *The paper was written while the author was Visiting Associate Professor at the Graduate School of Business, University of Chicago. It was written for the April 1990 Carnegie-Rochester Conference on Public Policy. The author would like to thank Tim Cook, Mike Dotsey, Bob Hetzel, and Alan Stockman for helpful discussions. The views expressed here do not necessarily reflect those of the Federal Reserve Bank of Richmond. INTEREST RATES AND THE CONDUCT OF MONETARY POLICY Abstract The paper describes key aspects of actual Federal Reserve interest rate targeting procedures and addresses a number of issues in light of these stylized facts. It reviews the connection between rate smoothing and price It critiques interest rate targeting as inflation tax level trend-stationarity. smoothing. It argues that stabilization policy implemented by interest rate targeting may inadvertently induce martingale-like behavior in nominal rates and inflation. The paper explains why central bankers prefer continuity of the short Lastly, it surveys empirical evidence of the rate and indirect rate targeting. Fed's influence over short-term interest rates. (JEL: 311) INTRODUCTION However disruptive the inflation instability of the 196Os, 70s and 80s may have been, it afforded a chance to observe the extent to which nominal interest rates moved with money growth, inflation, and expected inflation as Irving Fisher Data through 1971 (1930) predicted. provided evidence that short-term nominal rates moved in large part with changes in expected inflation, e.g., Fama (1975) While data from the period thereafter indicated and Nelson and Schwert (1977). a more important role for real rate variability, e.g., Hamilton (1985). inflation rate rose October 1979 and became more volatile, the Fed announced As the its famous move toward reserve targeting. The experience with reserve targeting from October 1979 1982 renewed interest in the instrument problem. Poole (1970) to the fall of had analyzed the choice of reserves vs interest rate targeting in a point in time model with a fixed price level. Sargent and Wallace (1975) addressed the problem in a fully dynamic context with a variable price level and variable inflation expectations. They argued that in a flexible price model with rational expectations, rate targeting made the price level indeterminate. But McCallum interest (1981) showed that interest rate targeting was consistent with a fully determinate equilibrium as long as the interest rate instrument was employed as part of a rule that targeted the money stock. McCallum's with rational optimizing paper reconciled actual Federal Reserve interest rate policy expectations model, monetary economics. he showed how a monetary Although by Goodfriend (1987) to show was not an rule could be made to manipulate inflation expectations in order to smooth the interest rate. exploited his how interest The idea was later rate smoothing by an optimizing central bank could explain non-trend-stationary price level behavior. Barro (1989) augmented Goodfriend's model to investigate the consequences of 2 random walk interest rate targeting. At about the same time, Mankiw (1987) interpreted highly persistent interest rate targeting as optimal inflation tax smoothing. Thus Federal Reserve interest rate targeting came to be seen as potentially explaining the actual highly persistent behavior of nominal interest rates and inflation. At a more institutional level, the shift in Fed operating procedures from tight Federal funds rate targeting in the 197Os, to the 1979-82 nonborrowed reserve procedures, to borrowed reserve targeting thereafter rekindled interest in the technical details of policy implementation. and others, noticed Brunner and Meltzer, Poole, that because reserve requirements were lagged during the early 8Os, weekly nonborrowed reserve targeting was closely related to borrowed reserve targeting. They pointed out that the latter was essentially the noisy Federal funds rate targeting procedure that the Fed had used in the 195Os, 6Os, and early 70s. We will see below that the Fed also switched in the 1920s. From this to indirect targeting 7ooks less interest rate targeting to borrowed reserve targeting perspective, the recent switch from direct from explicit anomalous. Except for the period from 1934 to the end of the 1940s when short-term interest rates were near zero or pegged, the Fed has always employed either a direct or an indirect Federal funds rate policy instrument. This paper contains a description of the key features of the Fed's interest rate targeting procedure based on data assembled in Cook and Hahn (1989), and on the views of financial market participants and Fed officials. motivate recent theoretical that must be explained developments. These are the stylized facts that They are the empirical regularities in order to understand the practical implementation of 3 monetary Moreover, policy. awareness of these regularities is essential to interpret empirical evidence on the Fed's influence over market rates. The plan of the paper is as follows. interest rate targeting procedures are described issues are discussed in Section II, in time instrument smoothing in a choice Key features of the Federal Reserve's in Section Theoretical I. beginning with a brief review of the point A discussion problem. dynamic-rational-expectations of the mechanics model follows, emphasizing consequences for the money stock and price level generating processes. III of rate Section discusses interest rate targeting as inflation tax smoothing. Section IV suggests how the high degree of persistence the Fed imparts to the Federal funds rate might naturally arise as a by-product of macroeconomic stabilization policy. use indirect, targeting. It also suggests an explanation for the Fed's tendency to i.e., borrowed The discussions, reserve, rather than direct Federal funds rate in turn, motivate central banker preferences for a continuity of the short rate. Finally, dominant Section influence begins with Miron's eliminated the V surveys on the process (1986) interest rate seasonal targeting pointed short-term (1987) the exerts interest rates. evidence converted Fed the a It that the Fed three-month rate finding effect of Federal funds rate target changes on money out by It also reviews the implications of interest Mankiw expectations theory of the term structure. rate targeting, and that Next, it reviews Cook and Hahn's (1989) market rates at longer maturities. rate generating evidence and Mankiw et al.'s approximately to a martingale. of a highly significant empirical Fama's (1984) and Miron for tests of the And it interprets, in terms of funds and Hardouvelis's information in the Treasury yield curve. (1986) (1988) findings of predictive 4 I. ASPECTS OF FEDERAL RESERVE INTEREST RATE TARGETING The standard view among Fed officials and financial market participants is that the Fed has a dominant interest rates. influence on the evolution of short-term market We may characterize the important aspects of the Fed's policy procedure pertaining to interest rates as follows: Throughout 1) its history, the Fed's policy Federal funds rate or its equivalent. instrument has been the At times, it has targeted the Federal funds rate directly in a narrow target band, but more often it has targeted the overnight rate indirectly using the discount rate and borrowed reserve targets. 