economics_of_money_banking__financial_markets

Reserve

Requirements

as a Policy Tool

War Finance and the Pegging of Interest Rates: 1942–1951

The spate of bank panics from 1930 to 1933 were the most severe in U.S. history, and Roosevelt aptly summed up the problem in his statement ÒThe only thing we have to fear is fear itself.Ó By the time the panics were over in March 1933, more than onethird of the commercial banks in the United States had failed.

In Chapter 16, we examined how the bank panics of this period led to a decline in the money supply by over 25%. The resulting unprecedented decline in the money supply during this period is thought by many economists, particularly monetarists, to have been the major contributing factor to the severity of the depression, never equaled before or since.

The Thomas Amendment to the Agricultural Adjustment Act of 1933 provided the Federal ReserveÕs Board of Governors with emergency power to alter reserve requirements with the approval of the president of the United States. In the Banking Act of 1935, this emergency power was expanded to allow the Fed to alter reserve requirements without the presidentÕs approval.

The first use of reserve requirements as a tool of monetary control proved that the Federal Reserve was capable of adding to the blunders that it had made during the bank panics of the early 1930s. By the end of 1935, banks had increased their holdings of excess reserves to unprecedented levels, a sensible strategy, considering their discovery during the 1930Ð1933 period that the Fed would not always perform its intended role as lender of last resort. Bankers now understood that they would have to protect themselves against a bank run by holding substantial amounts of excess reserves. The Fed viewed these excess reserves as a nuisance that made it harder to exercise monetary control. Specifically, the Fed worried that these excess reserves might be lent out and would produce Òan uncontrollable expansion of credit in the future.Ó5

To improve monetary control, the Fed raised reserve requirements in three steps: August 1936, January 1937, and May 1937. The result of this action was, as we would expect from our money supply model, a slowdown of money growth toward the end of 1936 and an actual decline in 1937. The recession of 1937Ð1938, which commenced in May 1937, was a severe one and was especially upsetting to the American public because even at its outset unemployment was intolerably high. So not only does it appear that the Fed was at fault for the severity of the Great Depression contraction in 1929Ð1933, but to add insult to injury, it appears that it was also responsible for aborting the subsequent recovery. The FedÕs disastrous experience with varying its reserve requirements made it far more cautious in the use of this policy tool in the future.

With the entrance of the United States into World War II in late 1941, government spending skyrocketed, and to finance it, the Treasury issued huge amounts of bonds. The Fed agreed to help the Treasury finance the war cheaply by pegging interest rates at the low levels that had prevailed before the war: 38 % on Treasury bills and 2 12% on long-term Treasury bonds. Whenever interest rates rose above these levels and the price of bonds began to fall, the Fed would make open market purchases, thereby bidding up bond prices and driving interest rates down again. The result was a rapid

5Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867Ð1960 (Princeton, N.J.: Princeton University Press, 1963), p. 524.

Targeting Money Market Conditions: The 1950s and 1960s

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 423

growth in the monetary base and the money supply. The Fed had thus in effect relinquished its control of monetary policy to meet the financing needs of the government.

When the war ended, the Fed continued to peg interest rates, and because there was little pressure on them to rise, this policy did not result in an explosive growth in the money supply. When the Korean War broke out in 1950, however, interest rates began to climb, and the Fed found that it was again forced to expand the monetary base at a rapid rate. Because inflation began to heat up (the consumer price index rose 8% between 1950 and 1951), the Fed decided that it was time to reassert its control over monetary policy by abandoning the interest-rate peg. An often bitter debate ensued between the Fed and the Treasury, which wanted to keep its interest costs down and so favored a continued pegging of interest rates at low levels. In March 1951, the Fed and the Treasury came to an agreement known as the Accord, in which pegging was abandoned but the Fed promised that it would not allow interest rates to rise precipitously. After EisenhowerÕs election as president in 1952, the Fed was given complete freedom to pursue its monetary policy objectives.

With its freedom restored, the Federal Reserve, then under the chairmanship of William McChesney Martin Jr., took the view that monetary policy should be grounded in intuitive judgment based on a feel for the money market. The policy procedure that resulted can be described as one in which the Fed targeted on money market conditions, and particularly on interest rates.

