Frameworks for Monetary Stability

4 The Design of U.S. Monetary Policy: Targets, Indicators, and Information Variables

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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This paper describes the use of targets, indicators, and information variables in the design of monetary policy in the United States. To provide a context for the discussion of these variables, it first reviews the objectives and the principal instruments of U.S. monetary policy and presents an analytical framework for understanding the effects of monetary policy on economic developments. It then considers various policy measures that have been proposed or have actually been used in formulating monetary policy in the United States. Finally, it summarizes the major points and offers some concluding comments.1

Objectives of Monetary Policy

The selection of appropriate targets, indicators, and information variables for monetary policy, as well as that of a central bank’s instruments, is based in part on the objectives of monetary policy. In various countries, monetary policy may have a number of goals, including promotion of macroeconomic health, finance of government expenditures, and fostering activity in certain economic or financial sectors.2 In the United States, the law makes clear that monetary policy is to focus on macroeconomic ends. Section 2A of the Full Employment and Balanced Growth Act of 1978 (the Humphrey-Hawkins Act) specifies that the Board of Governors and the Federal Open Market Committee are required to “…maintain long-run growth of the money and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Notable by their absence from these goals are objectives related to government finance or to activity in particular sectors of the economy or financial system. Clearly, the objectives of U.S. monetary policy are macroeconomic. A natural question to ask is whether the prescribed macroeconomic goals are compatible. In the view of the Federal Reserve, they are fully compatible in the long run—i.e., the period of time covered by the express language of the statute. As will be explained in more detail in the next section, modern economic theory generally holds that a stimulative monetary policy is not able to boost the level of aggregate real production and income in the long run; rather, it increases inflation and inflation expectations, but not output. Thus, in the long run, price stability—a condition where inflation is sufficiently low that it is not a consideration in businesses’ and households’ financial decisions—produces the lowest possible nominal interest rates, as they need to contain no premium for expected inflation.

Instruments of U.S. Monetary Policy

In the United States, the principal instruments of monetary policy are open market operations, the discount rate, and reserve requirements. The term open market operations generally refers to the purchase and sale of securities in the open market; a purchase of securities adds reserves to the banking system and a sale drains reserves. The Federal Reserve is also authorized to purchase and sell other instruments in the open market—including foreign exchange and gold—but transactions in these assets are much less frequent than in securities and are generally not regarded as primary instruments of monetary policy.3 By statute, open market operations are conducted under the direction of the Federal Open Market Committee, which consists of the seven members of the Federal Reserve Board, the President of the Federal Reserve Bank of New York, and on a rotating basis four of the Presidents of the other eleven Federal Reserve Banks.

The discount rate is the interest rate charged on adjustment borrowing at the Federal Reserve Banks’ discount windows. Adjustment credit is one of three discount-window lending programs. Adjustment credit may be provided to help meet depository institutions’short-term liquidity needs when other sources of funds are not reasonably available. (The other programs are the seasonal credit program and the extended credit program; interest rates on borrowing under these programs are set under formulas that relate them to market interest rates.) By law, proposals to change the discount rate are made by the boards of directors of the Reserve Banks and are approved or disapproved by the Board of Governors. Broad policies regarding the administration of the discount window also are determined by the Board of Governors.

The Board of Governors is required by statute to set reserve requirements on certain classes of deposits within fairly broad ranges. The law also specifies that reserve requirements are to be adjusted only for monetary policy reasons. Reserve requirements may not be used, for example, to direct the flow of credit to particular sectors.

Currently, open market operations are the most frequently used monetary policy tool. Most open market operations, however, are not intended to implement shifts in monetary policy but rather are defensive—that is, are used to offset other factors that would otherwise affect bank reserves in an undesired way. The discount rate is adjusted infrequently, typically no more than several times per year, and sometimes not at all for extended periods. Reserve requirements have been changed only rarely; in recent years such changes have been made mainly in response to changing structural conditions in banking markets.

Selective credit controls and exchange rates are not primary instruments of monetary policy in the United States, unlike the situation in many less developed countries. The Congress appropriately has not assigned to the central bank significant responsibilities for credit allocation. The United States has found that any necessary credit allocation can best be handled by other government agencies. Exchange rates are not viewed as the most useful policy target for a large, independent economy such as that of the United States and, as explained below, can have counterproductive results in some circumstances.

An Analytical Framework

Assessing the usefulness of alternative monetary policy variables requires an analytical framework. The Federal Reserve staff has found most useful a basis that corresponds closely to current mainstream macroeconomic theory. An implication of this mainstream theory is that monetary policy can have an appreciable impact on economic activity over shorter periods of time, while affecting mainly the rate of inflation in the longer run. Economists have been reasonably successful in quantifying aspects of this theory.4 Nevertheless, considerable uncertainty remains. Estimation of these relationships is difficult, particularly because the key relationships are subject to change as institutional features of the economy and financial system evolve in response to innovation and changes in laws and regulations.5 Consequently, policymakers are not able to rely heavily on estimated values of such relationships, but must take them only as rough indicators of underlying tendencies.

To develop this analytical framework, let us proceed by describing, in turn, the impact of a change in monetary policy on prices of financial assets, on the economy and inflation, and finally on financial aggregates.

Effects on Interest Rates and Prices of Financial Assets

A change in the stance of monetary policy may be implemented through the various monetary policy instruments described above. Consider a shift in the stance of monetary policy in a less accommodative direction; such a shift would probably be accomplished through open market sales of securities or an increase in the discount rate. The immediate effect of such a shift will be to raise money market interest rates, reflecting the shortfall of the supply of bank reserves relative to demand.