2) The Federal funds target has not been adjusted immediately in response to new information. only after change. Rather, the target has been adjusted at irregular intervals sufficient information has been accumulated to trigger a target Target changes are essentially unpredictable at forecast horizons longer than a month or two. 3) Target changes occur in relatively small steps of 25 to 50 basis points, though on occasions they have been considerably 4) bigger. Though they have often been separated in time by weeks or months, some target changes have been followed in relatively rapid succession (one or two weeks apart) by further changes in the same direction. 5) The Fed is understood to dislike "whipsawing the market,"i.e., following a target change too closely with a change in the opposite direction. A target change establishes the presumption that absent significant new information, the target will not be soon reversed. 6) According to market participants, money market interest rates of longer maturities are determined (up to a term premium) by the average expected level 5 of the Federal funds rate over the relevant time horizon (abstracting from default risk). 7) The Fed adjusts its funds rate target over time in an effort to achieve a favored mix of goals for unemployment, inflation, credit market conditions, and the exchange rate. Comment: On occasion the Fed and the markets may react to new information simultaneously. In such cases it should not be said that a Federal funds rate target change causes a change in market rates since the Fed is merely reacting to events in much the same way as the private sector does. More generally, to the extent that we believe the Fed reacts purposefully to economic events, we should not say that funds rate target changes are ever the fundamental cause of market rate changes, since both are driven by more fundamental shocks. Of course, such shocks may originate either in the private sector or in the Fed, the latter as policy mistakes or shifts in political pressure on the Fed. Nevertheless, the above points do assert that Federal funds rate targeting has substantially altered the timing and magnitude of the way fundamental shocks impact on market interest rates. Furthermore, because the Federal funds rate target reacts discontinuously to new information, to forecast target changes the public must political assess the Fed's view of incoming data as well influence on the Fed. as any shifting Such factors specific to Fed interest rate targeting (those that give rise to Fed watching as opposed to economy watching) must be added to any list of fundamental determinants of the process generating market interest rates. 6 II. INTEREST RATE SMOOTHING AND MONETARY THEORY The Federal funds rate targeting procedure described in Section I, by which the Federal Reserve purposefully influences the evolution of interest rates, is broadly known as interest rate smoothing. Since the procedure described above may be said to smooth interest rates in a number of ways, however, there is often confusion about what smoothing means. policy, this may not be a problem. rate smoothing, being modelled Various addressed For general discussions of monetary But for theoretical discussions of interest it is essential to be clear about what aspect of smoothing is and what is not. aspects of the Federal funds rate targeting procedure in the theoretical literature. have been Poole (1970) studied the conditions under which the Fed should target bank reserves or the Federal funds rate at a point in time. the feasibility maintaining He was concerned with point 1 above. of avoiding a continuity of fluctuations the short rate continuity of the short rate captures Goodfriend (1987) studied the consequences sense of minimizing surprise really captured in point 3. extent focused that they eliminate on choosing the changes the over the behavior (1981) addressed interest rate, time. Roughly in points i.e., speaking, 1 and 3 above. of interest rate smoothing in rates. of in the This aspect of smoothing is But it is also captured in points 1 and 2, to the temporary Federal constancy in interest rates. in McCalJum surprise funds rate rate movements. target to maintain Barro (1989) an expected He studied the random walk nature of Federal funds rate targeting implicit in the idea that target changes are unforecastable. Thus Barro studied aspects of smoothing captured in points 1 and 2, though he ignored the fact that target changes are triggered discontinuously in response to the 7 flow of new information. Interest deterministic seasonals theoretically in Barro (1989). rate smoothing as studied empirically can also (1986) by Miron mean removing and modelled The most extreme form of rate smoothing, a peg, has also been studied theoretically, e.g., McCallum (1986). The remainder of this section reviews the instrument choice problem and the mechanics and consequences of minimizing rate surprises in the context of optimal dynamic stabilization policy. in Section III. we focus in Seasonality Random walk interest rate targeting is discussed Continuity in the short rate is discussed in Section IV, more detail on some institutional and pegging were mentioned aspects for completeness, of Fed where behavior. but will be ignored here. II.1 Instrument Choice Poole (1970) problem. provided the classic statement and solution of the instrument The problem arises because policy must be implemented by predetermining a variable on a period-by-period basis. He recognized instrument would not matter in a world of certainty. knew the model of contemporaneously, the economy and could of If the monetary authority observe aggregate variables any feasible outcome could be achieved by setting either the Federal funds rate or aggregate bank reserves. confronting that the choice policymakers, To model the uncertainty actually Poole imagined the IS and LM relationships in the assumed model economy to be disturbed by contemporaneously unobservable shocks. Likewise, he contemporaneous assumed implicitly that because of a data aggregate output was unobservable as well. processing lag, Hence, the policy instrument had to be chosen before the IS and LM relationships could be located for sure. 8 Poole saw that if output deviates from a target level mainly because of IS shocks, then