An important characteristic of this policy procedure was that it led to more rapid growth in the money supply when the economy was expanding and a slowing of money growth when the economy was in recession. The so-called procyclical monetary policy (a positive association of money supply growth with the business cycle) is explained by the following step-by-step reasoning. As we learned in Chapter 5, a rise in national income (Y↑ ) leads to a rise in market interest rates (i↑ ). With the rise in interest rates, the Fed would purchase bonds to bid their price up and lower interest rates to their target level. The resulting increase in the monetary base caused the money supply to rise and the business cycle expansion to be accompanied by a faster rate of money growth. In summary:

Y ↑ i ↑ MB ↑ M ↑

In a recession, the opposite sequence of events would occur, and the decline in

income would be accompanied by a slower rate of growth in the money supply (Y↓ M↓ ).

A further problem with using interest rates as the primary operating target is that they may encourage an inflationary spiral to get out of control. As we saw in Chapter 5, when inflation and hence expected inflation rises, nominal interest rates rise via the Fisher effect. If the Fed attempted to prevent this increase by purchasing bonds, this would also lead to a rise in the monetary base and the money supply:

↑ e↑ i ↑ MB ↑ M ↑

Higher inflation could thus lead to an increase in the money supply, which would increase inflationary pressures further.

By the late 1960s, the rising chorus of criticism of procyclical monetary policy by such prominent monetarist economists such as Milton Friedman, Karl Brunner, and

Targeting

Monetary

Aggregates:

The 1970s

Allan Meltzer and concerns about inflation finally led the Fed to abandon its focus on money market conditions.

In 1970, Arthur Burns was appointed chairman of the Board of Governors, and soon thereafter the Fed stated that it was committing itself to the use of monetary aggregates as intermediate targets. Did monetary policy cease to be procyclical? A glance at Figure 4 in Chapter 1 indicates that monetary policy was as procyclical in the 1970s as in the 1950s and 1960s. What went wrong? Why did the conduct of monetary policy not improve? The answers to these questions lie in the FedÕs operating procedures during the period, which suggest that its commitment to targeting monetary aggregates was not very strong.

Every six weeks, the Federal Open Market Committee would set target ranges for the growth rates of various monetary aggregates and would determine what federal funds rate (the interest rate on funds loaned overnight between banks) it thought consistent with these aims. The target ranges for the growth in monetary aggregates were fairly broadÑa typical range for M1 growth might be 3% to 6%; for M2, 4% to 7%Ñ while the range for the federal funds rate was a narrow band, say from 712% to 814%. The trading desk at the Federal Reserve Bank of New York was then instructed to meet both sets of targets, but as we saw earlier, interest-rate targets and monetary aggregate targets might not be compatible. If the two targets were incompatibleÑsay, the federal funds rate began to climb higher than the top of its target band when M1 was growing too rapidlyÑthe trading desk was instructed to give precedence to the federal funds rate target. In the situation just described, this would mean that although M1 growth was too high, the trading desk would make open market purchases to keep the federal funds rate within its target range.

The Fed was actually using the federal funds rate as its operating target. During the six-week period between FOMC meetings, an unexpected rise in output (which would cause the federal funds rate to hit the top of its target band) would then induce open market purchases and a too rapid growth of the money supply. When the FOMC met again, it would try to bring money supply growth back on track by raising the target range on the federal funds rate. However, if income continued to rise unexpectedly, money growth would overshoot again. This is exactly what occurred from June 1972 to June 1973, when the economy boomed unexpectedly: M1 growth greatly exceeded its target, increasing at approximately an 8% rate, while the federal funds rate climbed from 412% to 812%. The economy soon became overheated, and inflationary pressures began to mount.

The opposite chain of events occurred at the end of 1974, when the economic contraction was far more severe than anyone had predicted. The federal funds rate fell dramatically, from over 12% to 5%, and persistently bumped against the bottom of its target range. The trading desk conducted open market sales to keep the federal funds rate from falling, and money growth dropped precipitously, actually turning negative by the beginning of 1975. Clearly, this sharp drop in money growth when the United States was experiencing one of the worst economic contractions of the postwar era was a serious mistake.