The effect on longer-term interest rates depends crucially on expectations. If, for example, market participants see the tightened stance of monetary policy as indicating a desire of the central bank to bring inflation to lower levels than previously expected, real long-term rates are likely to rise. The higher real long-term rates would tend, with substantial lags, to reduce aggregate demand and limit price pressures. Eventually, real long-term rates would move back to their equilibrium levels and lower inflation would permit an eventual easing of the monetary policy that lowered real short-term interest rates to their previous equilibriums. On the other hand, if market participants had fully anticipated the change in the stance of policy, and did not interpret it as signaling an altered long-run target for inflation, any effects on long-term real rates would likely be small.

The initial effect of a change in the stance of monetary policy on long-term nominal rates, however, is less clear than that on real rates. If the tighter stance of policy was expected by market participants to be successful in lowering inflation expectations, the inflation premium in long-term interest rates should decline. The short-run effect on nominal interest rates depends on the relative changes in real long-term rates and the inflation premium. Ultimately, short-term and long-term nominal rates should move to lower levels, as real rates move back to their initial equilibriums and inflation premiums decline.

The concept of forward interest rates is particularly useful in analyzing longer-term interest rates. Longer-term interest rates can be seen as averages of current short-term rates and implicit forward rates—defined as short-term rates for future time periods that are embedded in the term structure. Under generally accepted theories of the term structure of interest rates, forward rates closely reflect expected future interest rates.6 When monetary policy tightens, current short-term interest rates increase, either by definition or as a result of reduced supplies of reserves, money, or credit. Forward interest rates, however, may well decline. If monetary policy succeeds in lowering inflation expectations, in particular, the inflation premium in some or all of the forward rates may well be lower. The effect on long-term rates is a weighted average of the effects on the short-term rate and all of the forward rates over the term of the instrument.

Prices of financial assets generally are likely to be affected by the changed level of real interest rates. The discounted present value of the expected cash flows from equity shares and commodities probably will decline as a result of the higher discount factor implied by increased yields on bonds. Moreover, the higher expected real returns on bonds, stocks, and other financial investments are likely to lead to an appreciation of the dollar on foreign exchange markets.

Clearly, effects of changes in monetary policy on interest rates and financial asset prices are likely to precede influences on the economy and inflation. Financial markets are likely to be quite efficient in incorporating new information into asset prices. Indeed, efficient markets theory suggests that these changes should be instantaneous, while standard macroeconomic analysis indicates that the effects on the economy and inflation occur only with lags.

Effects on the Economy and Inflation

The effects of a change in the stance of monetary policy are seen as working through the financial effects sketched out in the preceding paragraphs. Higher real interest rates will directly restrain spending, as businesses and households in effect calculate the reduction in the present value of a higher stock of durables at higher real interest rates. The reduction in wealth stemming from the lower value of financial assets also will restrain domestic expenditures on goods and services. Finally, the higher foreign exchange value of the dollar will tend to depress exports and boost imports, lowering domestic production.

Econometric evidence suggests that these effects become noticeable in the aggregate within two quarters, reach their peak impact after about a year or two, and begin to reverse after several years. Some categories of spending are affected quickly, such as residential housing expenditures, while others, such as nonresidential construction expenditures, are affected with more of a delay.

The influences of monetary conditions on prices of goods and services work at least in part through the changes in aggregate demands described in the previous paragraphs. A restrictive monetary policy, by limiting the demand for goods and services, tends to reduce, or to limit increases in, prices of goods and services in the economy generally.

The natural rate hypothesis has proved particularly useful in the United States in analyzing the connection between real economic developments and inflation pressures. This hypothesis suggests that there is a “natural” rate of unemployment, which is determined by structural labor market factors, such as the quantity and quality of information on job openings and on individuals searching for jobs, as well as the level of unemployment benefits and other factors that influence the opportunity cost of being unemployed. When the actual unemployment rate is equal to the natural rate, the rate of inflation under this hypothesis tends to remain unchanged. When unemployment exceeds the natural rate, downward pressure is placed on wages and thus inflation is likely to fall; when unemployment is less than the natural rate, inflation tends to rise. The natural rate of unemployment—as opposed to the actual rate—is seen as being determined by microeconomic factors, and not by monetary policy.

Theoretical models suggest that inflation expectations, in addition to actual economic conditions, can have an important impact on actual inflation.7 Such expectations can influence inflation partly through long-term price and wage contracts. Expectations of future business costs, prices of competing products, and prices of consumption goods are central in determining contractual prices that will prevail for perhaps several years. In the United States, where inflation has generally been fairly stable in a low to moderate range, inflation expectations tend to move gradually, and short-run movements in inflation are determined predominantly by real economic developments. But inflation expectations give momentum to actual inflation and, at times, “credibility effects”—substantial discrete changes in inflation expectations resulting from significant policy actions—can be important as well in determining the path of inflation.8

The accelerationist model of inflation incorporates a particular assumption regarding the formation of inflation expectations into a natural rate model. Under the accelerationist approach, inflation expectations are assumed to be formed adaptively, on the basis of historical inflation experience, rather than fully rationally on the basis of all available information.9 (Such an assumption is likely to be useful in an economy where inflation rates tend to change gradually and to be less relevant in economies subject to sharply fluctuating rates of inflation.) An implication of the accelerationist model is that there is a short-run trade-off between inflation and output: that is, a short-run Phillips curve exists. Because prices and inflation rates do not adjust instantaneously, an expansionary monetary policy can boost employment and output in the short run. But in the long run, inflation expectations adjust fully to actual inflation, and an expansionary monetary policy can only increase the rate of inflation with no effect on employment or output; there is no Phillips curve trade-off in the long run.10

A considerable amount of empirical work has confirmed that the accelerationist approach is a good description of the inflation process in the United States. Econometric estimates suggest that a one percentage point gap between the actual and natural rates of unemployment sustained for one year tends to reduce the rate of inflation by one-half percentage point.

