The Fed’s Transition from Monetary Targets to Interest Rate Targets Introduction The Federal Reserve appeared to be taking on a completely different stance in 1994 versus 1993. During 1993 there were no changes in the policy directives of the Federal Open Market Committee and short-term interest rates remained steady. In contrast, during 1994, the FOMC announced six different policy changes while at the same time making an adjustment to the short-term interest rate. This change in policy was due to two factors. First, the economic environment had changed. The Fed’s monetary policy during 1993 was accommodative to permit the recovery of the economy from a recession, while the policy became more restrictive in 1994 as the economy appeared to be recovering and possibly heating up. Another cause of this apparent shift was growing consensus that price stability should be the ultimate long-term goal of the Federal Reserve. Also, the Fed adjusted its intermediate targeting strategy, placing more emphasis on interest rate targets over monetary aggregate targets. Monetary Goals To understand why the Fed changed its targets and goals the way it did, we should first examine the process the Fed uses to determine and pursue its stated goals. There are six monetary policy goals that are desired in an efficient economy. These are; 1) price stability, 2) high employment, 3) economic growth, 4) financial market and institution stability, 5) interest rate stability, and 6) foreign-exchange market stability. There has been in the past, and continues to be, some concern that these goals may be in conflict with one another. This concern, although valid for some circumstances, has been given more attention than it warrants. In particular, there has been an historic belief that there is a tradeoff between inflation and unemployment. Low inflation was expected to come at the cost of high unemployment and vice versa. The experiences of the 1970’s in the United States showed us that this is not necessarily true, as we experienced periods of simultaneously high inflation and high unemployment. The tradeoff that we expect is actually a short-term one, and as Alan Greenspan noted, in the long run “lower levels of inflation are conducive to the achievement of greater productivity and efficiency and, therefore, higher standards of living.” It appears that the pursuit of price stability may actually be necessary for maintaining low unemployment, economic growth, and interest rate stability in the long-term. Multi-Stage Process The emergence of price stability as the ultimate goal of the Fed’s monetary policy is not because there has been a decision to choose between conflicting goals, but rather, because achieving price stability facilitates the realization of the other goals of monetary policy over the long-term. Also, price stability appears to offer more value to society than any of the other goals. Not only can it facilitate the stability of some of the other goals, it is highly valued by businesses and individuals. An environment of stable prices makes financial planning much simpler, and thus people are much more willing to make investments in the economy if the future is not as uncertain as it could be. Although the Fed still needs to consider all six goals when making decisions regarding monetary policy, focusing on the primary goal of price stability permits a narrowing of focus and a more concerted effort determining monetary policy. To keep on track toward achieving the goal of price stability, there is a four-step process that is utilized. This process involves the use of the following: 1) policy tools, 2) operating targets, 3) intermediate targets and 4) monetary policy goals. The last step, the monetary policy goals, has already been discussed. To achieve its desired goals, the Fed uses its policy tools to make the appropriate adjustments to the economy. The tools available to the Fed are; open market operations, discount policy, and reserve requirements. The Fed uses all three of these tools but relies most heavily on open market operations. This is because it has a more direct impact on the economy. Buying or selling large amounts of bonds will either increase or decrease the monetary base and push interest rates up or down. Changes to the discount rate or reserve requirements are not a guarantee for an appropriate change in the monetary base because we are more dependent on the actions of the bank. The effectiveness of this strategy depends on how the banks view the excess reserves that have been created and what they do with them. Banks may be less likely to use the excess reserves for loan creation if they are worried that the Fed may readjust the reserve requirement to the old level. The chief problem when using the Fed’s policy tools to realize its goals is that the tools of the Fed do not have a direct impact on its goals. The effect is indirect and may have a substantial lag (12-18 months) before we see the desired result (or the wrong result). For this reason, the Fed uses targets to help in determining whether its policy tools are having the desired effect or not. The intermediate and operating targets that the Fed establishes are used as “sights” to keep monetary policy on track. Once the Fed executes an action using its policy tools, waiting for the effect on the desired goal would not be effective because of the lag time. Instead, the Fed can track its operating and intermediate targets to see how they are affected and if it is as expected. If so, everything is on target. If not, the Fed can make timely adjustments to how it uses its policy tools. Intermediate targets are one step