Using the federal funds rate as an operating target promoted a procyclical monetary policy despite the FedÕs lip service to monetary aggregate targets. If the Federal Reserve really intended to pursue monetary aggregate targets, it seems peculiar that it would have chosen an interest rate for an operating target rather than a reserve aggregate. The explanation for the FedÕs choice of an interest rate as an operating target is

New Fed

Operating

Procedures:

October 1979–

October 1982

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 425

that it was still very concerned with achieving interest-rate stability and was reluctant to relinquish control over interest-rate movements. The incompatibility of the FedÕs policy procedure with its stated intent of targeting on the monetary aggregates had become very clear by October 1979, when the FedÕs policy procedures underwent drastic revision.

In October 1979, two months after Paul Volcker became chairman of the Board of Governors, the Fed finally deemphasized the federal funds rate as an operating target by widening its target range more than fivefold: A typical range might be from 10% to 15%. The primary operating target became nonborrowed reserves, which the Fed would set after estimating the volume of discount loans the banks would borrow. Not surprisingly, the federal funds rate underwent much greater fluctuations after it was deemphasized as an operating target. What is surprising, however, is that the deemphasis of the federal funds target did not result in improved monetary control: After October 1979, the fluctuations in the rate of money supply growth increased rather than decreased as would have been expected. In addition, the Fed missed its M1 growth target ranges in all three years of the 1979Ð1982 period.6 What went wrong?

There are several possible answers to this question. The first is that the economy was exposed to several shocks during this period that made monetary control more difficult: the acceleration of financial innovation and deregulation, which added new categories of deposits such as NOW accounts to the measures of monetary aggregates; the imposition by the Fed of credit controls from March to July 1980, which restricted the growth of consumer and business loans; and the back-to-back recessions of 1980 and 1981Ð1982.7

A more persuasive explanation for poor monetary control, however, is that controlling the money supply was never really the intent of VolckerÕs policy shift. Despite VolckerÕs statements about the need to target monetary aggregates, he was not committed to these targets. Rather, he was far more concerned with using interest-rate movements to wring inflation out of the economy. VolckerÕs primary reason for changing the FedÕs operating procedure was to free his hand to manipulate interest rates in order to fight inflation. It was necessary to abandon interest-rate targets if Volcker were to be able to raise interest rates sharply when a slowdown in the economy was required to dampen inflation. This view of VolckerÕs strategy suggests that the FedÕs announced attachment to monetary aggregate targets may have been a smokescreen to keep the Fed from being blamed for the high interest rates that would result from the new policy.

6The M1 target ranges and actual growth rates for 1980Ð1982 were as follows:

Source: Board of Governors of the Federal Reserve System, Monetary Policy Objectives, 1981Ð1983.

7Another explanation focuses on the technical difficulties of monetary control when using a nonborrowed reserves operating target under a system of lagged reserve requirements, in which required reserves for a given week are calculated on the basis of the level of deposits two weeks earlier. See David Lindsey, ÒNonborrowed Reserve Targeting and Monetary Control,Ó in Improving Money Stock Control, ed. Laurence Meyer (Boston: KluwerNijhoff, 1983), pp. 3Ð41.

De-emphasis of

Monetary

Aggregates:

October 1982–

Early 1990s

www.federalreserve.gov /releases/H3

Historic and current data on the aggregate reserves of depository institutions and the monetary base.

Interest-rate movements during this period support this interpretation of Fed strategy. After the October 1979 announcement, short-term interest rates were driven up by nearly 5%, until in March 1980 they exceeded 15%. With the imposition of credit controls in March 1980 and the rapid decline in real GDP in the second quarter of 1980, the Fed eased up on its policy and allowed interest rates to decline sharply. When recovery began in July 1980, inflation remained persistent, still exceeding 10%. Because the inflation fight was not yet won, the Fed tightened the screws again, sending short-term rates above the 15% level for a second time. The 1981Ð1982 recession and its large decline in output and high unemployment began to bring inflation down. With inflationary psychology apparently broken, interest rates were allowed to fall.

The FedÕs anti-inflation strategy during the October 1979ÐOctober 1982 period was neither intended nor likely to produce smooth growth in the monetary aggregates. Indeed, the large fluctuations in interest rates and the business cycle, along with financial innovation, helped generate volatile money growth.