Although the natural rate hypothesis is quite useful in explaining U.S. inflation developments, it is an oversimplification. Price-setting behavior is influenced not only by conditions in labor markets, but also by conditions in other resource markets and in product markets. The amount of slack in manufacturing plant capacity, for example, is probably an important determinant of prices in the industrial sector. Also, changes in exchange rates have an important direct effect on certain types of price indexes, including consumer price indexes. Moreover, prices of commodities priced in dollars in world markets (in particular, that of oil) can have a significant direct impact on the price level and, during a transition period, on measured inflation rates.

Effects on Financial Aggregates

In general, economic theory suggests that, ceteris paribus, financial stocks are likely to relate fairly closely to nominal measures of income or wealth. For example, as incomes and expenditures expand, the demand for transactions money balances is likely to grow proportionately. And as wealth increases, broad measures of financial assets are likely to grow at a similar pace.

However, as the stance of monetary policy changes, influences other than income on financial aggregates do not remain constant. Consequently, changes in the stance of monetary policy are likely to be reflected in variations in the growth and composition of various financial aggregates relative to the pace of income growth. For example, a tightening of monetary policy initially increases short-term market interest rates. If money balances do not bear explicit returns, or if their returns do not adjust in line with market interest rates, the opportunity costs of holding money balances will increase as a result of a tightening of monetary policy. Consequently, the demand for money balances will tend to fall and, during a transition period, the stock of money will grow at a slower pace than nominal income. However, growth of nominal income is likely to slow as well, first as a result of a temporary deceleration in real output growth and later as a result of lower inflation rates. Ultimately, however, nominal income and money are likely to resume growth at a similar pace.

The direct effects of interest rate changes on the demands for monetary assets tend to occur with some lags. Money holders do not adjust their deposit balances instantaneously in responses to variations in interest rates. Nevertheless, the impact of changes in the stance of monetary policy on monetary aggregates tends to occur before the effects on aggregate demands for goods and services, production, and incomes. (For example, the effects on the monetary aggregates of appreciable movements in interest rates are typically apparent within three months.) Consequently, monetary aggregates historically have had a pronounced tendency to foreshadow future developments in the real economy.

Policy Targets, Indicators, and Information Variables

The practical issue faced by a central bank in conducting monetary policy is deciding on appropriate adjustments to the settings for its various instruments that are most likely to promote the achievement of its ultimate objectives. Economists have long recognized that changing the settings of monetary policy instruments in direct and sole response to currently available data on real economic activity and inflation may be suboptimal. First, reliable data on current activity and inflation usually are available only with a significant delay, owing to time needed by statistical offices to obtain data from individual firms, households, and government agencies and to process that data. Second, monetary policy influences real economic activity and inflation with considerable lags. For both of these reasons, a monetary policy that responds only to available data on recent activity and inflation risks inappropriate effects on the economy—in some circumstances, it may even exacerbate cyclical movements. Therefore, policymakers have attempted to identify variables that reliably predict aggregate demand and inflation. This section discusses a number of variables that have been proposed and, in some cases, actually used in conducting U.S. monetary policy.

The discussion that follows uses the terms target, indicator, and information variable.11 In addition, the terms instrument and objective are used. An instrument is under the direct control of the central bank. As mentioned previously, the principal instruments of monetary policy in the United States are open market operations, the discount rate, and reserve requirements. The ultimate objectives of U.S. monetary policy as established in the Humphrey-Hawkins Act are maximum employment, stable prices, and moderate long-term interest rates.

A monetary policy target is defined as a proximate goal or a guidepost—i.e., a goal that is not an objective per se but is thought likely, if achieved, to promote the attainment of the long-run objectives of policy. Monetary policy targets can be subdivided into operating targets and intermediate targets.

Operating targets are tactical objectives at which a central bank aims in the short run. These may be objectives established for the short interval between policy decisions. Operating targets are a practical necessity for policy implementation, because it is not reasonable that policy instruments be altered continuously in direct response to changing economic circumstances.

Intermediate targets represent objectives that are intermediate between operating targets and ultimate policy objectives. Intermediate targets would be established and, in principle, not be altered for substantial periods of time, such as a full year. While intermediate targets may be useful, they are not a practical necessity as are operating targets, and indeed may not be employed if suitable candidates are not available.

Indicator variables are measures that are not targeted by the central bank, but provide reliable signals as to the stance of monetary policy. Economists have long searched for such measures, which would provide a basis for objective assessments of whether monetary policy is “tight” or “easy.”

A third useful classification of measures relevant to monetary policy is that of information variables. Information variables are potentially useful for monetary policy, but are distinguished from target variables in that the appropriate levels or growth rates of such variables vary considerably depending on economic and financial circumstances, so that useful targets may not be set. Although targeting such variables is not likely to be productive, they nevertheless provide important information about aggregate demand and inflation pressures.

In this section, three basic groups of variables are considered as potential targets, indicators, or information variables for monetary policy: financial aggregates; interest rates and financial asset prices; and real economic variables and inflation measures. The advantages and disadvantages of specific variables within each of these groups are considered.12

Financial Aggregates

Financial aggregates merit considerable attention as targets for monetary policy. Monetary theory suggests that, over long periods of time and in a relatively stable financial environment, financial aggregates are likely to move broadly with nominal income or measures of nominal wealth. Because of this characteristic, financial aggregates may be suitable to serve as a nominal anchor: a variable that can be reliably targeted so as to achieve price stability. In the United States, a number of monetary aggregates have been proposed or actually used as intermediate targets.

