A History of the Federal Reserve, Volume 2 (115 page)

A main conclusion is that by attempting to hit a money growth target, the FOMC would change the relation between short- and long-term objectives. Market rates would fluctuate more, at least initially. Once the longerterm trend became clear, some of the instability in short-term rates would moderate. Greater attention to achieving money growth targets would increase control of “financial variables that more directly affect changes in the public’s spending propensities” (Axilrod, 1970a, 55).

The
committee
and
staff
reports.
The final staff reports appear in the appendix to the Report of the Committee on the Directive, dated March 2, 1970. The committee report recognized parts of the problem. It called for a change in the target from money market conditions to one or more monetary aggregates; it attempted to shift attention from short-term changes in the money market to longer-term changes in aggregate demand, economic activity and prices; and it recognized that there was very little relation between money market changes and longer-term policy goals. These are the principal criticisms by Brunner and Meltzer (1964) in their report to the House Banking Committee.

The report of the Committee on the Directive, prepared by Governor Maisel, chair, and Presidents Morris (Boston) and Swan (San Francisco), did not try to decide which aggregate would make the best target. Instead, it chose a total reserve target that could be consistent with different intermediate objectives such as money or credit growth or some broader measure of money. Each monthly meeting could reset the target, based on new information, but the presumption was that policy would change infrequently.

With Martin gone, the report accepted some of the principal criticisms of the procedures that developed during his tenure, particularly the weak connection between money market conditions and final goals and the absence of procedures that looked beyond the short term. “The weakest sector of the FOMC directive operations has been the Committee’s formulation of the role and posture of monetary policy for the immediate period which stretches between the current month’s targets and the ultimate goals. . . . [T]he specification of what monetary policy the Committee desires and the relating of such a policy to the Manager’s operations and the Committee’s goals remain critical problems” (Report of the Committee on the Directive, Board Records, March 2, 1970, 5).

Procedures had changed substantially in the five preceding years, partly responding to outside critics and partly to members’ and staff criticisms, particularly criticisms from Governor Maisel. Until 1965, the Board
and the FOMC operated under the “Riefler rule,” a prohibition against forecasts.
¹⁶⁴

By 1970, for each meeting the staff prepared a “green book” containing economic forecasts for six to fifteen months ahead and periodically made projections of money, credit, and interest rates believed consistent with the forecast. The two forecasts or projections were independent and unrelated. The committee report wanted the staff to relate proposed changes in the directive to anticipated changes in money, credit markets, and the economy.

The “blue book,” containing inter-meeting changes in interest rates and monetary aggregates, accompanied the green book. Blue book projections had been extended to a quarter, so the manager knew the staff forecast of reserves and money market conditions for a rolling three-month period.

The staff report was unanimous that “primary focus in the directive on money market conditions . . . can lead and often has led to inappropriate policy” (ibid., 7). The committee agreed and accepted that “financial markets are sufficiently resilient to offer scope for wider week-to-week fluctuations, and intermediate target changes, in money market conditions than has generally been permitted in the past” (ibid.). The report identified the problem as unforeseen changes in aggregate demand or demand for money that caused policy action to change in ways different from those desired by the FOMC without inducing sufficient FOMC response.

The committee recommended that the staff use a variety of methods, including judgment, to forecast the principal economic variables three times a year and relate their projections to movements in monetary aggregates and interest rates assuming unchanged policy. In addition, the staff was asked to project the same variables based on alternative policies. This is the origin of the three alternatives—tighter, easier, unchanged—that the staff provided at subsequent meetings. The FOMC would decide on a total reserves target for the next three months, expressed in qualitative terms in the directive and quantitatively in the instructions to the manager.
¹⁶⁵

