Abstract

Since the mid-1970s, monetary aggregates have been the intermediate targets of Federal Reserve policy. Targeting the growth in monetary aggregates implicitly assumes that the relationship between changes in growth in the monetary aggregates and economic activity is sufficiently reliable that the ultimate goals of monetary policy can be achieved by using monetary aggregates as intermediate targets. The Federal Reserve generally has established target ranges for the growth rates of Ml, M2, and M3 during the calendar year.59 With the Full Employment and Balanced Growth Act of 1978, Congress mandated that the Federal Reserve set annual target ranges for growth in monetary and credit aggregates and report these targets to Congress twice each year.

Intermediate Targets and Instruments

Since the mid-1970s, monetary aggregates have been the intermediate targets of Federal Reserve policy. Targeting the growth in monetary aggregates implicitly assumes that the relationship between changes in growth in the monetary aggregates and economic activity is sufficiently reliable that the ultimate goals of monetary policy can be achieved by using monetary aggregates as intermediate targets. The Federal Reserve generally has established target ranges for the growth rates of Ml, M2, and M3 during the calendar year.59 With the Full Employment and Balanced Growth Act of 1978, Congress mandated that the Federal Reserve set annual target ranges for growth in monetary and credit aggregates and report these targets to Congress twice each year.

During the 1980s, however, the relationship between monetary aggregates and economic activity became less stable and less predictable, especially in the short run.60 In light of the increased uncertainty surrounding the link between money and economic activity, the Federal Reserve has not set a target range for M1 since 1986, widened the ranges for both M2 and M3 for 1988, and maintained these wider ranges for M2 and M3 in 1989 and 1990. Furthermore, the Federal Reserve has broadened the scope of the variables that it monitors in formulating and evaluating policy to include a wide range of what it considers to be leading indicators of the course of the economy and inflation, such as commodity prices, exchange rates, the yield curve, and indicators of incipient pressures in the real economy.61 That these indicators have played a relatively important role in the formulation of monetary policy can be inferred, for example, from the Federal Reserve’s actions during the first five months of 1988. As noted in its July 1988 report to Congress, the Federal Reserve eased its monetary policy stance from late January to late March, and then became progressively less accommodative through late May.62 As these changes in policy stance occurred while the targeted aggregates (M2 and M3) were within their target ranges, it seems reasonable to infer that these policy changes were in response to movements in variables other than M2 and M3. Moreover, the Federal Reserve eased its policy stance several times during the last several months of 1989 while the growth of M2 was at the midpoint of its target range.

In response to signals relating to the future course of output and prices, the Federal Reserve can choose among several instruments to influence monetary and credit conditions. The two instruments discussed below are those currently employed most frequently.63 The primary instrument of monetary policy is open market operations in which the Federal Reserve buys or sells securities, thereby adding reserves to, or draining reserves from, the banking system. While the Federal Reserve is authorized to conduct open market operations in a variety of securities, it has chosen to conduct most transactions in U.S. Treasury securities because the treasury security market is extremely broad and deep, and therefore substantial purchases or sales of these securities will not have a significant impact on their yield. Most open market operations typically are not outright purchases or sales that permanently influence bank reserves, but rather take the form of repurchase or matched sale-purchase agreements that affect the level of reserves only temporarily.64 The Federal Reserve typically makes only six to ten outright purchases or sales each year. It uses repurchase or matched sale agreements more frequently, because it considers most of its open market operations to be defensive, that is, to offset temporary fluctuations in reserves. These agreements typically last for only 1 day, rarely for more than 7 days, and never exceed 15 days.65

Of secondary importance is the use made by depository institutions of the discount window at each Federal Reserve bank in acquiring reserves at their own initiative. Discount window credit is available upon request by a depository institution, but is subject to approval by the Federal Reserve Bank within the district in which the borrower is located. Depository institutions are not entitled to a specific quota of discount window credit to be used at their complete discretion; rather, the discount window is regarded by the Federal Reserve as a marginal source of funds that is to be used sparingly when other sources are not readily available. The Federal Reserve generally sets its discount rate (the rate it charges depository institutions for short-term loans) below short-term market rates. Hence, borrowed reserves obtained through discount window credit are rationed by administrative guidelines, as well as by price. As future access to the discount window is reduced for those institutions that use this source of credit too frequently, such reduced availability constitutes an additional implicit cost of using the discount window. Nonetheless, institutions generally become more willing to incur this cost as the spread between market interest rates and the discount rate widens, so that the demand for borrowed reserves is a positive function of the spread between short-term market rates (particularly the federal funds rate)66 and the discount rate.

