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Detecting changes in Federal Reserve policy.

In early 1983 the Federal Reserve shifted to a "borrowed reserves operating procedure," replacing nonborrowed reserves as an operating target. The relative stability of the federal funds rate and the modus operandi under this procedure suggest that it is tantamount to targeting the federal funds rate, the operating target that the Fed abandoned in 1979. Because the Fed has, in effect, returned to targeting the funds rate, Fed watchers can detect changes in policy with considerable accuracy. Their accuracy can be enhanced, however, by knowledge of economic and financial conditions and close study of the published records of meetings of the Federal Open Market Committee.

HAS THE FED eased? Has the Fed tightened? Such questions are asked endlessly - some would say ad nauseum - by Journalists, economists, and financial market participants.

The answers to these questions matter. Anyone trying to forecast the future course of the economy and financial markets must take account of the Federal Reserve's monetary policy. Moreover, those who work in financial markets have a need to know of policy changes promptly, because such changes affect interest rates almost immediately.

The Federal Reserve releases a "Record of Policy Actions of the Federal Open Market Committee" for each meeting that summarizes the Committee's discussion and the policy decisions made. However, the record for one meeting is not released until a few days after the subsequent meeting is held. Since the Federal Open Market Committee (FOMC) meets every six or seven weeks, there is a lag of that duration in the disclosure of FOMC policy decisions.

How can we learn of policy changes sooner than they are reported by the Federal Reserve? Efforts to answer that question have spurred the practice of "Fed watching." The thesis of this article is that under the FOMC's operating procedure of recent years, the Fed watcher can detect policy changes with considerable accuracy by observing the behavior of the federal funds rate. To develop this thesis, it is helpful to look at the various operating targets used by the FOMC in the past. We shall examine them only briefly, however, because operating targets are the subject of another article in the present issue of this Journal.


Operating targets are the measures at which the Federal Reserve aims in its open-market operations in order to achieve its policy objectives. Actually, operating targets are devices for attempting to reach intermediate targets, such as one or more measures of the money supply (i.e., [M.sub.1], [M.sub.2], [M.sub.3],), which in turn are expected to contribute to the ultimate goals of policy. The latter call for progress toward price stability, sustainable economic growth, and an appropriate pattern of international transactions.

At each meeting, the FOMC issues a directive to the Federal Reserve Bank of New York that conducts open-market operations. The directive is included in the published record of the Committee's meetings. It contains the operating instructions that are to guide the Trading Desk of the New York Fed until the next meeting. During the 1970s, the federal funds rate was employed as the operating target, and the directive would specify a rather narrow range within which the funds rate should be maintained; for example, the range was set at 10 3/4 to 11 1/4 percent at the meeting in August 1979.(1)

Faced with accelerating inflation and a weak dollar, the Federal Reserve in October 1979 abruptly changed its operating approach and began to target nonborrowed reserves rather than the federal funds rate as a means of controlling growth of the money supply. Then, in early 1983, the Fed shifted to borrowed reserves as an operating target in what H. Robert Heller, then a member of the Federal Reserve Board, described in an article as part of a "more judgmental approach."(2) The borrowed reserves operating procedure is still in effect.

Under the borrowed reserves procedure, the FOMC sets a level for bank borrowings from the Federal Reserve banks (excluding extended borrowing of troubled banks) that it believes is consistent with its objectives for growth of the monetary aggregates. Changes in banks' demand for reserves are then met by the provision of nonborrowed reserves through open-market operations in U. S. government securities. The Trading Desk will continue to feed in nonborrowed reserves in response to the demand of banks until the FOMC decides to raise the borrowed reserves level (tightening policy) or to lower it (easing policy).