output is best stabilized by holding bank reserves constant. if the deviation in output is mainly due to LM disturbances then the interest But Poole also recognized that under a rate should be the policy instrument. reserve instrument, themonetary And authority could observe contemporaneous interest rate movements which contained information about unobservable IS and LM shocks. ,He worked could out a combination contemporaneous by which bank reserves authority is interesting for our purposes because might wish to directly in time to analysis, carried out it shows why a alter the interest rate generating process in pursuit of deeper stabilization policy goals. point respond interest rate information to better stabilize aggregate output. Poole's analysis monetary policy assuming a fixed Yet Poole's is only a price level and zero expected inflation. II.2 Rate Smoothing and the Goodfriend's Price Level Generating (1987) model may be approached analysis to a flexible price-rational expectations Process as an extension model. of Poole's Goodfriend assumed that the central bank chooses its money supply rule to minimize fluctuations aggregate output arising from one-period-ahead price level forecast errors. he assumed variability that the to minimize central bank any distortions incomplete indexation of contracts. LM relationships, wishes to minimize that might expected And inflation arise due to costly He also assumed disturbances in and to the IS and as well as aggregate output and prices, to be observable with a one period lag. The new feature in Goodfriend's model is a money supply rule that allows the central bank to choose the contemporaneous money stock response to an 9 interest rate innovation a& the extent to which the contemporaneous money stock If the offset is exact, then the money response is offset in the next period. stock will be trend stationary, otherwise it won't be. persistence in the model, so the price There is no real-side level generating process is trend- stationary if and only if the money stock is. Goodfriend macroeconomic found that stabilization if the central bank of output and inflation, stationary process for money and prices. is concerned only with it will choose a trend- A combination policy a la Poole is optimal with an exact offset. The reason is as follows. The central bank adjusts the current money stock M, so that its best guess of the current price level P,, conditional on observing the interest rate rt, equals the price level expected as of last period. To achieve constant conditional expected inflation (assumed zero for simplicity), it would like to make the conditional expected future price level equal last period's expectation of the current price level. link between M t EP t tt1 = EP. t-1 t and E M t t+1 and setting the latter at a constant such that Breaking the link between M and trend-stationary This is done by breaking any t and E M t tt1 means complete offset money and prices. In the second part of his paper, Goodfriend showed that coupling a concern for rate smoothing with its other stabilization objectives induces a central bank to make the price level non-trend-stationary. trend-stationary money when the rate first a supply rule. To smooth the interest rate beyond that associated with macroeconomic money To see why, consider rises stabilization policy, the central bank adds more and drains more when it falls. Whereas the 10 contemporaneous conditional covariance between the interest rate and the price level was made zero before, stationarity, rate rate therefore, smoothing makes smoothing raises it positive. one-period-ahead With trend- price level forecast error variance and yields greater output instability. But in Goodfriend's model a central bank wishing to avoid such output instability could make M t respond to r as before and instead make E M t t tt1 respond negatively to r . Thus the interest rate could be smoothed by generating t negative expected.money when rt fell. growth when rt rose and positive expected money growth The central bank would thereby transform temporary shocks to the interest rate into permanent shocks to the money stock and the price level. The latter would no longer be trend-stationary but would drift through time randomly. Goodfriend determinate thus explained how an optimizing central bank could produce a though non-trend-stationary The idea was later used price level. by Barro to model non-trend-stationary inflation. Goodfriend's analysis is consistent with the monetarist view that interest rate smoothing creates macroeconomic instability, e.g., Poole (1978, Rate smoothing with trend-stationarity greater output instability. output instability if makes money pp. 106-10). too procyclical, causing The new idea is that rate smoothing need not cause the money supply process is made non-trend- stationary. A recent empirical Schwartz (1990) study of U.K. monetary policy by Bordo, Choudhri, and finds that if the Bank of England had followed a trend-stationary money supply rule since.the mid 197Os, it would have reduced the variance of the stochastic trend in prices by more than one half. They suggest that interest 11 rate smoothing may well have induced the Bank of England to allow money stock "base drift" to reduce the predictability of the trend price level. There may exist other mechanisms that generate non-trend-stationary and prices. does so. Van Hoose (1989) money has argued that the Fed's monetary targeting itself He uses a version of Goodfriend's model in which either an interest rate or a total reserves instrument is set period-by-period at levels that are expected to make the quantity of money demanded equal to the desired target. The key point is that the instrument does not respond to new information received within the period to which it pertains. combination policy is ruled out. So whichever instrument is used, a Using an interest rate instrument is an extreme form of smoothing and so clearly implies non-trend stationarity for exactly the reasons argued by Goodfriend. Since the Fed has never used a total reserves instrument, that could not be an alternative explanation for actual price level non-trend-stationarity. Goodfriend's model is only about the consequences of rate smoothing. It merely suggests that central banks smooth interest rates to cushion the banking system against interest rate shocks. detail. His explanation Cukierman (1989) works out the idea in is based on the fact that the interest rate on loan contracts is determined prior to the determination of the cost of funds to banks. Unanticipated credit or money demand shocks after banks have entered into loan commitments create a negative correlation between competitive deposit rates and bank profits. Rate smoothing protects the banking system against such negative cash flows and the risk of widespread It