removed from the monetary goals. Achieving the intermediate targets does not guarantee successfully meeting its goals but does increase the likelihood of that happening. The Fed has a range of intermediate targets, but this generally breaks down into a choice between monetary aggregates or interest rates. This is an either/or decision because the Fed cannot pursue both of these targets simultaneously. Setting an intermediate target in terms of a monetary aggregate means that any shift in money demand will result in changes to the interest rate. Similarly, setting an intermediate target in terms of an interest rate means that any shift in the money demand will have to be met with an adjustment to the money supply if we want to hold the interest rate constant. The bottom line is that if we choose one target, the other must be permitted to float. When the Fed makes a decision on which intermediate target to use, it evaluates them on the following three criteria: 1) measurability, 2) controllability and 3) predictability. The intermediate target has a direct impact on the desired monetary goal, but cannot be directly influenced by the policy tools. For this reason the Fed also establishes operating targets. Operating targets are directly influenced by the Fed’s policy tools, and in turn, have a directly impact the intermediate target. Thus, the final piece is provided and we have a series of linkages that connect the Fed’s policy tools to its monetary goals. Operating targets are also evaluated according to the same three criteria as the intermediate targets. The key here is that the two targets must be compatible. The operating target and intermediate target must both be either an interest rate target or a monetary aggregate target. Common operating targets are non-borrowed reserves and the federal funds rate Choosing an Intermediate Target Within the context of the previous explanation the Fed must make a decision of which goals to pursue and targets to track. Since the Fed has stated that it has decided to pursue price stability as its primary goal, it is then necessary to decide upon an appropriate intermediate target to track. This means we must choose between a monetary aggregate or interest rate. During the period from 1979 to 1982, the Fed focused on monetary aggregates as intermediate targets. Paul Volcker was chairman of the Board of Governors of the Federal Reserve system at this time and decided that this was the best method of tracking progress toward his goal of combating inflation. In 1982, the Fed began to shift away from monetary aggregates and focus more closely on interest rates. The argument at this time was that M1 had become less relevant as a measure of the money supply due to recent deregulation and financial innovations. In 1993, this shift continued and Alan Greenspan announced that both M1 and M2 would no longer be used as targets to guide monetary policy, but that reliance would instead be shifted to interest rate targets. The necessity of making this transition can be understood by examining how each intermediate target stacks up against the three criteria by which we judge the effectiveness of an intermediate target. Measurability – Both interest rate targets and monetary aggregates can be measured effectively and within a reasonable amount of time. Interest rates can even be tracked on a real-time basis. This instantaneous access to data does not necessarily guarantee an equal level of accuracy however, as these real-time interest rates are actually nominal rates and what is of concern to the Fed are real interest rates. It takes time to collect the data necessary to convert a nominal rate into a pertinent real rate, making interest rate targets less effective in the short-term than the long-term. Still, the data is effective and useful as long as we remember to consider its shortcomings and compensate accordingly. Monetary aggregates also have a short lag time – approximately two weeks for initial data. Some of the components of M1 or M2 take some time to tabulate, so just like the interest rate targets, the initial figures we have available to us are not as accurate as the follow up data two weeks or a month later. The other difficulty with measuring the monetary aggregate is deciding which one to actually measure. Deregulation and financial innovations can affect the way M1 or M2 react to changes in the Fed’s policy tools. A decision needs to be made concerning which aggregate is more effective as an estimator of the Fed’s ability to achieve its goals. Also, as people shift their wealth out of assets comprising the chosen monetary target and into new financial products that are not included in the aggregate, the characteristics of the monetary aggregate are now changed. The ranges of acceptable levels of M1 or M2 must be continuously adjusted to reflect this change. Controllability – When deciding whether interest rates or monetary aggregates are more appropriate as an intermediate target, the Fed needs to asses how well each can be controlled by its monetary policy tools. The Fed generally has significant control over both interest rate targets and monetary targets. The Fed can use open market operations, and to a lesser extent, changes to the discount rate or reserve requirements, to create the planned change to the federal funds rate, and subsequently to the market interest rates. Although control is quite effective it cannot be absolute because there are other factors and participants in the economy which the Fed cannot control. For example, although the Fed may lower the discount rate or its reserve requirements, it cannot force the banks to