Narrow Monetary Aggregates. Historically, narrow monetary aggregates have been considered to be potentially the most reliable indicators of future spending propensities. Narrow monetary aggregates, by definition, consist of transaction balances or measures closely related to transaction balances. Because transaction balances are necessary for spending, aggregate transaction balances should bear some relationship to aggregate expenditures.

M1. In the United States, M1 is the standard measure of transaction balances. M1 consists of currency and coin, demand deposits, and other checkable deposits. (Other checkable deposits are interest-earning balances with no restrictions on transactions; such deposits became available to households, nonprofit organizations, and municipal governments on a nationwide basis beginning in the early 1980s.)

Over most of the 1960s and 1970s, the velocity of M1 was reasonably predictable. The demand for M1 was somewhat interest elastic, but not excessively so. The interest elasticity reflected the fact that the opportunity cost of holding M1 balances varied with the level of interest rates, as currency and demand deposits did not earn explicit interest.

Reflecting recognition of the reasonable stability and predictability of M1 velocity, the Federal Open Market Committee adopted formal targets for M1 growth beginning in the mid-1970s. Under the requirements of the Humphrey-Hawkins Act, passed into law in 1978, the Federal Reserve began to set and announce annual targets for M1 growth in 1979, along with targets for other money and credit measures.

These targets were not interpreted as absolute numerical objectives. Indeed, both the Federal Reserve and the Congress recognized that changing circumstances could require allowing actual money growth to deviate from target.13

Nevertheless, the Federal Reserve placed considerable weight on its M1 target for a period of about three years beginning in October 1979. At that time, faced with mounting inflation rates and inflation expectations, the Federal Reserve modified its operating procedures to ensure better control over growth of the money stock, especially M1, by targeting nonborrowed reserves.14 The Federal Reserve employed these operating procedures until late 1982.15

In October 1982, the Federal Reserve formally abandoned the nonborrowed reserves operating procedure. By that time, it had become apparent that the velocity of M1 had become considerably more variable. The increased variability of velocity is now recognized to have resulted from a much heightened interest rate sensitivity that stems primarily from the other checkable deposits component of M1. Interest returns on other checkable deposits adjust only sluggishly when short-term market interest rates vary. Households tend to keep a large volume of “savings” funds in such accounts when market interest rates are low, but when market interest rates rise, a substantial proportion of such funds is redirected outside of M1.

Consequently, M1 has become extremely interest elastic, contributing to the instability of its velocity. As a result of these developments, the Federal Reserve ceased setting annual target ranges for M1 growth in 1987.

In more recent years, M1 growth has been appreciably distorted by two additional developments. Foreign demands for U.S. currency have grown more rapidly than domestic demands, and not entirely smoothly.16 In addition, the levels of demand deposits have been significantly affected by huge waves of mortgage refinancing activity as long-term interest rates moved irregularly to twenty-year lows. Because of regulations, these refinancings have caused associated balances in demand deposits to rise and fall sharply in several periods, with corresponding distortions in the growth of M1.17

Although deregulation and other changes in financial circumstances have reduced the usefulness of M1 as an intermediate target, it nevertheless appears to retain a fairly stable demand function. Federal Reserve staff have found that this relationship can be used to obtain marginal improvements in estimates of current gross domestic product (GDP), given the observed quantities of money and the level of interest rates. Consequently, M1 retains some usefulness as an information variable for monetary policy. However, it does not appear to have useful indicator properties at present.

Monetary Base. The monetary base can be considered a narrow monetary aggregate. Measurement of the monetary base can proceed from the asset side of the central bank’s balance sheet or from the liability side. In the United States, the monetary base is more frequently derived from the liability side. In these terms, the monetary base is essentially equal to the sum of Federal Reserve currency outstanding and banks’ reserves held at Federal Reserve Banks.

The close relationship between the monetary base and the central bank’s balance sheet has been seen by some analysts as arguing in favor of targeting the base. These analysts stress the fact that a central bank can more closely control growth of its balance sheet (and hence the monetary base) than broader measures of money. Also, these analysts consider increases in the monetary base as the necessary “raw material” for expansion of the money stock. In the United States, however, institutional considerations and empirical relationships have tended to suggest that a key role for the monetary base, particularly as an intermediate target for monetary policy, would not be beneficial.

First, the monetary base is closely related to M1, and for that reason shares some of the less desirable characteristics of that aggregate. The largest component of the base (accounting for about three-fourths of it) is currency; as noted above, currency growth in recent years has been affected considerably by foreign currency demands. The other component, reserve balances, relates closely to required reserves.18 Because reserve requirements currently are assessed only on transaction balances (demand deposits and other checkable deposits), which are the deposit components of M1, the reserve balance component of the monetary base tends to be closely associated with the deposit component of M1.19 For these two reasons, movements in the monetary base relate to those of M1; in effect, the monetary base represents a re-weighting of the components of M1.

Staff of the Federal Reserve Board have conducted an empirical investigation of the properties of a nominal-income targeting rule using the monetary base as an operating target (Hess, Small, and Brayton, 1993). This research found that the linkages between the base and nominal income weakened over the past decade, that conclusions regarding the usefulness of the base as an operating target were quite sensitive to econometric estimates of various coefficients, and that the federal funds rate may be preferable as an operating target to the monetary base.20

Total, Nonborrowed, and Borrowed Reserves. Occasionally, proposals for the use of reserves as a monetary policy target arise. In general, institutional considerations and empirical relationships do not support the use of such variables as intermediate targets. The relationship of total reserves and nonborrowed reserves to nominal income is indirect and quite loose. Nevertheless, policymakers monitor reserves growth carefully, for excessive growth in reserves ultimately would be inflationary.

