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Federal Reserve operating targets, past and present.

The Federal Reserve's choice of operating target has important consequences for its ability to control inflation and to counter episodes of financial instability. Historically, its practice of stabilizing the federal funds rate produced procyclical growth in money and inflation. After a relatively brief shift to a reserve target in 1979-82, the Fed returned to stabilizing the federal funds rate, a practice that reduces its credibility as an inflation fighter. The Federal Reserve would achieve credibility, and ironically more flexibility to stabilize financial conditions, if it made effective use of bank reserves as its operating target.

IN CONDUCTING MONETARY POLICY, the Federal Reserve must estimate the effects of its open-market operations on inflation and economic activity. All the intermediate steps running from open-market operations to bank reserves and the federal funds rate to money and credit to prices and output are not important in their own right, they are just part of the process producing policy's impact on ultimate objectives. But the linkages between policy action and ultimate effects are complex and uncertain, so that the Fed tries to make the problem more manageable by breaking the policy process into steps.

It starts by using open-market operations in an effort to achieve "operating targets," which are the values of bank reserves and the federal funds rate that it believes are consistent with achieving the values of "intermediate targets" (e.g., growth in the monetary aggregates), which in turn are deemed consistent with achieving the desired ultimate effects on inflation and economic activity. The operating targets are sufficiently "close" to actual open-market operations as to be hit with considerable accuracy. Intermediate targets are "further removed" from open-market operations but closer" to the ultimate objectives. These intermediate targets cannot be hit as accurately as operating targets, but the Fed adjusts its operating targets in attempts to achieve goals for the intermediate targets. The policy loop is completed by adjusting the intermediate targets, and the operating targets with them, in response to information that the ultimate objectives are not being achieved.

The choice of operating target(s) affects the Federal Reserve's ability to achieve its intermediate and ultimate objectives. Desired values of intermediate targets can be hit on average either by using the federal funds rate or a reserve aggregate as the operating target. Which of these two is more effective depends upon the sources of shocks causing errors in hitting the intermediate targets.(1) Furthermore, some reserve measures are more productive than others. For example, total reserves and the monetary base are more closely related to the monetary aggregates than are nonbol-rowed reserves, but they are more difficult to hit as operating targets.

The choice of operating target also affects the public's perception of what policy is and the Federal Reserve's ability to communicate when it has and when it has not changed policy. Suppose the Fed has chosen total bank reserves as its operating target and that it seeks to maintain a constant growth in these reserves. Further suppose that there is an unexpected increase in loan demand. Banks will attempt to increase their lending, reserve demand will rise, and the federal funds rate and other short-term market interest rates will increase. The Federal Reserve has not changed policy, in the sense that it has not deviated from its operating target, yet interest rates have risen. But the public is likely to interpret the increase in interest rates as a tightening of monetary policy.

Now suppose that the Fed had adopted the federal funds rate as its operating target, electing to hold it constant. In this situation, an increase in loan demand will again increase the demand for reserves, but in order to keep the federal funds rate from rising the Fed will have to accommodate the increase in reserve demand by providing more reserves through open-market operations. In this case, an unchanged policy produces an increase in money and credit with no change in short-term interest rates. The public is likely to interpret the increase in money and credit as an easing of monetary policy.

When there is an unexpected increase in loan demand, an unchanged interest rate policy results in a greater stimulative effect on output and inflation than an unchanged policy in terms of total reserves. But it can be shown that the use of a reserve measure as the operating target results in more stimulus than a federal funds rate target when there is an unexpected reduction in money demand or increase in money supply for given values of real output and inflation. By combining reserves and the federal funds rates as operating targets, the Fed could protect against both types of shock. But what would an unchanged policy mean in this case? It would really involve an unchanged "rule" governing how reserves are allowed to respond to interest movements. This is all well and good but such a rule would be very difficult for the public to interpret.


The Federal Open Market Committee (FOMC), the body within the Federal Reserve responsible for conducting monetary policy, uses open-market operations as the instrument for affecting financial and economic conditions.(2) Why then is policy not formulated and assessed in terms of open-market operations? The reason is that open-market operations are very difficult to interpret and evaluate. There are large seasonal swings in currency holdings by the public and sizeable fluctuations in Federal Reserve float and other factors that affect bank reserves. As a consequence, open-market operations are conducted to counteract the undesirable fluctuations in bank reserves that would otherwise occur. These open-market operations, essentially defensive in nature, are often much larger in magnitude than the open-market operations done to achieve some ultimate economic objective. This complication makes it difficult for policy makers to formulate or even think about policy in terms of the volume of open-market operations needed to achieve the desired objective. Decision-makers need measures of policy action that have intuitive appeal allowing easy communication, clear instructions to staff, reliable monitoring that instructions have been carried out, and the capability of monitoring by outsiders, such as members of Congress and market participants. These "policy variables" are called operating targets. The actual targets used have changed from time to time and are discussed in detail below, but all are measures or indicators of reserve availability.

An unchanged policy means that the operating target remains unchanged; the FOMC's trading desk in New York is instructed to pursue open-market operations defensively to aim for an unchanged value of the operating target. Errors of varying magnitude are made in achieving the target, depending upon the operating target used. For example, a total reserve target is harder to hit than a nonborrowed reserve target, which in turn is harder to hit than a target for the federal funds rate. These errors tend to be relatively small, but, to the extent that they occur, attempting to hit an operating target introduces slippage in achieving objectives for intermediate targets. Open-market operations chase after the operating target rather than the intermediate target, and errors in achieving operating targets are not perfectly correlated with those in achieving intermediate targets.