The staff recognized that the proposed pro
cedure would not be easy to implement.
¹⁶⁶
Its memo supported the proposed change, however. Both
the staff and the committee either neglected or underestimated the difficulties in using money market conditions—for example, a daily or weekly short-term interest rate—to hit a target for a monetary aggregate three months ahead. First, the staff recognized that it had not developed a procedure for estimating borrowed reserves. The staff assumed that expected borrowing would remain at the average level of recent weeks. This was not helpful and created a problem at the time and again in 1979–81, a later attempt to use a reserve target. Second, the staff left to the manager to decide whether a change in reserves or money was permanent or transitory. Neither he nor they had much basis for making the judgment, but it became important. Under the money market procedure, the manager supplied all such changes, in effect treating all changes as transitory. The FOMC could then make a change at the next meeting. The new procedure required the manager, perhaps assisted by the staff, to make these judgments as they occurred. This, too, proved to be a problem. Muth (1960) showed that the size of the adjustment depended on the relative variance of permanent and transitory components, but the staff did not use this analysis. Third, neither the report nor the appendixes discussed what would replace the evenkeel procedure. None of the material suggested auctioning all government securities to permit the market to set the price. Fourth, the FOMC had adopted lagged reserve accounting. Member banks held reserves based on deposits two weeks prior to the settlement date. This change fixed the amount of required reserves, reducing flexibility and making control of monetary aggregates difficult.

164. Riefler left at the end of 1958, but the rule remained. It is hard to know what the rule meant in practice, since the FOMC recognized recessions and recoveries promptly. The rule banned econometric models but was silent about judgmental forecasts.

165. The staff would base its forecast or projection on seasonally adjusted data but use its seasonal factors to give the manager a seasonally unadjusted number for total reserves. This required a forecast of member bank borrowing and excess reserves as well as estimates of float, Treasury deposits, etc. The committee recognized that much was unknown or subject to error, possibly large error.

166. “We have not progressed to the point where an econometric model can be the foun
dation of our projections; indeed, we may never do so. . . . [S]taff projections for the year ahead are based on many hours of judgmental forecasting” (Appendix B to Report of the Committee on the Directive, Board Records, March 2, 1970, 3). The staff expected to continue to rely mainly on judgmental forecasts for a year ahead, supplemented by model forecasts for longer periods.

International aspects of policy did not appear in any of the documents. Although there was a short reference to euro-dollar flows, the effect of improved control of monetary aggregates on the capital account and the value of the dollar received no mention. This suggests the limited attention these matters received at the time.

The
report
to
the
FOMC.
Maisel’s opening statement to the April 1970 FOMC meeting recognized that in January the full committee had adopted some of the proposed changes. He asked, in addition, that the FOMC issue an explicit statement explaining the change and agree to devote more time and attention at FOMC meetings to longer-term objectives and how to achieve them. The report criticized the use of money market conditions— “particularly net borrowed reserves and the Federal funds rate”—because
they “often led to inappropriate policy, particularly in periods of rapidly shifting demands for credits” (FOMC Minutes, April 7, 1970, 71).
¹⁶⁷
The report added: “On too many occasions, and for too extended a period of time, the amount of money and credit has grown at a rate far greater or far smaller than would have been desirable in the economic circumstances” (ibid., 72).

The Maisel committee proposed that members state their objectives for aggregate demand (neutral, stronger, or weaker than projected) and the quantitative condition they believed would achieve their objective over time. The manager would then “specify desired changes in total reserves for the next three months that are consistent with the consensus of the FOMC’s views about desired financial conditions” (ibid., 72). The committee proposed including a total reserves path for the next four weeks.
¹⁶⁸
At each meeting, the FOMC could adjust the three-month path in the light of new information. Maisel recognized that the federal funds rates would fluctuate over a wider range. To prevent the market from misreading these fluctuations, he wanted the FOMC to announce that the four-week average growth of total reserves was now the target.