borrow from the discount window or use its excess reserves to make new loans. Likewise, although the Fed can use OMO to manipulate the market interest rate, it cannot directly control nominal rates since it cannot so easily adjust the public’s view of expected inflation. The control the Fed exerts over monetary aggregates is also significant, but not absolute, as the Fed cannot control the banks and the non-bank public, who are capable of influencing the money supply as well. The actions of these two groups can have a substantial influence on monetary aggregates. Additionally, their actions, particularly those of the non-bank public can be unpredictable to the Fed and change over time. An example of this is the introduction and rise in popularity of bond and stock mutual funds. This has caused a shift out of some of the assets comprising M2, making M2 growth behave uncharacteristically. Another development in the marketplace may have contributed to the slowing growth of M2 during 1993 – a slowing in refinancing activity caused a run-off of liquid funds. Also contributing to the change in the behaviour of M2 has been an increased opportunity cost of holding M2 assets during 1993 as interest rates on 3-month Treasury bills increased, making it less likely that people would choose to hold these assets. While all of the previous examples contributed to the fact that M2 growth slowed in 1993, they were generally short adjustments and explainable. The bigger issue was that even when taking these factors into consideration, M2 velocity was increasing more rapidly than should be expected, meaning it was becoming less controllable by the Fed’s policy tools. Predictability – There are two problems with the predictability of interest rates as an intermediate target. First, the Fed’s influence over real rates is weaker than its influence over nominal rates. This was discussed earlier, and of course, is correct. There is nothing the Fed can due to nullify this, but they can minimize it by using the data available to develop an estimation of expected inflation that is as accurate as possible. For example, during the course of 1994, the Fed tracked interest rates for bonds of varying maturity. By doing so they can evaluate the yield curve and the implied expected rate of inflation that is built into it. Second, it is argued that a Fed policy to stabilize interest rates is inconsistent with the goal of steady economic growth. I agree that a goal of interest rate stability may be inconsistent with the goals of steady economic growth or price stability (in the short-term). However, what we are not deciding on the merits of interest rate stability as a goal, but on the merits of the interest rate level as an intermediate target. As an intermediate target the interest rate is not necessarily held constant, but is adjusted to the appropriate level that is necessary to keep the economy on track toward the Fed’s stated goal of price stability. The ability of interest rates to predict the Fed’s ability to achieve its goals is quite effective. As we know there is a strong correlation between interest rates, price levels, and economic growth. Monetary aggregates are also effective at predicting the desired goal. As an example, during an economic expansion, the rising demand for money causes interest rates to rise, which in turn causes a reduction in consumer and business spending, keeping the economy from over heating. Conclusion Based on the preceding analysis it was wise for the Fed to shift toward primarily using interest rates as an intermediate target. Both M1 and M2 were proving to be less controllable than in the past, so using interest rates would be more effective. This is not to say that this change should be permanent. Indeed the Fed will continue to evaluate the targets it uses, and the economic environment may change sufficiently in the future to warrant returning to the use of monetary aggregates. There is also the possibility that an aggregate other than M1 or M2 may prove to be more appropriate for us to rack. Neither interest rates nor monetary aggregates can have all of the attributes the Fed seeks at all times. Instead, there needs to be appropriate analysis to determine which works best at the present time, and adjust accordingly. The reason for more apparent activity by the Fed during 1994 can be explained by three factors. First, the increasing focus on price stability allowed the Fed to take action without having to worry as much about how it affected the other 5 goals. Second, an increasing use of interest rate targets meant that they were using targets that were more indicative of the effectiveness of its policy tools and the need for further action. Continuing to track monetary aggregates may not have revealed the need to take action. Third, the economy had been heating up and some action to slow the growth was simply needed at this time. The change in the Fed’s policy actions from 1993 to 1994 is not as drastic as it may first appear. It is merely a continuing evolution of the manner in which the Fed executes the strategy and tactics of its monetary policy. The effectiveness of this modification of its policy is borne out by the lack of any visible sign of inflation at the end of 1994. Additional time will provide the necessary information to determine if this policy stance is still effective in the future and adjustments will undoubtedly have to be made.
References “The FOMC in 1993 and 1994: Monetary Policy in Transition.” Federal Reserve Bank of St. Louis Review, March,1995 “Flying Swine: Appropriate Targets and Goals of Monetary Policy” Journal of Economic Issues, June, 1996