Reserve measures may usefully be employed as operating targets in some circumstances. As mentioned previously, the Federal Reserve used nonborrowed reserves as an operating target between 1979 and 1982. Subsequently, borrowed reserves were used as an operating target for a number of years, in view of a fairly close empirical relationship between the difference between money market interest rates and the discount rate and the volume of borrowed reserves. That relationship has since weakened considerably, however, and borrowed reserves currently play only a formal key role in the specification of the short-run stance of policy.

Broader Monetary Aggregates

As M1 became less reliably linked to economic developments and inflation pressures beginning in the early 1980s, the Federal Reserve began to place more weight on the broader aggregates, especially on M2. More recently, however, the velocities of these broader aggregates have themselves become more variable and difficult to predict. Consequently, Federal Reserve staff have searched for useful alternative broad monetary measures.

M2 and M3. The monetary aggregate M2 consists of M1 as well as retail savings and time deposits, shares in certain money market mutual funds, and certain bank-managed liabilities with one-day terms to maturity. M3 adds to M2 additional categories of managed liabilities and money market mutual funds. Historically, movements in M2 primarily represented shifting household demands for very liquid or safe assets with relatively low denominations, while M3 was more closely associated with the funding needs of bank and thrift institutions.

During the 1980s, econometric research identified what appeared to be a stable linkage between the demand for M2, market interest rates, and nominal income.21 The basic relationship can be summarized in graphical form, where the velocity of M2 is related to the opportunity cost of holding M2. The opportunity cost of holding M2 is defined as the return on holding three-month treasury bills (an investment alternative to holding M2-type assets) minus the average return on the instruments in M2. A separate line of research—referred to as the P* model—suggested that, in the long run, the rate of inflation was tied closely to the growth of M2 (Hallman, Porter, and Small, 1991).

The close relationship between M2 velocity and interest rates broke down around the turn of the current decade. M2 velocity rose well above the level that would be suggested by its opportunity cost as defined above. As this relationship became less and less reliable, the Federal Reserve gradually reduced the weight accorded to this aggregate in the conduct of monetary policy. The velocity of M3 was affected similarly, as the relative role of depository institutions in extending credit declined while that of open market sources of funds rose. The P* model appeared to break down simultaneously.

During the last few years, the Federal Reserve has continued to establish annual ranges for M2 and M3. The Humphrey-Hawkins Act requires the Federal Reserve to establish ranges for some monetary aggregates, and at the current time no monetary aggregate has been identified that clearly has superior properties as a target or indicator. M2 and M3 continue to be monitored closely as information variables, but are no longer used as intermediate targets.

M2+. As the relationships between the standard broad aggregates and nominal income have loosened over recent years, the Federal Reserve has investigated alternative monetary aggregates. One possible aggregate that has received considerable attention has been dubbed M2+. This aggregate adds balances in stock and bond mutual funds to M2.

The velocity of M2+ over the past few years has been more stable than that of M2. On the other hand, Federal Reserve staff analysis has failed to uncover a stable, robust demand function for the aggregate. Also, questions can be raised about the potential indicator value and information content of an aggregate whose value can fluctuate considerably with changes in stock and bond prices.

In view of these considerations, the Federal Reserve staff continue to monitor M2+ and to conduct studies of its behavior. The Federal Open Market Committee, however, has not adopted targets or monitoring ranges for this aggregate.

Credit Aggregates

Broad measures of debt and credit have also been used as targets, indicators, or information variables for monetary policy in the United States. The Humphrey-Hawkins Act, in fact, requires the Federal Reserve to establish annual target ranges for a measure of credit, in addition to targets for monetary aggregates.

In the late 1970s and early 1980s, the Federal Reserve set targets for bank credit—i.e., the total amount of credit provided by commercial banks, through direct loans and through securities purchases, to households, businesses, and governments.22 Changing structural conditions in U.S. financial markets, however, were eroding the role of banks in financing economic activity: In particular, businesses were making more use of open markets and foreign banking institutions in obtaining financing, loosening the relationship between bank credit and overall economic activity. Consequently, the Federal Reserve ceased establishing annual ranges for bank credit in 1984.

Benjamin Friedman (1982) presented empirical evidence that appeared to suggest a reliable relationship between aggregate credit and nominal income. After further empirical work, the Federal Reserve in 1984, to meet the requirements of the Humphrey-Hawkins Act, began to adopt target ranges for domestic nonfinancial sector debt, which is defined as the total debt of nonfinancial business firms, households, governments, and other nonfinancial entities in the United States. Experience with this aggregate has not been entirely satisfactory: Its velocity has moved over a much wider range than expected. Velocity of debt fell considerably in the mid-1980s, as leverage of businesses and households increased dramatically and government deficits burgeoned. Debt velocity subsequently rose, as attitudes toward debt became much more cautious.

In general, policymakers’ confidence regarding the use of debt aggregates as targets, indicators, or information variables is less strong than it has been historically for targeted monetary aggregates. Unlike monetary aggregates, a reliable theory of the relationship between aggregate debt and income has not been developed. Moreover, empirical evidence does not suggest that credit measures necessarily tend to lead spending and incomes; to the extent that a relationship exists, it may be contemporaneous rather than predictive. Finally, experience of the past fifteen years or so strongly suggests that debt aggregates are not related in a simple, unchanging way to spending and incomes.

Nevertheless, the Federal Reserve in the last few years has closely monitored credit conditions—including the behavior of credit aggregates, the terms and conditions set by banks on loans and credit developments in open markets, and households’ and firms’ attitudes toward balance sheets and debt-servicing burdens. The economic downturn in 1990 and 1991 appears to have been exacerbated by a much more cautious attitude of borrowers toward credit and a heightened reluctance of lenders to extend credit, especially to borrowers of less than top quality.

Interest Rates and Financial Asset Prices

Interest rates (real or nominal) are another class of potential targets, indicators, or information variables. The attraction of nominal interest rates is heightened by the ability of a central bank to control them closely, especially those at short maturities.