Heller observed that under federal funds targeting, the federal funds rate was relatively stable and total reserves fluctuated widely, while under nonborrowed reserves targeting the funds rate was more volatile and reserves fluctuated less widely.(3) (That, of course, concurs with economic theory: if you control price, you cannot control volume and vice versa.) He found that under the borrowed reserves operating procedure, the federal funds rate was less stable than under federal funds targeting but more stable than under nonborrowed reserves targeting. Total reserves fluctuated somewhat more widely under borrowed than nonborrowed reserves targeting.(4)


The examination of the data of the federal funds rate and reserves ended in late 1987 in the Heller article. In order to carry the analysis forward and to provide comparisons for this study, the variability of the funds rate (but not reserves) was calculated for various periods by tile same method used by Heller. That method measured variability by "changes in the average weekly federal funds rate (in percent) as deviations from the mean change over the period."(5) For this study, the variance of the deviations or differences was computed for each period, so that variability could be readily compared across periods. The following table sets forth the variance for the period from December 30, 1987 to December 26, 1990 and for four previous three-year periods.
 Table 1
 Variability of the Federal Funds Rate*
Borrowed Res
 12/30/87-12(26/90 .018
 1/02/85-12/30/87 .082
 02/09/83-02/05/86 .139
Nonborrowed Reserves Targeting
 09/26/79-09/22/82 .676
Federal Funds Targeting
 09/29/76-09/26/79 .019
 * Variance of differences between changes in the average weekly
federal funds rate (in percent) and the mean change over the

The table sends the striking message that the variability of the federal funds rate in the latest three years was virually identical with the final three years of federal funds rate targeting. So far as the behavior of the funds rate is concerned, one can conclude that there is a distinction without a difference between federal funds rate targeting and the borrowed reserves operating procedure still in effect.

Futhermore, it appears that, over the years that the borrowed reserves procedure has been in place, the Federal Reserve has moved toward tighter control of the federal funds rate. The variance declined from the period ending February 5, 1986 to the (somewhat overlapping) period ending December 30, 1987,(6) and then dropped again in the past three years. The tendency for the FOMC to adjust the borrowed reserves "assumption" - a term the Fed seems to prefer to "target" - for "technical reasons" rather than to change the federal funds rate seems to have increased.


The data on the variability of the federal funds rate suggest that the recent version of the borrowed reserves operating procedure is a reincarnation of the federal funds rate targeting. The Federal Reserve seems to have come full circle back to its operating procedure of the 1970s. Statistically, perhaps a distinction could still be made on the basis of variability of reserves, which is not examined in this study, but among Fed watchers the impact of policy on the funds rate receives most attention.

Aside from statistics, the modus operandi of the borrowed reserves procedure seems to bring it very close to federal funds rate targeting (at least to someone who has not had the benefit of sitting in on FOMC meetings). Under this procedure, demands for total reserves are calculated, and the FOMC decides what portion the banks will (or should) obtain from discount window borrowing for temporary adjustment or seasonal purposes. Then, as noted earlier, the Fed normally meets changes in demand for bank reserves by supplying (or draining) nonborrowed reserves through open market operations - until such time as the FOMC changes the borrowing assumption.

The process of adjusting the supply of nonborrowed reserves to the changing demand for reserves would seem to be an exercise in keeping the price of reserves, the federal funds rate, stable. Of course, banks can change their preferences for borrowed reserves. But published summaries of FOMC meetings give some indications that the Committee is inclined to change the borrowing assumption rather than the federal funds rate when it wants to maintain an unchanged policy stance.(7)

if we now have an operating procedure that is tantamount to federal funds rate targeting, detecting moves by the Fed toward easing or tightening becomes easier. Significant changes in the federal funds rate that are sustained for more than a few days will normally signify that the Fed has made a short-run policy change. The art in Fed watching is in judging whether the change is significant and whether it will be sustained. Significance may be gleaned from the Fed's recent style; for example, over the past year policy moves in the funds rate have typically been in the 25 basis points (.25 percent) vicinity. Determining whether the change will be sustained beyond a day or so is more difficult. The Fed watcher must rely on his/her knowledge of current economic and financial conditions and judgment as to the Fed's probable response. In this regard, reading the records of policy actions of the FOMC will help, as discussed below.

As part of the larger study, Timothy Cook and Thomas Hahn surveyed the market's perception of Fed-induced changes in the funds rate during the period of federal funds rate targeting in the 1970s. They concluded: "Begininng in late 1974, the Desk's control of the funds rate became so tight that the public was able to perceive most changes in the funds rate target on the day they were first implemented."(8) authors took the perceived changes in the target from reports in the Wall Street Journal on the following business day. From the Journal they compiled 76 reported changes over the period from September 1974 to September 1979.