There are three types of discount window credit. Adjustment credit consists of short-term loans extended by Federal Reserve banks to depository institutions to help them meet temporary reserve needs. Most institutions repay these loans within a few days; the largest banks are required to repay this credit the next business day. Seasonal credit consists of longer-term loans to smaller depository institutions that have relatively strong seasonal patterns in their deposits or loan demand. These two types of borrowing are affected by changes in the spread between the federal funds rate and the discount rate, rising when the spread widens and falling when the spread narrows. The third type of discount window credit is extended credit; it is longer-term credit extended to institutions experiencing such severe financial problems that they face prolonged difficulties in obtaining funds from other sources. Extended credit borrowing is considered to be relatively insensitive to interest rates and is normally not included in the measure of borrowing by depository institutions that is used by the Federal Reserve in implementing monetary policy.

Policy Formulation and Operating Procedures

The Federal Open Market Committee (FOMC) formulates monetary policy and issues directives for its implementation. The FOMC is composed of the seven Governors of the Federal Reserve Board, the President of the Federal Reserve Bank of New York, and four of the eleven presidents of the remaining Federal Reserve banks who serve on a rotating basis. The FOMC meets eight times a year (approximately every six weeks), evaluates current policy within the context of the state of the economy, and then decides on a short-run (that is, until the next meeting) course for policy that is broadly consistent with its longer-term intermediate targets and policy goals, but that also reflects the current state of the economy. At two meetings a year, longer-term monetary growth targets are determined. The period covered by the targets is from the fourth quarter of one calendar year to the fourth quarter of the next calendar year. In late June or early July the FOMC re-evaluates the current year’s targets and proposes provisional targets for the next year. In late January or early February of the following year, these provisional targets are reconsidered and final targets agreed on for the current year.

The intermeeting policy stance decided by the FOMC is embodied in a directive—a relatively specific set of instructions governing the implementation of policy during the intermeeting period. The directive is issued to the Federal Reserve Bank of New York, which acts as the agent of the FOMC in conducting open market operations. The FOMC identifies a control variable that guides the day-to-day purchase and sale of securities, describes in general terms how the short-run path for the control variable is to be altered in light of unexpected economic developments, and defines the scope within which the Federal Reserve Bank of New York may operate without consulting the entire FOMC. The general directive from each FOMC meeting is contained in the minutes of that meeting which are released to the public on the Friday following the succeeding FOMC meeting. More specific directives, released annually by the Federal Reserve Bank of New York, for 1988 are summarized in Table 6.

Table 6.

United States: Directives from the Federal Open Market Committee, December 1987–December 1988

article image
Source: “Monetary Policy and Open Market Operations during 1988,” Quarterly Review, Federal Reserve Bank of New York (New York), Vol. 13, No. 4/Vol. 14, No. 1 (Winter–Spring 1989), pp. 83–102.

A technical adjustment only due to a perceived shift in the relationship between borrowing and the spread between the federal funds and the discount rates.