insolvencies. would appear feasible for loan rates to float daily with the Federal funds rate, or for banks to hedge their loan commitments by holding time deposits of similar maturity. Is the fact that they generally do not choose to do so 12 itself a consequence of central bank rate smoothing? One would want to analyze the social value of rate smoothing more fully in a model in which banks choose the optimal level of capital together with the extent to which they hedge interest rate risk. Of course, during a potential liquidity crisis the central bank ought to follow Bagehot's (1873) advice and defend a short-term rate ceiling to prevent interest rate spikes from creating widespread insolvencies. Federal funds rate automatically insolvency Now, targeting the protects the banking system against risk of in the event of a liquidity crisis. But it would be sufficient to announce and defend a ceiling suitably above the current normal range of market rates. It is difficult to understand the Fed's inclination to target the Federal funds rate period-by-period III. INTEREST in terms of lender of last resort concerns. RATE TARGETING AS INFLATION TAX SMOOTHING Highly persistent interest rate targeting cannot be explained as financial market stabilization policy. After all, our current saving and loan problems began with the unexpected persistently high interest rates of the 1970s and early 80s. The attractiveness of Mankiw's (1987) view of rate targeting as optimal inflation tax smoothing is that it predicts highly persistent nominal interest rates, inflation, and money growth such as we have observed in recent decades. The theory (1979) optimal sources. The second as expressed tax smoothing by Mankiw model. is basically The government an extension raises of Barro's revenue from two The first is a tax on output, such as an income tax or a sales tax. is seigniorage, the printing of new money. The government must satisfy a present value budget constraint by adjusting tax rates on goods and money as it receives new information on its revenue requirements over time. The 13 goal of the government is to minimize the expected present value of dead-weight losses due to the use of distortionary taxes. Expected dead-weight losses areminimized by maintaining expected constancy in both the goods tax rate and the nominal interest rate. The real interest rate is assumed constant, so the nominal rate moves with expected inflation, which is also a martingale. The theory implies that the contemporaneous marginal dead- weight costs of raising revenue through direct taxation or seigniorage should be equal. So the level of direct taxation should move together with inflation and nominal interest rates. The theory of optimal seigniorage gets support from evidence, documented by Mankiw, that nominal rates and inflation in the post war U.S. positively covary with government receipts as a percent of GNP. Mankiw does not discuss how a central bank could actually implement optimal inflation tax smoothing. For this one must supplements Goodfriend's model in two ways. an exogenous random walk. to Barro (1989). Barro He makes the interest rate target shocks and deterministic seasonals to money demand and the ex ante real interest rate. So modified, Barro tests the model's implications on U.S. data from 1890 to 1985. Roughly speaking, Barro checks restriction (0,1,2) the the walk he adds permanent interest rate feature of the model, and the that both money growth and inflation should each follow an ARIMA process. interwar random And go He rejects the model on pre-Fed data, finds mixed results for period, but cannot reject the model for the post-World War II period. Barro's work appears to provide support for the tax smoothing theory of monetary policy. However, a closer look reveals that he uses the tax smoothing theory merely to motivate including the random walk interest rate target in the model. Though he offers no alternative theory, he admits that interest rate 14 targeting could have nothing to do with fiscal concerns. potentially supportive targeting, of other explanations for So Barro's work is also random walk interest rate such as one sketched in Section IV below. Poterba and Rotemberg (1990) extend Mankiw's empirical analysis to Japan, France, Germany, and the U.K., but find a significant between inflation and tax rates only in Japanese data. with mixed results, unit root tests and cointegration sample of ten industrialized positive association Grilli (1988) reports, tests of the theory on a countries. At the theoretical level, Kimbrough (1986) and Lucas (1986) have suggested that modelling money as an intermediate good can overturn the traditional conclusion that the inflation tax should be used in a second-best world. If the tax rate on final output is set optimally, taxing money is inefficient. Barro points out, however, that a positive tax rate on money allows the government to tax output in the underground economy, and that if the main existing taxes are on some factor inputs, especially labor, then it may be desirable to tax other inputs such detail. as monetary services. Woodford (1988) surveys these issues in In Mankiw's words, the precise circumstances under which the use of the inflation tax is second-best optimal remain an unsettled issue. Mankiw's model of optimal seigniorage makes expected money growth inflation react to new information on government revenue requirements. an optimal inflation tax rule should also allow the contemporaneous and price level to react to such news. The inflation amounts to an ex post capital levy. revenue obtained and However, money stock by surprise As with other surprise capital levies, surprise inflation raises revenue with little dead-weight loss. Although systematic inflation surprises cannot arise in rational expectations equilibrium, the rule would optimally allow for inflation surprises contingent on innovations 15 to expected government revenue requirements. Judd (1989) makes some related points in a more general analysis of the role for surprise contingent capital levies in a dynamic-stochastic On this basis, economy. one can question of rate targeting should be interpreted as optimal inflation tax policy at all. Recall, in assuming that the central bank minimized period ahead price level forecast errors. a concern for stabilization Barro's (1988) model that he followed Goodfriend whether policy, one- While such might be well motivated by it is contrary to optimal inflation tax policy. IV. CONTINUITY OF THE SHORT RATE This section asks why central bankers themselves might have a preference for maintaining continuity of the short rate. The preference is reflected in the Fed's use of a Federal funds rate policy instrument reserve instrument. It rather than a bank is also evident in the reluctance to change the target frequently and in the reluctance to