Nominal Interest Rates

Although nominal interest rates have the advantage of controllability, they are unlikely to be satisfactory intermediate targets for monetary policy. Indeed, using nominal interest rates as intermediate targets may be seriously misleading. For example, assume that the central bank targeted a nominal interest rate of 6 percent and that the economy was initially in a noninflationary equilibrium. Assume next that spending propensities exogenously increased. The stronger spending tendencies would increase production and raise inflation rates. As the central bank took steps to maintain the nominal interest rate at 6 percent in the face of rising inflation expectations, real interest rates would automatically decline. The fall in real interest rates would further stimulate demand and exacerbate the increase in inflation and inflation expectations. (The converse of this analysis holds for negative spending shocks.) Thus, using nominal interest rates as intermediate targets, in the absence of frequent feedback from some variable tied to aggregate demand, is likely to be unstable.

Nevertheless, nominal interest rates in some circumstances may be quite useful as operating targets. Depending on institutional considerations, such interest rates may be quite controllable. This characteristic obviously improves the precision of monetary control. Probably more importantly, it conveys reasonably clearly to the markets changes in the stance of monetary policy. As an operating target, nominal interest rates must be subject to frequent adjustment in light of incoming monetary, financial, and economic data. In the United States, the interest rate on overnight interbank funds (the federal funds rate) is used by the Federal Reserve under current procedures as an operating target. The Federal Open Market Committee at each meeting (roughly every six weeks) specifies that the Federal Reserve Bank of New York is to maintain, increase, or decrease the existing degree of reserve pressure. These instructions translate directly into operating targets for the level of the federal funds rate.

In some countries, the monetary authority may be required to stabilize interest rates in order to ease the financing of government deficits. Indeed, in the United States an explicit agreement to do so existed during the 1940s. However, steps have since been taken to draw a sharp line between debt management policy and monetary policy. In March 1951, the Federal Reserve and the Treasury entered into an accord that considerably reduced the Federal Reserve’s responsibilities for assisting with debt management by stabilizing interest rates.23 In the 1980s, legislation was enacted that prohibited the Treasury from borrowing directly from the Federal Reserve. In recent decades, the Treasury’s Financing activities have seldom been a significant consideration in the design and implementation of U.S. monetary policy.

Slope of the Yield Curve

In recent years, the slope of the yield curve has also been proposed as a useful indicator for monetary policy. This view holds that a steepening of the yield curve would indicate that inflation expectations are increasing and would suggest a tightening of monetary policy. The increased inflation expectations would be reflected in higher inflation premiums in long-term interest rates, but not in shorter-term interest rates, which would be tied down in the short run by monetary policy. Conversely, recessionary tendencies would tend to lower inflation expectations and longer-term interest rates, leading to a flattening of the yield curve, so that suggesting an easing of monetary policy would be appropriate.

Several considerations enter into the evaluation of the yield curve as a policy indicator. First, inflation expectations must be reasonably sensitive to actual demand and inflation pressures for this indicator to be useful. If long-term interest rates, by contrast, are determined importantly by factors other than demand pressures and inflation expectations (such as temporary supply and demand circumstances in the bond market or fluctuations in investor sentiment), long-term interest rates will tend not to reflect underlying inflation pressures very closely.

A second potential difficulty with this approach is that the behavior of longer-term interest rates depends importantly on investors’ perceptions of the central bank’s behavior. If, for instance, investors believe that the central bank will react aggressively to any signs of inflationary pressures, inflation expectations might not rise much and the yield curve in fact might not steepen much in response to inflation pressures.24

A third problem is that a given slope of the yield curve can be consistent with any stable rate of inflation. Thus the yield curve in isolation is not useful as a monetary policy target.

Despite the difficulties of using the term structure as a policy target or indicator, the Federal Reserve examines closely the term structure of interest rates for clues about inflation expectations and credit market pressures. The decomposition of long-term rates into forward rates that was described above has, in recent years, been found to be a particularly interesting way to analyze financial markets for information relevant to the conduct of monetary policy. In current circumstances, the yield curve has been found to be a useful information variable for U.S. monetary policy.

Commodity Prices

Commodity prices have also been suggested as an indicator of monetary policy. Commodity prices are set in continuous auction-like trading, and hence quickly reflect changes in underlying supply and demand conditions. By contrast, wages and finished-product prices may be set by contracts that do not change for long periods of time, or may change sluggishly for other reasons, and thus are not sensitive indicators of price pressures. Moreover, because commodities may be quite durable, their prices tend to reflect expectations of prices and costs well into the future. For the purposes of monetary policy, a single sensitive commodity (such as gold) could be used, or an index of a basket of commodities could be employed. The key issue is whether commodity prices are good indicators of inflation expectations and actual inflation pressures.

To the extent that commodities are used as industrial inputs, they are subject to idiosyncratic supply and demand forces in particular industries. These forces are likely to affect the prices of these commodities, independent of overall inflation pressures in the economy. This is particularly true of economies such as the United States, where the industrial sector does not dominate overall economic activity. On the other hand, prices of commodities such as gold, where the stock greatly exceeds current industrial demands and new supplies, are likely to more closely reflect inflation expectations. They also are heavily influenced, however, by political and economic developments worldwide, and hence do not necessarily provide accurate indications of domestic inflation pressures.

Although commodity prices have some drawbacks, many policymakers find that at times they provide useful information, when viewed in the context of a range of other indicators. Consequently, the Federal Reserve monitors commodity prices informally in the conduct of policy.

Exchange Rates

A central role for exchange rates in U.S. monetary policy has occasionally been proposed. Exchange rates are used by many countries, of course, as intermediate targets and, often, as operating targets for monetary policy. Exchange rates are an important channel through which monetary policy can affect the economy. Moreover, exchange rate misalignments can lead to serious imbalances in trade and current accounts.

