A History of the Federal Reserve, Volume 2 (114 page)

Several of these comments are correct. Data are imprecise and some are revised later. Economic theory has not produced persistently reliable forecasts of short-run changes. Qualitative information can provide useful input into activist policy decisions. Announcing a target focuses public anticipations. None of these arguments alleviated the need for more precise control, but they raised an issue that, to my knowledge, was never discussed: Why not adjust policy decisions to coincide more closely with the time frame for which information is more reliable and economic models more useful?

Not only are new data often inaccurate and subject to revision, users cannot distinguish between persistent and temporary changes as they occur. The number of observations to make accurate judgments depends on relative variability of the persistent and transitory components. Frequently this will require several observations and considerable time. Reacting to changes too quickly can produce major mistakes.

Through the Great Inflation and afterward the Federal Reserve failed to distinguish between temporary or one-time changes in the price level and changes in the persistent rate of price change. One-time changes can be caused by excise tax changes, currency revaluations, changes in productivity, and many similar factors. Prices rise or fall and changes may continue for a short time, but they do not persist if not financed by monetary policy.

Table 4.8 shows the forecast errors for various periods. During the Great Inflation, the average absolute forecast error was about 3 percent for real growth and more than 1.5 percent for inflation. Errors in forecasts four quarters ahead were smaller than quarterly errors for real growth but not for inflation. These data suggest that focusing on short-term changes was unlikely to succeed. See Orphanides (2002).

Operating
Procedures

Several of these issues came to the fore as part of extensive staff research on the consequences of using monetary aggregates in place of money market conditions. In October 1968 Chairman Martin appointed Governor Maisel as chair of a three-person committee (with Presidents Morris and Swan) to reconsider FOMC operating procedures and the instructions given to the account manager. Background papers discussed the deficiencies in policymaking procedures including lack of clarity about objectives, shortterm focus, the manager’s autonomy, and excessive concern for money market changes.

A lengthy, very perceptive, forthright paper by Stephen Axilrod (1970a) began by noting that the first paragraph of the directive described economic conditions in a way that did not permit readers to understand the analysis that lay behind the FOMC’s instructions or the tradeoffs between competing objectives (ibid., 3–4).
¹⁵⁷
System policy accommodated all changes in the money market until the introduction of the proviso clause in 1966 directed the manager to alter money market conditions if the bank credit proxy rose or fell more than anticipated. “In practice, this [the proviso clause] has represented a rather minor element of constraint, partly because the Committee has been willing to tolerate wide swings in bank credit and partly because the proviso clause has not in application been taken as a strong target of policy” (ibid., 9).
¹⁵⁸
“No large change in money market conditions has ever been undertaken in connection with the proviso clause” (ibid., 11).

Use of targets for monetary aggregates required reconsideration of
“even keel” policy. Staff analysis suggested that the meaning of the term was imprecise. Axilrod (1969) studied empirical data for 1966–68 and concluded that the most consistent effects were on the federal funds rate and free reserves. He noted that typically even keel extended from “a week before the announcement of terms [on a Treasury issue] to a week after settlement date” (ibid., 4), but he observed variations in practice. The reason for intervening was to “help underwrite Treasury issues . . . with a short period of time in which market forces rather than new monetary policy decisions are the main factors affecting interest rates” (ibid., 2).
¹⁵⁹

157. “The vagueness of the statement of goals when limited to ultimate objectives of policy may reflect the inability or unwillingness of the FOMC itself to take, or make known, a position on the trade-off problem, thereby possibly reflecting a gap in the discussion of policy and in the formulation of the directive” (Axilrod, 1970a, 5). Axilrod noted also that it was difficult to relate the FOMC’s goals to its instructions (ibid., 6).

158. Deposit data were available daily. Axilrod does not mention the problem of separating temporary from persistent changes in bank credit. Accommodation of such changes dates back to the start of the Federal Reserve in 1913, when the gold standard served as a constraint. Also, generally, the staff projected bank credit only one month ahead.

Axilrod noted that typically the System did not use even keel policy when the Treasury issued bills. He gave four reasons: (1) the Treasury auctioned bills but not coupon securities; (2) coupon issues were generally larger, and the Treasury required payment for bills in a week but gave ten to fourteen days on coupon issues; (3) rate fluctuations have a larger effect on the value of coupon issues because of their longer maturity; and (4) if the Treasury issue failed to attract the requisite amount of sales, the Federal Reserve would have to buy the issue. He recognized (Axilrod, 1970a, 12) that the System could reduce its use of even keel by getting the Treasury to auction coupon issues.

During the three years studied, even keel remained in effect 40 percent of the time (ibid., 6). One result was that “in such periods the Federal Reserve has permitted somewhat more expansion in monetary aggregates than it might otherwise in order to keep interest rate fluctuations more damped than they otherwise would be” (ibid., 13).
¹⁶⁰

Soon afterward, a staff study reconsidered even keel after few months of experience with money or credit targets. This time the staff recognized more fully the market’s problems: (1) government security dealers, acting as underwriters, would experience large losses or gains if expectations changed during a period when they had to distribute Treasury coupon issues; and (2) they would not know whether changes in money and shortterm rates represented random fluctuations or a persistent policy change. As a result, “the commitment [to even-keel] will still have to be defined
largely in terms of maintaining a reasonably flat trend in day-to-day money market conditions during the Treasury financing period, even when the monetary aggregates are given top billing as operating targets” (Staff study, “Even-keel and the Monetary Aggregates,” Board Records, July 17, 1970, 10). The study recognized the implication: control of monetary aggregates would have to take place outside even-keel periods (ibid., 15).