In October 1982, with inflation in check, the Fed returned, in effect, to a policy of smoothing interest rates. It did this by placing less emphasis on monetary aggregate targets and shifting to borrowed reserves (discount loan borrowings) as an operating target. To see how a borrowed reserves target produces interest-rate smoothing, letÕs consider what happens when the economy expands (Y ↑ ) so that interest rates are driven up. The rise in interest rates (i ↑ ) increases the incentives for banks to borrow more from the Fed, so borrowed reserves rise (DL ↑ ). To prevent the resulting rise in borrowed reserves from exceeding the target level, the Fed must lower interest rates by bidding up the price of bonds through open market purchases. The outcome of targeting on borrowed reserves, then, is that the Fed prevents a rise in interest rates. In doing so, however, the FedÕs open market purchases increase the monetary base (MB ↑ ) and lead to a rise in the money supply (M ↑ ), which produces a positive asso-

A recession causes the opposite chain of events: The borrowed reserves target prevents interest rates from falling and results in a drop in the monetary base, leading to a fall in the money supply (Y↓ M↓ ).

The de-emphasis of monetary aggregates and the change to a borrowed reserves target led to much smaller fluctuations in the federal funds rate after October 1982 but continued to have large fluctuations in money supply growth. Finally, in February 1987, the Fed announced that it would no longer even set M1 targets. The abandonment of M1 targets was defended on two grounds. The first was that the rapid pace of financial innovation and deregulation had made the definition and measurement of money very difficult. The second is that there had been a breakdown in the stable relationship between M1 and economic activity (discussed in Chapter 22). These two arguments suggested that a monetary aggregate such as M1 might no longer be a reliable guide for monetary policy. As a result, the Fed switched its focus to the broader monetary aggregate M2, which it felt had a more stable relationship with economic activity. However, in the early 1990s, this relationship also broke down, and in July 1993, Board of Governors Chairman Alan Greenspan testified in Congress that the Fed would no longer use any monetary targets, including M2, as a guide for conducting monetary policy.

Federal Funds

Targeting Again:

Early 1990s and

Beyond

International

Considerations

C H A P T E R 1 8 Conduct of Monetary Policy: Goals and Targets 427

Finally, legislation in 2000 amending the Federal Reserve Act dropped the requirement that the Fed report target ranges for monetary aggregates to Congress.

Having abandoned monetary aggregates as a guide for monetary policy, the Federal Reserve returned to using a federal funds target in the early 1990s. Indeed, from late 1992 until February 1994, a period of a year and a half, the Fed kept the federal funds rate targeted at the constant rate of 3%, a low level last seen in the 1960s. The explanation for this unusual period of keeping the federal funds rate pegged so low for such a long period of time was fear on the part of the Federal Reserve that the credit crunch mentioned in Chapter 9 was putting a drag on the economy (the ÒheadwindsÓ referred to by Greenspan) that was producing a sluggish recovery from the 1990Ð1991 recession. Starting in February 1994, after the economy returned to rapid growth, the Fed began a preemptive strike to head off any future inflationary pressures by raising the federal funds rate in steps to 6% by early 1995. The Fed not only has engaged in preemptive strikes against a rise in inflation, but it has acted preemptively against negative shocks to demand. It lowered the federal funds rate in early 1996 to deal with a possible slowing in the economy and took the dramatic step of reducing the federal funds rate by 34 of a percentage point when the collapse of Long Term Capital Management in the fall of 1998 (discussed in Chapter 12) led to concerns about the health of the financial system. With the strong growth of the economy in 1999 and heightened concerns about inflation, the Fed reversed course and began to raise the federal funds rate again. The FedÕs timely actions kept the economy on track, helping to produce the longest business cycle expansion in U.S. history. With a weakening economy, in January 2001 (just before the start of the recession in March 2001) the Fed reversed course again and began to reduce sharply the federal funds rate from its height of 6.5% to near 1% eventually.