In summarizing their findings, Cook and Hahn said "Overall, 71 of the 76 changes in the funds rate target changes in the series we constructed from the Journal can be clearly linked to actual changes announced in the Report of Open Market Operations. Five changes cannot be clearly linked

. . Even in these cases, the Journal accurately reported the Desk's operations, but market participants misunderstood the funds rate target these operations were signaling."(9)

Now that it is perceived that the Fed is once again controlling the federal funds rate, although perhaps not as closely as in the 1970s, market participants look at rate changes as signals that the Fed has changed the level that it prefers for the funds rate. The author did not try to replicate the work of Cook and Hahn for recent years, but a more casual monitoring of market perceptions, coupled with the records of FOMC policy actions (published six to seven weeks later), suggest that these perceptions have again become rather accurate.


The "Record of Policy Actions of the Federal Open Market Committee", mentioned previously, provides useful insights to monetary policy. We focus here on the directive to the Feneral Reserve Bank of New York contained in the published record, although the summary of economic and financial conditions and the members' discussion of policy actions that precede the directive are invaluable.

The last paragraph of the directive, called the operational paragraph," sets forth the policy that is to be implemented in the, near term. If no change is to be made, the paragraph will begin, "In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions."(10) In the parlance of the borrowed reserves procedure, a decision to ease would normally read ... seeks to decrease slightly (or somewhat) the existing degree of pressure on reserve positions."(11) A tightening decision would begin, ". . . seeks to increase slightly (or somewhat) the existing degree of pressure on reserve positions."(12)

These instructions do not mention the federal funds rate. Yet each time that the Committee voted to increase or to decrease the existing degree of pressure on reserve positions at the meetings of the past three years, which were reviewed for this study, the federal funds rate rose or fell shortly thereafter. Changing the existing degree of pressure has become synonymous with changing the funds rate. (This is not to say that the borrowing assumption bas not also changed.)

One cannot spot policy changes alone from the first sentence of the operational paragraph of the directive. Also of importance - sometimes greater importance - is the proviso clause that follows the first sentence. This clause provides for possible policy adjustments between meetings. For example, the one for the meeting of May 15, 1990, read, "Taking account of . . . slightly greater reserve restraint or slightly lesser reserve restraint would be acceptable in the intermeeting period."(13)

The foregoing proviso clause is "symmetrical" or unbiased" because the language suggests an equal inclination toward greater or lesser reserve restraint. Under this clause, a policy adjustment could be made between meetings, either after a consultation between the Chairman of the Federal Reserve Board and the Manager for Domestic Operations at the Federal Reserve Bank of New York or a telephone meeting of the FOMC. But a policy adjustment would not be as likely under a symmetrical as under an "asymmetrical" or "biased" proviso clause. An asymmetrical clause in the direction of restraint would read similarly to the following from the directive for the meeting of March 28, 1989: ". . . somewhat greater reserve restraint would, or slightly lesser reserve restraint might, be acceptable in the intermeeting period."(14)

In the delicately discriminating language of directives, "somewhat" is stronger than "slightly" and "would" is stronger than "might." An asymmetrical clause biased toward ease would couple the stronger words with "lesser reserve restraint." A milder version of a biased instruction would not use both words. For example, reference could be made to slightly greater reserve restraint" and to "slightly lesser reserve restraint," with the bias indicated by which of the two was coupled with "would." The reader may feel by now that this discussion has deteriorated to hair splitting, but such is the language of Federal Reserve policy. It means something to the policy makers in terms of interest rates and reserves. During the years 1988 through the early part of 1991, there appeared to be more changes in the federal funds rate associated with action under the proviso clause than with an explicit decision at the FOMC meeting to change "the existing degree of pressure on reserve positions." (The Fed raised the funds rate substantially from the spring of 1988 to the spring of 1989 and lowered it substantially from the fall of 1990 to the spring of 1991.) Moreover, dissents of the Committee members in voting on the directive have often been based on the tilt, or lack of tilt, in the proviso.