Since the advent of targeting monetary aggregates, the FOMC has identified three different control variables in its directive and in effect has employed three somewhat different operating procedures to implement monetary policy.67 Prior to October 1979, the directive specified a relatively narrow range within which the federal funds rate was to be contained by open market operations. Whenever growth in the monetary aggregates was slower or faster than desired, the FOMC would adjust the acceptable range for the federal funds rate. As the control of inflation became increasingly more difficult with this approach for implementing monetary policy, the Federal Reserve adopted a new procedure in October 1979 designed to improve monetary control. This new procedure redirected attention away from controlling the federal funds rate to controlling the supply of nonborrowed reserves (that is, the reserves of the banking system not supplied through the discount window). Specifically, the intermeeting target path for growth in the monetary aggregates was translated into a target path for nonborrowed reserves; the Federal Reserve Bank of New York then aimed open market operations at achieving this target path for nonborrowed reserves. This reserves-oriented procedure played an important role in the disinflationary process of the early 1980s.68

The nonborrowed reserves procedure depended critically on the existence of a predictable, reliable relationship between the monetary aggregates and economic activity. In particular, the operation of this procedure did not involve any automatic accommodation of shifts that may have occurred in the demand for money. To the extent that such shifts did occur, they affected the real economy unless the short-run operating target for nonborrowed reserves was explicitly altered to accommodate the demand shifts. Without such an accommodation, shifts in money demand were transmitted directly to the real economy via interest rate changes. If money demand shifts were infrequent or relatively predictable, the nonborrowed reserves operating procedure would be appropriate.

Especially in the early 1980s, however, more frequent and less predictable money demand shifts were observed (at least ex post), due in large part to financial deregulation and innovation. Moreover, even after the adjustment to these changes had taken place, the demand for money (especially M1) was found to be significantly more interest sensitive than it had been before.69 Partly on account of these developments, the Federal Reserve moved in late 1982 to a less automatic, more judgmental approach that has continued to the present and that places primary emphasis on borrowed reserves.70 The increased use of discretion inherent in this procedure has enabled the Federal Reserve to be more responsive and accommodative to perceived changes in the demand for money. Reflecting the increased flexibility of the new procedure, the directive from the FOMC to the Federal Reserve Bank of New York is now less specific than the directive under either of the previous two operating procedures. Particularly under the federal funds rate targeting procedure, the directive specified a relatively narrow range for the federal funds rate. Similarly, under the nonborrowed reserves procedure, the directive stipulated a reserve path consistent with specific growth rates for the monetary aggregates. By contrast, under the current borrowed reserves procedure, the directive indicates only the FOMC’s desired degree of pressure to be maintained on reserve positions of depository institutions during the intermeeting period. For example, the directive from the November 14, 1989 meeting of the FOMC states that “the Committee seeks to maintain the existing degree of pressure on reserve positions” (Board of Governors of the Federal Reserve System, 1990, p. 60).

The “pressure on reserve positions” generally refers to the level of adjustment plus seasonal borrowing from the discount window of the Federal Reserve. Specifically, the FOMC provides the Federal Reserve Bank of New York with a borrowed reserves objective that is considered to be consistent with the intermeeting path for monetary policy. This level of borrowed reserves is then subtracted from an estimate of the demand for total reserves71 (computed by the staffs of the Board of Governors and the Federal Reserve Bank of New York) to derive a path for nonborrowed reserves. The operating desk at the Federal Reserve Bank of New York assesses the market factors affecting the availability of nonborrowed reserves and then decides on appropriate open market operations. While this procedure may appear to be quite similar to the nonborrowed reserves procedure which preceded it, it is actually quite different. In particular, under the nonborrowed reserves procedure, any change in the demand for total reserves did not affect the specified nonborrowed reserves path, whereas under the current procedure, any such change in the demand for total reserves is accommodated by adjusting the nonborrowed reserves path in order to achieve the borrowed reserves objective.72

The functioning of the current operating procedure is most easily understood by examining the relationship between borrowing and the spread between the federal funds rate and the discount rate. For a given discount rate, there is a level of borrowing that is consistent with the federal funds rate determined by the Federal Reserve as necessary to achieve the desired rate of growth for the targeted monetary aggregate or aggregates in particular, and its desired monetary policy stance in general. The task of the operating desk at the Federal Reserve Bank of New York is to conduct open market operations so as to achieve this level of borrowing, which in effect then determines the federal funds rate. The current procedure is therefore very similar to targeting the federal funds rate, but with an element of additional flexibility. Empirical analysis has indicated that an increase of about 25 basis points in the spread between the federal funds rate and the discount rate is associated with an additional $100 million of borrowing.73

