I would like to comment on one part of the excellent and concise survey by Leite and Sundararajan¹ of issues in interest rate management. Perhaps the comment—which relates to the section on open market policies—may seem excessively technical or involve the splitting of hairs. However, the article appears designed to provide persuasive policy advice, and I believe the monetary policy discussion runs the risk of misleading policymakers in certain important respects.

The authors clearly and correctly state the conditions under which a monetary aggregate or an interest rate should be the preferred target for monetary authorities. They also make it clear that because of multiple disturbances—some stemming from conditions in the financial sector, others from conditions affecting the demand for goods and services—and imperfect information, the policy authorities can adopt a strategy of continuously reviewing their target settings.

The authors then go on to state the following:

Although it would still be necessary to choose between interest rate or money supply targets at any point in time, this choice would generally be subsidiary to the more important task of setting the consistent target levels for these variables. Thus, even in a liberalized interest rate regime, the authorities must constantly hold a view of the appropriate level of the interest rate and strive to achieve it (pp. 750–51).

There are a number of problems with those two sentences, with very practical implications for how monetary policy is conducted.

First, it is not necessary to choose between an interest rate or money supply target during any reasonable operating period, even one as short as two weeks. Monetary policy can (and in most practical cases probably should) function with a range of tolerance for both interest rate and money supply targets (or outcomes). In a very short period, the authorities can achieve a specified target for the interest rate of choice, but that target can be changed within the operating period, depending on evolving behavior of the money supply. It is not, incidentally, practically possible to achieve a money supply target in a short operating period (which is my interpretation of the authors’ somewhat ambiguous phrase, “at any point in time”), but that of course is no argument against setting and being guided by one.

In any event, while an interest rate may be chosen as a daily operating guide, that decision can be viewed as a matter of operational convenience and need not imply that the monetary authorities necessarily must make a choice in any fundamental sense about a particular level of that interest rate or of the money supply. If they believe they have made such a choice, they will—given human nature and the soul-searching that will have gone into the choice—be slow, possibly too slow, to change the target as economic circumstances alter.

Second, even if it were necessary to decide between an interest rate or money supply target “at any point in time,” I would not agree the choice is generally subsidiary to the task of setting consistent target levels for both. In my experience, it is not given to economists in practice to be able to find mutual consistency between the money supply and interest rates. Even if they could do so on the basis of particular economic and financial assumptions, that would not be of great help to policymakers. Policymakers would still have to make the judgment about whether to put more stress on money supply or interest rates once the economy and/or financial structure start varying (as they most certainly will) from the initial assumptions that lay behind the targets.

The problem for policymakers is not to choose among a number of alternative, and presumably internally consistent (at the time made), relationships between money supply and interest rates, but to choose which to follow or emphasize when one or the other starts going off course. Policymakers may even wish to choose what might appear in advance to be an inconsistent set of relationships, depending on how strongly they wish to give operating weight to a measure of money supply or to an interest rate.

While it is crucial and also evidence of objectivity in staff analysis for policymakers to be given technically consistent money and interest rate relationships for consideration, policymakers in an obviously inflationary period may wish to “err” on the side of money growth restraint. In a clearly recessionary period, they may wish to “err” by adopting a relatively low interest rate target.

Finally, I do not believe the authorities must constantly hold a view of the interest rate level and strive to achieve it. The authorities may say to themselves, as the Federal Reserve did from late 1979 to late 1982, that, under the particular circumstances of the time, they are not prepared to make a judgment about what interest rate level is desirable (within a very broad range of tolerance) and that they will control only the level of the depository system’s reserves (nonborrowed reserves in the case of the Fed at that time).

There can be circumstances when it is wise to make such a judgment. One would be when control of inflation is the prime objective and when in particularly volatile market and economic conditions neither inflation expectations nor the real return on capital is knowable with any reasonable degree of certainty. It would be practically impossible for policy to construct, and thus by definition, to achieve, an appropriate interest rate level.