Fed

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