change targets in steps bigger than 25 or 50 basis points. The tendency is, however, not a hard and fast rule so that target changes may occur more frequently and step sizes may be bigger in periods of greater underlying volatility, e.g., the period from October 1979 to October 1982. The purpose of this section is two-fold. It is to offer an alternative explanation for the high degree of persistence the Fed imparts to interest rates, and to understand its preference for indirect rather than direct Federal funds rate targeting. In so doing, we will develop an understanding of central banker preferences for continuity of the short rate. 16 IV.1 Stabilization and the Persistence of Interest Rates While it may be possible to rationalize temporary rate smoothing as optimal financial stabilization policy, it doesn't seem reasonable to rationalize highly persistent rates this way. The tax rate smoothing theory is appealing because it predicts highly persistent rates. But there is little evidence that the Fed considers fiscal implications when it routinely adjusts its Federal funds rate target. So we seek to understand how the routine pursuit of macroeconomic stabilization policy might induce the Fed to impart martingale-like short-term behavior to interest rates. An argument to this effect might run as follows. The Fed adjusts its Federal funds rate target over time in an effort to stabilize unemployment and inflation as best it can. Output and prices do not respond directly to weekly Federal funds rate movements, but only to rates of at least three or sixth months maturity. stabilizing Hence, the Fed and manipulating targets the longer-term Federal funds money market rate with rates. the aim of Let's say it chooses a current week's Federal funds rate target for its effect on the threemonth rate for the following thirteen weeks. As point 6 in Section I asserts, the market determines the three-month rate (abstracting from a time-varying term premium and default risk) as the average expected level of the Federal funds rate over the next three months. loan with a three-month Federal funds overnight To see why, note that a bank may fund a three month certificate of deposit, or for the next three months. it could plan to borrow So cost minimization and competition among banks keep the CD rate in line with the average expected future Federal funds rate. Bank loan rates are linked to expected future funds rates by a similar argument. And arbitrage among holders of money market securities links Treasury bill and commercial paper rates to CD rates of similar maturity. 17 Since longer-term rates are determined as an average of expected future Federal funds rates, the Fed could target the three-month rate with a variety of expected future Federal funds rate paths. maintain an expected constancy months. Since simplicity is highly valued in communicating policy intentions, But clearly the simplest is to in the Federal funds rate for the next three it is easy to understand why the Fed might manage its Federal funds rate target so as to maintain an expected constancy of the Federal funds rate over any threemonth period. expected But we can say more. constancy Adjusting the target so as to maintain an in the Federal funds rate for three months rules out any expected change in the three-month rate in any week of the upcoming three-month period. This, in turn, implies an expected constancy forever. So even though the Fed may care only about controlling the current three-month rate, doing so by maintaining a three-month expected constancy of the Federal funds rate tends to impart a more permanent expected constancy to interest rates. Thus we can appreciate how the pursuit of stabilization policy itself may tend to impart a high degree of persistence to short-term interest rates. We have not said anything yet about the ex ante real interest rate. But suppose real rate shocks, whether or not they are influenced by monetary policy, are transitory. Then the interaction interest rate generating between the Fed's martingale-like process and the ex ante real rate process highly persistent component in the inflation generating process. nominal implies a This view would explain inflation persistence not as optimal tax smoothing, but as the outcome of an expected continuity that the central bank builds into the short rate in the pursuit of stabilization policy. Continuity plays another role here as well. The Federal funds rate target is not changed in response to new information received daily or even weekly. By 18 point 2 of Section accumulation I, target of new information such, in practice changes occur discontinuously only after is deemed sufficient to trigger a change. it may be possible to predict somewhat the likelihood target change before it occurs. an AS of a Thus the expected future funds rate may vary around the prevailing Federal funds rate target causing the Fed to lose leverage over, say, the three-month changes itself minimizes rate. To some extent, somewhat the loss of understand point 3 of Section I in this regard. to relatively the infrequency control. But By restricting one of target may also target changes small steps of 25 or 50 basis points, the Fed reduces the extent to which the expected future funds rate will vary around the current target. course there is a tradeoff here. For the restriction Of to be credible, the Fed must actually delay or spread out target changes that it might otherwise like to make immediately. IV.2 Direct vs Indirect Point Federal 1 of Section Funds Rate I described Targeting the Federal Reserve as having either direct or indirect Federal funds rate targeting throughout employed its history. This section contrasts direct and indirect targeting, and reviews briefly their history. It also discusses the costs and benefits of each from the point of view of a central bank. The operations Fed targets to defend allowed to move. the Federal a relatively funds rate directly by using open market narrow band within which the funds rate is For example, from 1975 to October 1979 the range was commonly 25 basis points, see Cook and Hahn (1989, app. A). means moving the band up or down. within the band, triggering In practice, a target change One can imagine the funds rate bouncing around "defensive" open market operations whenever it hits 19 A target change becomes apparent to the the upper or lower intervention points. market whenever the rate moves beyond a previously defended point. funds rate targeting, the market understands target changes Under direct clearly and immediately by merely observing Federal funds rate movements. Indirect funds rate targeting is more complicated. Here the Fed estimates the banking system's demand for reserves, and provides the bulk of those reserves through open market purchases. But it forces the banking system to borrow a small