159. “Even keel” replaced the policy of pegging interest rates to specific pre-announced ceilings. It has a loose relation to an investment bank’s policy of maintaining a market in newly underwritten issues for a period following initial sale.

160. “The major impact of even keel is that the System refrains from changing its constellation of money market conditions in a period of Treasury financings, whereas it would not refrain from doing so in a period of particular corporate or state and local government financing” (Axilrod, 1970a, 13). This formulation is very similar in its implication to Chairman Martin’s interpretation of independence within the government—that the government had to be financed; the System could not refuse to assist in its financing at or near current interest rates (see Cha
pter 2).

The
manager’s
autonomy.
In the 1950s and early 1960s, the account manager received vague instructions from the FOMC, and there was little correspondence between the members’ suggestions, so the manager could exercise considerable judgment. Efforts to increase the committee’s control led to the publication of the “Blue Book,” containing staff projections of bank credit, deposits, money, interest rates, and other variables. The projections assumed some set of money market conditions: prevailing, easier, or tighter. Axilrod (1970a, 15) recognized that “given the multiplicity of variables, the manager has considerable scope to play off one variable against another . . . so long as at least some key variables remain within specified ranges.”

In practice, FOMC members often rejected the constraints that associated one set of money market conditions with values for money or credit growth. Instead, they chose a different money stock growth rate at a given interest rate or a different interest rate for a given money growth rate (Lombra and Moran, 1980, 44). James Pierce (1980, 83) described the FOMC’s procedures as similar to choosing from “a menu in a Chinese restaurant: We will have one item from alternative A, [tighter] one item from B [unchanged] and split an item between B and C [easier]. The choices were often ‘wish lists,’ i.e. a low federal funds rate was selected along with slow money growth.”
¹⁶¹

Pierce (ibid., 82) summarized the outcome:

If one examines data for that period, one notes that an interesting phenomenon surfaces. Each month the FOMC set ranges of tolerance for the federal funds rate and for growth of the monetary aggregates. After the fact,
the
funds
rate
was
always
in
the
targeted
range,
while
money
was
rarely
in
its
range.
The reason is that the FOMC was not using M
₁
as a target. M
₁
was to be achieved
provided
the federal funds rate did not stray outside its allowable range. . . .

The implications of pegging money growth was explained time and again to the FOMC, to individual Federal Reserve Board members, and to Reserve bank presidents. Despite these explanations, the FOMC
chose
not
to
change
its
operating
procedures.
(emphasis added)

161. During the period they discussed, Lombra and Pierce were members of the Federal Reserve staff. Pierce had a major role in preparing material for the forecasts.

Axilrod (1970a, 19) gave two reasons. First, use of money market conditions provided a target that the manager could hit daily or weekly with little difficulty. Second, setting the federal funds rate or free reserves accommodated short-term changes in demand. As a principal example, he used seasonal changes in the demand for currency. He recognized, however, that a money market target provided or absorbed “bank reserves, credit and money in a pro-cyclical fashion” (ibid.) Here Axilrod accepted that Federal Reserve actions frequently reinforced cyclical changes in output and inflation instead of damping them.
¹⁶²

Axilrod’s lengthy discussion recognized fully that “an increase in inflationary anticipations . . . will increase the interest rate premium demanded by investors and will make borrowers more willing to pay it. Similarly, an abatement of inflationary expectations will have the reverse effect” (ibid., 27). The FOMC was slow to make this proposition an integral part of its analysis, and discussion and staff briefings did not make the distinction consistently. Consequently nominal rates were often considered “high” even if real interest rates were negative.

Effects
of
a
money
target.
Axilrod recognized also that “the System in the past has appeared reluctant to change money market conditions by more than small gradual amounts. Such short-run and longer-run goals for the money market can often interfere with the attainment of the longer-run interest rate, bank credit, and money objectives of policy—all of which appear to be more closely related to economic activity than are money market conditions themselves” (Axilrod, 1970a, 32). Axilrod took a long step toward the critics’ position. He recognized the value of smoothing the money market to avoid wide swings in interest rates and possible liquidity problems, but he concluded that “more fluctuation in money market conditions than has been permitted seems to have desirable aspects” (ibid., 35).
¹⁶³
Once the market became accustomed to fluctuations in short-term rates, it would not respond by changing credit conditions, and it would
learn not to interpret all such changes as policy changes. This was very different from the traditional answer (Roosa, 1951) that assigned responsibility to the System for smoothing the market.

162. This was a standard complaint of the Federal Reserve critics called monetarists. Axilrod (1970a, 31) accepted that opening the discount window and letting the discount rate adjust freely to market rates, as proposed by Brunner and Meltzer (1964), would accommodate these demands with much less intervention. In a classic paper, Poole (1970) analyzed the choice problem under uncertainty. He showed that the proper choice of money or an interest rate depended on the principal source of variation in the economy. A money stock target lowered expected loss if most of the disturbances came from the real economy. If most disturbances came from shifts in the demand for money, an interest rate target was more appropriate.

163. Pierce (1970) did simulations as part of the staff study supporting the work of the Committee on the Directive. He concluded that the FOMC could improve its success at achieving long-term goals if it permitted more short-term fluctuation in market rates to achieve more control of money growth. The policy simulations used the Board’s new MPS econometric model with 125 or more structural equations.