In the United States, exchange rates are not currently used as targets. U.S. exports and imports, while sizable relative to aggregate economic activity, are not as proportionately large as in many other countries. Nevertheless, exchange rate movements can have a direct impact on measured inflation rates and do importantly affect aggregate demand. Consequently, exchange rates are monitored closely in the United States as indicators for monetary policy.

Real Interest Rates

Given the difficulties associated with the monetary aggregates as targets and indicators in the United States in recent years, increased attention has been devoted to the use of real interest rates in the conduct of policy. Real interest rates play a central role in the determination of aggregate demand and inflation pressures in many theories of the macroeconomy. Moreover, a concept of a “natural real rate” can be developed that integrates neatly into the theory of inflation that was sketched out in the discussion of effects on the economy and inflation,25 Under this approach, when the actual real rate of interest is at the natural real rate, aggregate demand is equal to the amount of production that will place actual unemployment at the “natural rate” of unemployment.

Thus, when the actual real rate of interest is equal to the natural rate, the economy is at full employment (defined as the actual rate of unemployment equal to the natural rate of unemployment) and the inflation rate is constant, tending neither to rise nor to fall. When the actual real rate of interest is below the natural rate, unemployment falls below the natural rate and inflation increases. When the real interest rate is above the natural rate, aggregate demand is insufficient to keep unemployment at its natural rate, and inflation tends to fall. Monetary policy, under this approach, should aim to keep the real interest rate at the natural rate when the economy is at full employment. When inflation threatens, real rates should be raised above the natural rate; when recession is the larger risk, real rates should be moved below the natural rate.26 Because of the lags between changes in interest rates and subsequent variation in demand and inflation, real interest rates can be important forward-looking indicators.

Obviously, reliance on the real interest rate as a target or indicator for monetary policy requires estimates both of the real rate and of the natural real rate. A key difficulty in making the first estimate is that inflation expectations, which must be subtracted from nominal rates to obtain real rate estimates, are not directly observable. Federal Reserve staff members rely on surveys of households, investors, and forecasters and on moving averages of past inflation rates to obtain such estimates. These approaches, however, are clearly subject to considerable error. Measuring the natural real rate is even more difficult, both because measuring real rates is problematic and because the natural rate may vary depending on economic circumstances, especially exogenous factors that affect the level of aggregate demand, such as government spending and the strength of foreign economies. In the United States, various econometric models have been used to make such estimates. Different techniques have produced considerably different estimates, even for the same time periods. Estimates also vary by the term to maturity and other characteristics of the interest rate, such as the credit quality of the underlying instrument.

Although econometric techniques have not produced precise estimates of natural rates of interest that can be used as policy targets, their important role in determining aggregate demand and a rough idea of likely equilibriums has permitted real interest rates to be used as important indicators of monetary policy in the United States.27

Data on Economic Developments and Inflation

The use of data on real economic developments and on inflation to guide monetary policy has obvious appeal, as they measure directly the extent to which a central bank achieves its macroeconomic goals. However, as noted above, this approach is fraught with dangers: Because monetary policy affects the economy and inflation with considerable lags, a monetary policy that responds to contemporaneously observed economic and inflation developments is likely to delay appropriate actions and thus risk further destabilizing the economy. Moreover, by definition, real economic variables and inflation measures cannot be used as operating targets or as intermediate targets. They also cannot be used reasonably as indicators of monetary policy. Real economic developments and inflation pressures, while subject to considerable influence by monetary policy over longer periods of time, are affected by many factors other than monetary policy.

Nevertheless, in the absence of reliable financial indicators, real economic and inflation data need to be examined closely to determine both the current state of the economy and of price pressures as well as potential future trends. Reliable data on employment, production, incomes, and expenditures are invaluable in determining whether aggregate output is above or below the economy’s potential and is contributing to rising or falling inflation rates. Clearly, suitable sampling techniques for gathering raw data and adequate resources for processing them are crucial for the provision of reliable and timely macroeconomic data. Particularly important in the provision of useful data on the economy are statistics that provide information on future economic developments, such as new orders, unfilled orders, inventories, housing starts, future government outlays and receipts, and surveys on expectations of future economic conditions.

The United States enjoys a wealth of statistical information on the economy. Federal Reserve policymakers and staff analyze these data in depth to obtain clues on the trajectory of the economy. However, it is generally recognized that these data are an inadequate basis, in themselves, for good monetary policy.

Concluding Remarks

Monetary policymakers in the United States have available a broad range of potential targets, indicators, and information variables. These variables range from traditional financial aggregates to interest rates to data on the real economy and inflation. These alternatives have considerably different characteristics as targets and indicators; also, their characteristics may vary considerably from one era to another, depending especially on economic and financial structural circumstances.

In recent years, no single variable, or even a small set of variables, has been deemed to be a reliable target for U.S. monetary policy. Some variables have become notably less reliable—particularly monetary aggregates. Consequently, these measures have received less weight in the formulation of monetary policy. As a consequence of these developments, a broad range of variables are monitored by the Federal Reserve in conducting monetary policy, including (but not limited to) all of the measures discussed in this paper.

The lack of a single, small set of reliable policy variables obviously complicates the task of conducting monetary policy. The selection of the appropriate stance for monetary policy is made more difficult. But perhaps equally significant, it increases the difficulty of monitoring the stance of monetary policy by borrowers, lenders, the Congress, and the public generally. For these reasons, the Federal Reserve has continued to conduct intensive research into possible approaches to monetary policy that would be more “rule-based” and less discretionary than those currently employed, but none have yet been uncovered that seem superior to the current judgmental approach.