While records of the FOMC meetings, including the directives, are published some six to seven weeks after the meetings, they can still aid one in detecting policy changes as they occur. Did the Committee members previously appear to be more concerned with inflation or with the strength of the economy? What economic indicators seemed to be receiving the heaviest weight? Was the vote for the last directive unanimous or split? Armed with the discussion and directives of previous meetings and with current economic and financial information, the analyst should be able to make a fairly good estimate as to whether a change in the federal funds rate represents a change in policy.

The proviso clause begins with a recitation of factors (omitted above) on which it is dependent, such as, "progress toward price stability, trends in economic activity, the behavior of the monetary aggregates, and developments in foreign exchange and domestic financial markets, . . "(15) These indicate what to look for in way of economic information that may prompt Fed policy action. Normally, they do not change much from meeting to meeting, but a change in the order in which the factors are listed or a change in their wording should alert the Fed watcher of a change in policy emphasis. (16)

In short, the records of' FOMC meetings provide a rich source of intelligence on Federal Reserve behavior. Close study of these records can help one to see through the eyes of the Fed (although hardly with 20/20 vision) and to judge better what it is up to.


Under its current borrowed reserves operating procedure, the Federal Reserve has, in effect, returned to targeting the federal funds rate. That may have resulted in better or worse monetary policy in recent years (a question outside the subject of this article), but it has made Fed watching easier. Economists and market participants can detect changes in Federal Reserve policy with considerable accuracy from changes in the federal funds rate. Detecting changes, however, has hardly become a mechanical exercise. Informed judgment is needed to distinguish between temporary blips in the funds rate and policy changes, and judgment can be enhanced by close study of the published records of Federal Open Market Committee meetings.

One obvious caveat should be added. Changes in the federal funds rate will continue to serve as a good clue to policy changes as long as the Federal Reserve adheres to its present operating procedure. Should it change the procedure, as it did abruptly in 1979, and less abruptly in 1982-83, it will be time for a revised edition of this article.


1 Record of Policy Actions of the Federal Open Market Committee," Meeting held on August 14, 1979, Federal Reserve Bulletin, October 1979, p. 844.

2 H. Robert Heller, "Implementing Monetary Policy," Federal Reserve Bulletin, July 1988, p. 426.

3 Ibid.

4 Ibid., p. 427.

5 Ibid. The Heller article presented charts that showed the variability so measured. No composite statistical measures of the deviations or differences were given, but they did not appear necessary because the variability visible from the charts adequately supported the conclusions drawn.

6 Money market specialists may point out that the federal funds rate surged in the weeks ending December 31, 1986 and January 7, 1987 due, as I recall, to computer failure in New York City. To avoid distortion, these weeks were deleted in calculating the variance for the january 2, 1985 to December 30, 198 1- period.

7 For example, see "Record of Policy Actions of the Federal Open Market Committee," Meeting held on February 6-7, 1990, Federal Reserve Bulletin, May 1990, p. 337.

8 Timothy Cook and Thomas Hahn, "The Effect of Changes in the Federal Funds Rate Target on Market Interest Rates in the 1970s,". Journal of Monetary Economics 24 (November 1989), 1). 333.

9 Ibid., p. 338.

10 "Record of Policy Action of the Federal Open Market Committee," Meeting held on February 5-6, 1991, Federal Reserve Press Release, March 29, 1991, p. 22.

11-12 This language is found repeatedly in directives beginning with the one for the meeting of February 8-9, 1983.

13 "Record of Policy Actions of the Federal Open Market Committee," Meeting held on May 15, 1990, Federal Reserve Bulletin, September 1990, p. 752.

14 "Record of Policy Actions of the Federal Open Market Committee," Meeting held on March 28, 1989, Federal Reserve Bulletin, July 1989, p. 507.

15 "Record of Policy Actions of the Federal Open Market Committee," Meeting held on February 5-6, 1991, Federal Reserve Press Release, March 29, 1991, pp. 22-23.

16 The proviso clause is followed by a statement of the growth rates of the monetary aggregates, intermediate policy targets ([M.sub.2] and [M.sub.3] in recent years), with which the reserve conditions are expected to be consistent over a period of a few months.
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Author:Heebner, A. Gilbert
Publication:Business Economics
Date:Jul 1, 1991
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