fraction from the discount window. Given the non-price-rationing at the discount window, the quantity of discount borrowing that banks are willing to do depends positively on the spread between the Federal funds rate and the discount rate. So for a given discount rate, targeting borrowed reserves allows the Fed to target the Federal funds rate indirectly. targeting, however, borrowed reserve In contrast to direct funds rate targeting is inherently noisy because borrowing cannot be targeted exactly and because the demand schedule for borrowed reserves itself is unstable. rate combination In other words, a given borrowed reserve-discount will tend to tie the funds rate only loosely to a target. Moreover, since there is no narrow band within which the rate is clearly kept, it is not as obvious to the market what the target is. And it generally takes the market longer to perceive changes in the target. During the early years of the Federal Reserve System, there was no nonprice-rationing at the discount window and the discount rate was the Fed's policy instrument. In 1919 and 1920 discount window borrowing even exceeded member bank reserve balances at the Fed. Consequently, the overnight loan rate, e.g., then the call loan rate, was directly 192os, Fed nonborrowed open market reserves. linked to the discount security And the purchases largely Fed gradually came rate. replaced to treat Later in the borrowed with borrowing as a 20 privilege and not a right. Having effectively introduced non-price-rationing at the window, the Fed then began to target the Federal funds rate indirectly with a borrowed reserve target. In the 193Os, interest rates declined to a fraction of the levels averaged in the 20s. market rates, Essentially, so they had The discount rate was reduced but not allowed to fall below discount window borrowing was negligible from 1934 on. short rates were near zero during this period and the Fed did not bother to target them either directly or indirectly. policy was constrained During the 4Os, monetary by the wartime and postwar interest rate peg. When monetary policy regained its independence after the 1951 Accord, the Fed returned to the indirect Federal funds rate targeting procedure it had used in the late 20s and early 30s. At the time the procedures were known as "free reserve" or "net borrowed reserve" targeting, see Brunner and Meltzer (1964). The Fed continued to target the Federal funds rate indirectly until the early 197Os, when it shifted gradually to directly targeting the Federal funds rate within a narrow band. The period of nonborrowed reserve targeting between October 1979 and the fall of 1982 was one in which the Fed was willing to allow a more volatile funds rate. But while strictly targeting nonborrowed reserves could funds rate to be determined automatically by market forces, have allowed the in practice, funds rate was usually indirectly controlled by a borrowed reserve target. the Cook (1989) has documented that roughly two-thirds of the movement in the funds rate during this period was due to deliberate discretionary actions of the Fed, e.g., changing the discount rate or the borrowed reserve target. Since 1982 the Fed appears to have completely reverted targeting procedures akin to those of the 2Os, 5Os, and 60s. to indirect Recently, there is 21 some evidence of a gradual return to direct targeting within a narrow band, though that has not yet been formalized in the Directive. Why has the Fed employed both direct and indirect procedures for targeting the Federal funds rate? the purpose Direct targeting would appear to have an advantage for of controlling, say, the three-month rate. It communicates the current target exactly to the market, and allows the market to pick up a target change immediately. But we can appreciate what the Fed perceives to be the benefit of indirect targeting in the following two statements. The first statement is one by Governor Strong from 1927: ...It seems to me that the foundation for rate changes can be more safely and better laid by preliminary operations in the open market than would be possible otherwise, and the effect is less dramatic and less alarming to the country if it is done in that way than if we just make advances and reductions in our discount rate....[Strong 1927, p. 3331 The second statement is one by Chairman Greenspan from 1989. He is talking about whether the Fed should be mandated to publicly state its current Federal funds rate target discussed below, this and announce issue is closely immediately a target change. related to the perceived But as benefit indirect targeting. Chairman Greenspan says: The immediate disclosure of any changes in our operating targets would make this information available more quickly to all who were interested, but it would have costs. Simply put, this provision would take a valuable policy instrument away from us. It would reduce our flexibility to implement decisions quietly at times to achieve a desired effect while minimizing possible financial market disruptions. Currently, we can choose to make changes either quite publicly or more subtly, as conditions warrant. With an obligation to announce all changes as they occurred, this distinction would evaporate; all moves would be accompanied by announcement effects akin to with those currently associated discount rate changes.... [Greenspan 1989, pp. 14-151 of 22 Remarkably, although the statements were made sixty years apart, they make essentially the same point. Any direct interest rate targeting procedure, especially one in which the current target is publicly announced, would likely give a target change the status of a major news event. best that routine target changes not make the news. reserve, targeting gives the Fed that option. But the Fed believes it Indirect, i.e., borrowed It allows the Fed to control the current funds rate without defending a narrow target band, so the market at large cannot easily see the target. transmit Fed intentions quietly for two reasons. Fed watchers follow the funds rate target and thus to the market. continuity changes can be brought about Open market operations can be used to gradually change the borrowed reserve target. resolved gradually. Target And the uncertainty surrounding target changes is By stretching out a target change, i.e., by maintaining a of the short rate, the Fed can keep its target change out of the headlines. Essentially, perception of its target it does so by assuring that a change is not sufficiently newsworthy in the general on any one day. Of course, by using the discount rate to change the funds rate target, the Fed can always grab the headlines We targeting. can thus if it wants to. appreciate the perceived The option to quietly change benefit of indirect its target, however, funds rate is not without cost. It opens the door to having its