Under this procedure, a greater degree of reserve restraint, that is, a tighter monetary policy stance, corresponds to a higher borrowing objective. For a given discount rate, this would be accomplished through open market operations that would reduce nonborrowed reserves, force additional borrowing at the discount window, and thereby exert upward pressure on the federal funds rate, widening the spread between the federal funds rate and the discount rate. The higher federal funds rate then leads to a higher level of interest rates that is intended to slow growth in the monetary aggregates and the overall economy, thereby exerting some restraint on actual and potential inflationary pressures.74 Similarly, a lesser degree of reserve restraint, that is, a more accommodative policy stance, corresponds to a lower borrowing objective, a lower federal funds rate, increased growth in the monetary aggregates, and stimulus to the real economy.

Identifying Changes in Policy

Given the features of the current operating procedure as described above, it is useful to ask under what conditions short-run (that is, daily or weekly) movements in variables that are integral elements of the procedure, that is, the federal funds rate, the discount rate, borrowed reserves, and nonborrowed reserves, indicate changes in the policy stance of the Federal Reserve. The interpretation of short-run changes in some of these variables depends on the stability of the relationship between borrowing and the spread between the federal funds rate and the discount rate. If this relationship is relatively stable, movements in some of these variables can indicate changes in the Federal Reserve’s policy stance. If, however, this relationship is not very stable, it may be difficult to discern policy implications from movements in some of these variables.

The federal funds rate is clearly the key variable for discerning changes in the Federal Reserve’s monetary policy stance. Changes in the federal funds rate could in theory represent adjustments taken by the Federal Reserve to achieve an unchanged borrowed reserves objective in the face of a shift in the relationship between borrowing and the spread between the federal funds rate and the discount rate. However, the Federal Reserve has typically adjusted the borrowing objective when such shifts have been identified (see footnote 75). Consequently, increases or decreases in the federal funds rate that deviate significantly from the range of recent movements can be identified and generally indicate changes in the Federal Reserve’s policy stance. For example, on November 7, 1989, market participants noted that the Federal Reserve added reserves to the banking system even though the federal funds rate was trading below the widely perceived 8.75 percent Federal Reserve target. When the Federal Reserve repeated this action the following day under similar conditions, market participants generally concluded that the Federal Reserve had eased its policy stance slightly, a conclusion that was confirmed in the minutes of the FOMC meeting held on November 14, 1989, which were released on December 22, 1989.

Observed changes in borrowing over and above normal fluctuations could signal policy changes, but they could also reflect a change in the borrowing relationship that the Federal Reserve had identified and hence, would indicate a new borrowing objective.75 Consequently, it is very difficult to discern policy changes from movements in borrowed reserves. Identifying policy changes from short-run movements in nonborrowed reserves under the current operating procedures is also quite difficult. As noted above, the Federal Reserve typically smooths short-term fluctuations in the federal funds rate by supplying or draining nonborrowed reserves as necessary. Consequently, short-term changes in nonborrowed reserves reflect these smoothing operations and hence usually do not contain information concerning changes in the current stance of policy.

Adjustments in the discount rate under the current operating procedure are typically transmitted to market interest rates and consequently are nearly always indicative of policy changes. In particular, for a given borrowing target an increase in the discount rate feeds through directly to the federal funds market as some depository institutions are “forced” away from the discount window by the higher discount rate and bid for an unchanged supply of nonborrowed reserves. As a result, the federal funds rate rises until the necessary spread is attained to achieve the unchanged borrowing objective. It is possible that a change in the discount rate could simply reflect an adjustment to a change in the borrowing relationship described above. Given the announcement effect associated with discount rate changes, however, it appears unlikely that the Federal Reserve would take such a visible action as a mechanical adjustment measure.76 Instead, the Federal Reserve generally signals a change in its policy stance when it changes the discount rate.77 It should be noted that while a discount rate change typically signals a change in Federal Reserve policy, the discount rate is not changed frequently enough to be considered a timely indicator of the Federal Reserve’s current policy stance. Consequently, the federal funds rate is currently the primary, and certainly the most timely, indicator of the Federal Reserve’s policy stance.