Morris noted that the committee had chosen total reserves because members who wanted to control bank credit or money could agr
ee on the growth of total reserves consistent with their different objectives. “There was a wide degree of agreement that the Open Market Committee’s shift
toward aggregative targets thus far in 1970 had been a desirable development and that the Committee should continue to pursue such targets.” But agreement was neither strong nor deep. Burns’s summary of the consensus said that the directive committee should continue to function informally, but the FOMC would not take any additional steps and would not issue a statement about the change. The FOMC rejected the reserve target and chose three-month averages for both money and bank credit growth, but it retained money market conditions as an operating target and did not decide what to do if money and bank credit diverged. In practice, the manager and the FOMC were supposed to emphasize money growth. The FOMC would now specify a level of the federal funds rate believed to be consistent with its money growth target, and the manager would adjust his operations to achieve the money target.

167. Many of these criticisms are similar to an earlier report for Congress (Brunner and Meltzer, 1964) and a 1964 internal report by a committee consisting of Governor Mitchell and Presidents Ellis and Swan. Neither the Committee on the Directive nor these reports recognized that frequent changes in the federal funds rate that prevented excessive or deficient growth of money or base money over six months or a year would achieve many of the objectives that these reports favored. President Scanlon (Chicago) reminded Maisel of a main point in the FOMC’s 1964 report. “The Committee is not really concerned about short-run developments in the money market except as these affect the Manager’s ability to achieve longer-run goals, and it is these longer-run effects on monetary aggregates that are closely linked
[sic]
to desired trends in real economic variables. . . . The essential element of this approach is . . . that the committee set a specific desired rate of change in an aggregate monetary variable with maximum freedom for the Manager as to the methods employed in reaching it” (letter, Charles J. Scanlon to Sherman J. Maisel, Board Records, January 12, 1970, 3). Scanlon further urged “detailed elucidation of the FOMC’s conception of the monetary process,” (ibid., 4). He included the “trade-offs or Phillips curve relationships among them . . . the interrelationship between monetary and fiscal policy,” (ibid., 4). This went much further than the Maisel committee ventured and was never adopted.

168. The committee chose total reserves because “it would be difficult for the members of the FOMC to agree on a specific theory of monetary policy, on the relevant variables, or on the relationship between possible variables and desired results. . . . Thus, the FOMC must be able to agree on desired reserve movements, even if it is fragmented in its individual views as to how such operations are expected to influence monetary policy and how such policy will influence the economy” (FOMC Minutes, April 7, 1970, 73).

Maisel described the most important change as “the agreement, which the market would understand, that a movement in money market conditions would not mean that monetary policy had changed. Policy was to be measured by movements in the monetary aggregates” (Maisel, 1973,254).

Maisel’s proposal did not really change much. Pressures to concentrate on short-term changes remained strong.
¹⁶⁹
Adjusting fully to shortterm movements in money growth or bank credit required frequent, large changes, up and down, in market rates, larger changes in interest rates than the FOMC would accept.

One of the more puzzling decisions was to avoid any announcement. If implemented as proposed by the Committee on the Directive, participants in the market for federal funds and other short-term securities would at once observe larger daily and weekly changes in market rates. Failure to explain the procedural change would increase uncertainty, misinterpretation, and speculation that would work against successful implementation. The lack of announcement underscores the ambivalence that Chairman Burns must have felt about the proposal. He would pay some lip service to the aggregates when it served his purpose, but he would not implement the recommendations.

At a broader level the decision not to announce the change shows the lingering effect of traditional central bank secrecy. The Federal Reserve, and other central banks, did not yet accept that well-informed market participants could help to implement policy smoothly and efficiently. A broad
understanding of the mutual interdependence of the market and the central bank remained a missing element in the theory and practice of central banking.
¹⁷⁰

169. Pressures from the Joint Economic Committee of Congress to maintain money growth in the 2 to 6 (or 3 to 5) percent range are not mentioned by Maisel or the FOMC, but they may have played a role in getting to an agreement or in getting Chairman Martin to accept an aggregate target at his last meeting (see Joint Economic Committee, 1968).