target misinterpreted, e.g., Wessel and Herman (1989). a risk of being misinterpreted The Fed faces a tradeoff. if it wants It must accept the option to quietly change its target. We may understand the Fed's choice of direct vs indirect targeting as driven by shifts in its perception of the cost of being misinterpreted avoiding the headlines. relative to the benefit of 23 V. EMPIRICAL EVIDENCE AND IMPLICATIONS The paper has explored the view that the Fed dominates the evolution of short-term interest rates. This section surveys empirical founding of the Fed and from the 1970s that demonstrates rates. evidence from the the Fed‘s power over The evidence supports the expectations theory of the term structure as embodied in point 6 of Section implications for conventional I. tests Federal funds rate targeting of the expectations theory itself has of the term structure that are discussed briefly. V.l The Founding of the Fed The Federal Reserve radically altered the character of short-term movements when it began operations in 1914. rate Consider one measure of the short- term rate, the monthly average New York call loan rate as reported in Macaulay (1938). Prior to the creation of the Fed, this rate rose suddenly and sharply from time to time. For example, in October 1867, after remaining between 4 and 7 percent for the previous three years, the call loan rate rose suddenly from 5.6 to 10.8 percent. Although this change seems large by post-war U.S. standards, similar episodes ocurred 26 times beween the Civil War and the creation of the Fed. Moreover, surprising frequency, Accompanying much less sudden changes on 8 of over occasions 10 percentage during the points same occurred 49-year with period. these sudden upward jumps in call loan rates were similar though severe movements in 60- to go-day commercial paper rates. These episodes were distinctly temporary, ranging from one to four months, with many lasting for no more than one month. Such extreme temporary spikes are absent from interest rate behavior since the creation of the Fed. 24 Another distinctive feature of the period before the Fed was the large According to Miron (1986), seasonal in short-term rates. variation of the call loan rate from 1890 to 1908 the average seasonal ranged from a peak of t4.6 percent in January to a trough of -1.39 percent in June. annual mean winter. By Rates were at their in the spring, below it in summer, and above the 1920s the prominent interest rate it in the fall and seasonal had virtually disappeared. Mankiw et al. (1987) documented a substantial process generating the three-month time loan rate. found the rate to be quickly mean-reverting between 1920 and 1933 change in the stochastic Between 1890 and 1910, and highly seasonal. they By contrast, they found it to be close to a random walk. Mankiwet al. also examined the relation between three- and six-month rates before and after the founding of the Fed. The two rates moved together more closely in the later period, as predicted by the expectations theory of the term structure given the greater persistence of the three-month rate. The evidence strongly suggests that the Fed altered the process generating short rates. rates. Yet Mankiw et al. do not explain how the Fed was able to smooth The problem is that the U.S. was on a gold standard during the period, and the Fed was committed to maintain a fixed dollar price of gold. How then was the Fed able to pursue a second objective, namely, interest rate targeting? answer, worked out in Goodfriend (1988), of policy freedom under a gold standard. money and gold. Goodfriend explained The is that a central bank has two degrees It can choose policy rules for both how the Fed stockpiled excess gold reserves, and allowed its stockpile to vary in support of the fixed dollar price of gold while using monetary policy to target the interest rate. 25 V.2 Federal Funds Rate Targeting in the 1970s The standard test of the Fed's influence on interest rates is to regress rates on current and past money growth. The regressions yield little support for the view that the Fed can influence rates, see Reichenstein (1987). However, one may question the findings by noting, as Mishkin (1982) did, that such tests may be misspecified if the Fed smooths Indeed, rates. interest rate targeting requires the Fed to accommodate changes in money demand to support the current target. So there need be no close relationship between observed changes in money growth and interest rates. Cook and Hahn (1989) test for evidence of the Fed's influence on rates by examining the reaction of interest rates to Fed target changes. the reaction of rates to target changes September 1979. They estimate in the period from Sepember 1974 to This period is unique in that the Fed controlled the Federal funds rate so closely that market participants could identify most target changes on the day they were first implemented, and the changes were reported in the financial press the following day. Cook and Hahn found that changes in the Federal funds rate target were followed movements by large movements in the same direction in intermediate-term long-term rates. in short rates,. moderate rates, and small but significant movements in The 3-,6-, and 12-month bill rates all moved by about 50 basis points in response to a 1 percentage point change in the funds rate target. 3-year bond rate moved by 29 basis points. The The lo-year bond rate move was 13 basis points. And the 20-year bond rate moved 10 basis points. All regression coefficients were significant at the 1% level. The similar response of 3-, 6- and 12-month bill rates to target changes is striking confirmation of the idea that the Fed maintains an expected constancy 26 in the Federal funds rate for periods as long as a year. But the declining responses of 3- to 20-year bond rates are consistent with slow mean reversion in rates. In this regard, Cook and Hahn's findings are broadly consistent with those of Fama and Bliss (1987). A particularly interesting aspect of Cook and Hahn's results is that bill rates move by only about 50 percent of a target change. This suggests that on average the market has already built into rates about half of each target change by the day it occurs. Roughly speaking, about half of each target change appears to be expected by the time it happens. IV.1 that, given forecastable the Fed's targeting to some extent. This supports the conjecture in Section procedures, target changes ought to be The similarity of the response of 3- to 12-month bills, however, implies that any forecastability must be limited to a horizon of only a month Hardouvelis or so. (1988). We find just this sort of evidence Fama, for example, presents evidence in Fama (1984) and that the one-month forward rate has power to predict the spot rate one month ahead. The assumption interpretation that movements rates and not the reverse. of Cook and Hahn's regression results rests in the funds rate target caused movements on the in other They defend their assumption as follows: The Desk changed the funds rate target in this period either under instructions from the FOMC or under the Desk's explicit As we document in a interpretation of the latest FOMC directive. working paper (1989), in all but five of the former cases the actual change in the target lagged the FOMC instructions by one or more days, and in about half of the latter cases the market's perception of a change in the target lagged the Desk's decision to change the target by at least one day. In these cases the reverse causation argument makes no sense because changes in the target initially decided on prior to the day they were reported to have occurred by the Journal could not possibly have been made on the basis of the movement in market rates that day. [Cook and Hahn 1989, p. 3421. 