59

M1 consists of currency, travelers checks, demand deposits, and other checkable deposits. M2 is Ml plus savings accounts, money market deposit accounts, general purpose and broker/dealer money market mutual funds, small (less than $100,000) time deposits, overnight repurchase agreements, and overnight Eurodollars issued to U.S. residents by foreign branches of U.S. banks. M3 is M2 plus large time deposits, institution-only money market mutual funds, term repurchase agreements, and term Eurodollars issued to U.S. residents.

60

See Axilrod (1985), Heller (1988), and Wenninger (1986). While this relationship has been called into question, it appears that the Federal Reserve continues to have confidence in the longer-term relationship between growth in the monetary aggregates and the rate of inflation. See, for example, Heller (1988), p. 422.

61

These indicators are enumerated in Heller (1988) and in Johnson (1989).

63

Reserve requirements are also in principle an instrument of policy. While changes in reserve requirements do release or absorb reserves, and hence, could be used to affect the reserve positions of depository institutions, only limited use is now made of reserve requirements in the short-run implementation of monetary policy.

64

Matched sale-purchase transactions are conducted only in treasury bills, while repurchase agreements may be conducted in the entire range of treasury securities.

66

The federal funds rate is the interest rate in the overnight interbank market on deposits at the Federal Reserve that depository institutions with reserve deficiencies borrow from institutions with excess reserves.

68

See Axilrod (1985) and Heller (1988) for a more complete discussion of the evolution toward, and an evaluation of, nonborrowed reserves targeting.

69

See, for example, Wenninger (1986).

70

This rationale for this shift in operating procedure is provided in Heller (1988), p. 426.

71

Total reserves equal borrowed plus nonborrowed reserves, or equivalently, required plus excess reserves.

72

See Gilbert (1985) and Thornton (1988) for a discussion of this point.

73

See Thornton (1986), pp. 9—12. However, the relationship between borrowing and the federal funds rate is not completely stable and has exhibited permanent shifts. When these were perceived to have occurred, frequently formal adjustments to the targeted level of borrowed reserves have been made. Such adjustments have occurred since late 1988. See footnote 75.

74

Johnson (1990) provides a Wicksellian interpretation, that is, that inflationary pressures will be moderated as market interest rates rise relative to the “natural” interest rate.

75

In an addendum to the minutes of the FOMC meeting held on November 1, 1988 (released on December 16, 1988), it was noted that, subsequent to the FOMC meeting of November 1, depository institutions had reduced their demands on the discount window as adjustment plus seasonal borrowing had declined, falling significantly below the level anticipated at the November 1 meeting. The Federal Reserve Bank of New York, however, adjusted the reserve paths to incorporate a lower level of borrowing so that the federal funds rate would continue to trade in its previously established range. Minutes of the FOMC meeting during 1989 indicate several subsequent “technical” adjustments to the borrowed reserves objective. This increased propensity to alter the borrowed reserves objective may indicate that the Federal Reserve has begun to place less emphasis on the borrowed reserves objective and more on maintaining the federal funds rate at a particular level.

76

Batten and Thornton (1984) and Thornton (1986) have found that discount rate changes, when they are announced, have a statistically significant impact on the federal funds rate, the three-month treasury bill rate, and the trade-weighted index of the foreign exchange value of the dollar. Both studies concluded that this “announcement effect” indicated that market participants interpreted a discount rate change as signaling a change in the stance of monetary policy.

77

For example, in announcing the increase in the discount rate on February 24, 1989, the Federal Reserve stated that the action was taken to reduce inflationary pressures. Moreover, it is clear from the minutes of the FOMC meeting held on March 28, 1989, that the Committee intended the discount rate increase to signal a tightening of policy.

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