Particularly in these circumstances, the Federal Reserve must be careful in the design and implementation of policy to husband its credibility, for it cannot point to a monetary aggregate or other measure that establishes clearly that its policy is noninflationary and consistent with sustainable growth. Consequently, the importance of achieving a consistent record of noninflationary growth for maintaining monetary policy credibility, with its benefits for the efficient conduct of monetary policy, cannot be overemphasized.


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The views expressed in this paper are those of the author and do not necessarily reflect those of the Board of Governors of the Federal Reserve System, where he is Associate Director of the Division of Monetary Affairs.


For more detailed consideration of some of the issues raised in this paper, see Federal Reserve Bank of New York (1990).


A discussion of the selection of monetary policy objectives, targets, and instruments in developing countries was presented by Coats and Khatkhate (1980).


Under current operating procedures, the reserve effects of any foreign exchange intervention activities are sterilized through open market operations in government securities.


An extensive discussion of a large macroeconometric model that is based on mainstream macroeconomic theory and that is used by the Board staff for analysis of alternative policies and for forecasting was provided by Brayton and Mauskopf (1985).


The difficulty of quantitatively assessing economic relationships is illustrated by comparing results found by Mauskopf (1990) and Benjamin Friedman (1989), both of whom addressed econometrically the issue of changing economic relationships. Mauskopf finds that, during the 1980s, the effects on the real economy of a change in the stance of monetary policy were little different than in earlier decades. Friedman, by contrast, uncovers evidence of altered sensitivities of various types of spending. Mauskopf did. however, find evidence of considerable changes in financial relationships.


Under the pure expectations theory, with risk-neutral investors forward rates are equal to expected future rates. Under theories that allow for risk-averse investors, forward rates are equal to expected future rates plus premiums that allow for the risk of future changes in interest rates. A useful discussion of term structure theory is available in Van Horne (1990).


Taylor (1982) presents a more complete discussion of the role of expectations in the formulation of monetary policy.


In recent years, economists have produced a large volume of research on credibility in monetary policy. A summary of this research is presented by Blackburn and Christensen (1989).


Although research surrounding the rational expectations approach to macroeconomics has clarified many issues in the determination of output and inflation, empirical analysis has not shown it to be a good description of the macroeconomic structure of most economies. The rational expectations approach posits that firms, households, borrowers, and lenders use all information efficiently in forming expectations. Under simple rational expectations approaches, there is no trade-off, even in the short run, between inflation and unemployment. More complicated rational expectations models that allow, for example, for contracting often do indicate a short-run trade-off.


A more detailed exposition of the accelerationist model of inflation can be found in Chapter 15 of Dolan and Lindsey (1994).


The terminology of targets, instruments, and indicators was formalized by Brunner and Meltzer (see Brunner and Meltzer (1967)) and Brunner (1969) and Benjamin Friedman (1975).


An econometric evaluation of alternative indicators for monetary policy was prepared by Evans, Strongin, and Eugeni (1993).


The Humphrey-Hawkins Act indicates that “Nothing in this Act shall be interpreted to require that the objectives and plans with respect to the ranges of growth or diminution of the monetary and credit aggregates disclosed in the reports submitted under this section be achieved if the Board of Governors and the Federal Open Market Committee determine that they cannot or should not be achieved because of changing conditions: Provided, that in the subsequent consultations with, and reports to, the aforesaid Committees of the Congress pursuant to this section [the House and Senate Banking Committees], the Board of Governors shall include an explanation of the reasons for any revisions to or deviations from such objectives and plans.”


Previous procedures called for setting a level of the federal funds rate that was judged to be consistent with desired money supply growth. The new monetary control procedure involved the establishment of target paths for nonborrowed reserves designed to be consistent with desired growth in M1. (Nonborrowed reserves are defined as total reserves, less the volume of reserves obtained by borrowing from the discount window.) If money growth rose above target, the Federal Reserve would hold nonborrowed reserves to their path, and banks would be forced to obtain the increment to required reserves from the discount window. Given banks’ reluctance to turn to the window, the resulting increase in money market interest rates would tend to reduce money demand over time, helping to return money growth to target.


An assessment of experience under the nonborrowed reserves operating procedures was presented in New Monetary Control Procedures (see United States, Board of Governors of the Federal Reserve System, 1981).


Federal Reserve staff estimate that as much as two-thirds of U.S. currency is currently outside the United States.


Broader monetary aggregates also have been affected by these developments, but to a smaller extent proportionately than M1.


Depository institutions must hold their required reserves either in vault cash or in deposits with Federal Reserve Banks (reserve deposits). Institutions also may hold additional reserves, termed excess reserves. Consequently, reserve balances are equal to required reserves plus excess reserves minus vault cash applied to reserve requirements.


The required reserve ratio on transaction balances is 3 percent at each institution for balances up to $51.9 million and 10 percent for balances above that level.


It should be noted that the authors of the cited research used the term “instrument” in a sense closer to the use of the term “target” in this current paper.


An important contribution to this research was made by Moore, Porter, and Small (1990).


Bank credit is defined to exclude liquid funds provided by banking firms to other banks and to thrift institutions.


The Federal Reserve retained its statutory responsibilities for serving as fiscal agent for the Treasury, which include conducting auctions of treasury securities as agent, operating a “book-entry” system for recording the ownership of treasury securities, and maintaining deposit accounts for the Treasury.


This issue and other related questions were explored by Fuhrer and Moore (1992).


Milton Friedman (1968) articulated this approach.


Reinhart (1993) presents a more formal analysis of possible roles for real interest rates in the monetary policy process.


Federal Reserve Board Chairman Greenspan (1993) presented to the Congress an overview of the potential use of real interest rates in current circumstances.

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