27 Cook and Hahn go on to say that 20 out of the 76 target changes in their sample did occur on the same day as the Wall Street Journal reported them. But they reestimated argued that even these were unlikely to be contaminated. their basic regression leaving out the suspect They observations, without significantly different results. V.3 Implications for Tests of the Expectations Theory of the Term Structure The views of market participants together with Cook and Hahn's findings constitute strong evidence that expectations of the future level of the funds rate influence current market rates. Yet a recent group of papers that have studied the slope of the money market yield curve have found little; if any, support for the expectations theory of the term structure, see references in Cook and Hahn (1989). The standard test of the expectations theory in these papers is to regress the change in the 3-month rate from period t to period ttl difference between the 6-month and 3-month spot rates in period t. on the Mankiw and Miron (1986) pointed out that in the presence of a time-varying term premium, the coefficient in such a regression tends to be biased downward. proportion The greater the of the variance of the yield curve slope due to the expected term premium and the less due to the expected change in the 3-month rate, the greater will be the downward bias. Cook and Hahn showed that the slope of the yield curve from three to twelve months is not responsive to new information influence interest rate expectations. (funds rate target changes) that So the variance of the yield curve slope over this range is likely to be dominated by movements in the term premium. Thus, as Mankiw and Miron argued, the conventional test of the expectations 28 theory performs poorly in the presence of interest rate targeting as practiced by the Federal Reserve. CONCLUSION The paper described key features of the Federal Reserve's interest rate targeting procedures and addressed a number of issues in light of these stylized facts. It pointed out various ways in which the procedures may be said to smooth rates, and identified each with one or more theoretical model of rate smoothing. The theoretical models all had in common the idea that interest rates are smoothed by manipulating expected money growth and inflation. This suggested, in turn, that rate smoothing may be an important determinant of the inflation generating inflation process. and At tends a minimum, to induce rate smoothing can imply more non-trend-stationarity in the persistant price level. Moreover, policy that maintains an expected constancy in rates tends to induce non-trend-stationarity There was in the inflation rate. some question expected constancy in rates. about what motivates the Fed to maintain One possibility, critiqued such rate smoothing is optimal inflation tax smoothing. near in the paper, is that An alternative argument advanced in the paper is that stabilization policy, implemented by interest rate targeting, inflation. inadvertantly induces martingale-like Thus we saw Fed rate targeting as potentially explaining the actual high degree of inflation persistence in the U.S. is radical behavior in nominal rates and for two reasons. It reverses The rate targeting perspective the usual view of the relationship between inflation and interest rates, and it suggests that explaining the process generating inflation involves understanding central bank interestratetargeting. 29 As described in the paper, instead of targeting the funds rate within a narrow band, the Fed has often chosen to target it loosely using borrowed reserve The resulting objectives. target, makes relationship noise in the funds rate obscures the funds rate appear free of Fed influence, the underlying and weakens the This between the funds rate and longer-term money market rates. point bears repeating because it tends to complicate empirical investigation of the stylized facts of rate targeting presented here. Empirical work could proceed, though, by recognizing that longer-term rates would be closely related to the market's estimate of the underlying borrowed reserve target;which indicates the Fed's intentions for the current and expected future funds rates. We saw that indirect funds rate targeting is valued by the Fed because it gives the central bank the option of quietly changing its target. works by obfuscation, misinterpreted. however, it raises the risk of the Because it target being This suggested that the Fed's tendency to shift back and forth from direct to indirect targeting is driven by perceived shifts in the cost of being misinterpreted vs making the headlines. It is hard to imagine environments with stable preferences that allow such relative costs to vary over time. But progress our on this question would make an important contribution to understanding of central banking. The last section of the paper surveyed empirical evidence from the founding of the Fed and the 1970s demonstrating rates. the Fed's power over market interest It nicely supported a number of the stylized facts preseneted beginning. Even the greatest skeptic of the Fed's power at the to systematically influence market interest rates should find the evidence surveyed here troubling. Of course, all this says nothing about the Fed's power over ex ante real interest rates. But we need to take first things first. 30 REFERENCES Bagehot, W. (1873) Barro, R. Lombard Street, New York: Arno Press, (1978). (1989) Interest Rate Targeting, Journal of Monetarv Economics, 23: 3-30. (19;s) On the Determination Economy, 87: 940-71. of the Public Debt, Journal of Political Bordo, M:, Choudri, E., and Schwartz, Anna. Price-Level Drift, and Base (1990) Money Stock Targeting, Predictability: Lessons from the U.K. Experience, Journal of Monetarv Economics, 25: 253-72. Brunner, K. and A. 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