In February 1994, with the first change in the federal funds rate in a year and a half, the Fed adopted a new policy procedure. Instead of keeping the federal funds target secret, as it had done previously, the Fed now announced any federal funds rate target change. As mentioned in Chapter 14, around 2:15 P.M., after every FOMC meeting, the Fed now announces whether the federal funds rate target has been raised, lowered, or kept the same. This move to greater transparency of Fed policy was followed by another such move, when in February 1999 the Fed indicated that in the future it would announce the direction of bias to where the federal funds rate will head in the future. However, dissatisfaction with the confusion that the bias announcement created for market participants led the Fed to revise its policy, and starting in February 2000, the Fed switched to an announcement of a statement outlining the Òbalance of risksÓ in the future, whether toward higher inflation or toward a weaker economy. As a result of these announcements, the outcome of the FOMC meeting is now big news, and the media devote much more attention to FOMC meeting, because announced changes in the federal funds rate feeds into changes in other interest rates that affect consumers and businesses.

The increasing importance of international trade to the American economy has brought international considerations to the forefront of Federal Reserve policymaking in recent years. By 1985, the strength of the dollar had contributed to a deterioration in American competitiveness with foreign businesses. In public pronouncements, Chairman Volcker and other Fed officials made it clear that the dollar was at too high a value and needed to come down. Because, as we will see in Chapter 19, expansionary monetary policy is

www.federalreserve.gov /centralbanks.htm

The Federal Reserve provides links to other central bank web pages.

one way to lower the value of the dollar, it is no surprise that the Fed engineered an acceleration in the growth rates of the monetary aggregates in 1985 and 1986 and that the value of the dollar declined. By 1987, policymakers at the Fed agreed that the dollar had fallen sufficiently, and sure enough, monetary growth in the United States slowed. These monetary policy actions by the Fed were encouraged by the process of international policy coordination (agreements among countries to enact policies cooperatively) that led to the Plaza Agreement in 1985 and the Louvre Accord in 1987 (see Box 3).

International considerations also played a role in the FedÕs decision to lower the federal funds rate by 34 of a percentage point in the fall of 1998. Concerns about the potential for a worldwide financial crisis in the wake of the collapse of the Russian financial system at that time and weakness in economies abroad, particularly in Asia, stimulated the Fed to take a dramatic step to calm down markets. International considerations, although not the primary focus of the Federal Reserve, are likely to be a major factor in the conduct of American monetary policy in the future.

1.The six basic goals of monetary policy are high employment, economic growth, price stability, interestrate stability, stability of financial markets, and stability in foreign exchange markets.

2.By using intermediate and operating targets, a central bank like the Fed can more quickly judge whether its policies are on the right track and make midcourse corrections, rather than waiting to see the final outcome of its policies on such goals as employment and the price level. The FedÕs policy tools directly affect its operating targets, which in turn affect the intermediate targets, which in turn affect the goals.

3.Because interest-rate and monetary aggregate targets are incompatible, a central bank must choose between them on the basis of three criteria: measurability, controllability, and the ability to affect goal variables predictably.

Unfortunately, these criteria do not establish an overwhelming case for one set of targets over another.

4.The historical record of the FedÕs conduct of monetary policy reveals that the Fed has switched its operating targets many times, returning to a federal funds rate target in recent years.

5.The Taylor rule indicates that the federal funds rate should be set equal to the inflation rate plus an ÒequilibriumÓ real funds rate plus a weighted average of two gaps: (1) an inflation gap, current inflation minus a target rate, and (2) an output gap, the percentage deviation of real GDP from an estimate of its potential full employment level. The output gap in the Taylor rule could represent an indicator of future inflation as stipulated in Phillips curve theory. However, this theory is controversial, because high output relative to potential as measured by low unemployment has not seemed to produce higher inflation in recent years.

QUIZ Questions and Problems

Questions marked with an asterisk are answered at the end of the book in an appendix, ÒAnswers to Selected Questions and Problems.Ó

*1. ÒUnemployment is a bad thing, and the government should make every effort to eliminate it.Ó Do you agree or disagree? Explain your answer.

2.Classify each of the following as either an operating target or an intermediate target, and explain why.

a.The three-month Treasury bill rate

b.The monetary base

c.M2

*3. ÒIf the demand for money did not fluctuate, the Fed could pursue both a money supply target and an interest-rate target at the same time.Ó Is this statement true, false, or uncertain? Explain your answer.

4.If the Fed has an interest-rate target, why will an increase in money demand lead to a rise in the money supply?

*5. What procedures can the Fed use to control the threemonth Treasury bill rate? Why does control of this interest rate imply that the Fed will lose control of the money supply?