Use of intermediate targets introduces further slippage in the policy process. The trading desk is instructed to achieve some value for an intermediate target, say M2. Staff experts then estimate the open-market operations needed to achieve the value of the operating target that it needed to achieve the intermediate, target. These estimates are often substantially in error, so that the M2 target is often missed. The trading desk has some latitude to adjust the operating target, and hence open-market operations, to push M2 back on target, but substantial adjustments must await FOMC meetings. But the open-market operations made to return M2 to target will not necessarily get the economy closer to the final objectives; M2 will just perform closer to its targeted value. Of course, if M2 were perfectly correlated with the ultimate objectives, then putting it on path would do the same for the economy. But the correlation is far from perfect. There is no getting around the fact that the effect of policy runs from open-market operations to the ultimate objectives of policy, such as inflation. By using open-market operations to achieve first an operating target and then an intermediate target rather than aiming directly at ultimate targets introduces slippage.

In an ideal world without communication problems and other practical considerations, operating and intermediate targets would not exist, policy decisions would run from instruments (open-market operations) to ultimate targets. In this world, the ultimate objectives would be specified, and the open-market operations needed to achieve them would be estimated. Because of reporting lags in data for the price level and other ultimate targets, and lags in the effects of policy actions on the ultimate objectives, the FOMC would examine the behavior of a number of economic indicators whose values are available more rapidly and whose performance gives clues as to whether the policy action is having its desired effects. If these indicator variables are behaving as expected, policy is not changed, but if they suggest that the economy is not performing as expected open-market operations are modified.(3) Note that indicator variables are not restricted to the monetary aggregates; they include interest rates, quickly reported measures of spending and prices, and anything else providing information about the current and prospective state of the economy. They provide information on performance of ultimate objectives that cannot be observed directly; indicator variables are not forced back to predetermined values as is the case with intermediate targets. Rather, they provide clues concerning the success of the policy being pursued and how it might be modified.

The extent to which open-market operations should respond to indicator variables depends upon the extent to which these variables provide reliable information about the state of the economy and the effects that open-market operations are having. The degree of response (feedback) may be small or even nonexistent, or it might be substantial, depending upon the information content of the indicator variables and the reliability of relationships.

There are many reasons that actual policy departs so substantially from the ideal. One reason is that policy makers lack faith in statistical models and in feedback rules, including the wisdom of having no feedback at all. This leads them to fall back on their own judgment and intuition in formulating policy strategies. But perhaps more fundamentally, policy makers have so many objectives and so few means of achieving them that there is a continuous need to trade one objective off against another, resulting in frequent shifts in policy and frequent intervention by policy makers. The Federal Reserve has been given, and has accepted, an impossible task. It is responsible for providing the monetary anchor that keeps inflation under control while at the same time it is expected to counteract short-term fluctuations in real output, employment and the price level, i.e., it is the nation's primary counter-cyclical policy maker. To make matters even more complicated, the Fed is also charged with handling all sorts of special events, ranging from dealing with episodes of financial instability to stabilizing the exchange rate for the dollar when that is deemed desirable. This is not the place to discuss whether it is appropriate for the Fed to have all these objectives in the first place. But it is appropriate to point out the virtual impossibility of accomplishing all or even most of them at the same time. All the FOMC can do is vary open-market operations. The chances that a given amount of open market operations can achieve more than one goal for any substantial time is slim indeed. The overabundance of policy objectives relative to the means of achieving them has produced great confusion in financial markets about what Fed policy is and great expenditure of resources on trying to divine whether Fed policy has changed and to what degree. Market participants themselves look to indicators in the economy in the hope of detecting changes in policy. As switches are made from one objective to another, monetary policy is being changed and performance of one objective suffers relative to the current favorite.


Over the years, the Federal Reserve has used a number of different operating targets to help it implement and monitor monetary policy.(4) It has switched from one to another, as technology and other factors have made various ones obsolete and as policy objectives have shifted.

Following its accord with the U.S. Treasury in 1951 in which the Fed was no longer called upon to peg interest rates, the FOMC gradually removed its support from interest rates on U. S. Treasuries and by 1953 had adopted an operating target of affecting "money market conditions." This was accomplished by setting desired ranges for free reserves (member bank excess reserves less reserves borrowed from the Federal Reserve). Bank credit (total bank loans plus securities) was adopted as the intermediate target with goals stated in qualitative rather than quantitative terms, i.e., greater or slower growth in bank credit rather than numerical objectives for growth. The FOMC determined the money-market conditions it thought were consistent with its qualitative objectives for bank credit, and the trading desk was expected to maintain free reserves consistent with these conditions until the next FOMC meeting. When the FOMC sought to restrict growth of bank credit, and indirectly economic activity, it tightened money-market conditions by reducing free reserves, engaging in open-market operations to drain reserves from the system that reduced excess reserves and increase borrowing at the discount window. The tightening of money-market conditions raised market interest rates and constrained bank credit. Improvements in computer technology led to development of the federal funds market in the 1960s, in which banks with excess reserves lent to banks with reserve deficiencies. This development changed the behavior of free reserves, because banks came to hold substantially less excess reserves and banks with reserve deficiencies could borrow from other banks rather than from the Fed. For a while the FOMC continued to focus on money-market conditions by influencing free reserves, but it became clear that the federal funds rate was a better means, so the federal funds rate became the primary operating target. The FOMC set a desired value for the federal funds rate thought consistent with its goals for bank credit and instructed the trading desk to engage in open-market operations to maintain the funds rate at that value until the next FOMC meeting. If market forces were tending to raise the federal funds rate, indicating an excess demand for bank reserves, the trading desk purchased securities and supplied reserves until the funds rate fell back to its targeted value. If there was an excess supply of reserves tending to reduce the federal funds rate, securities were sold and bank reserves removed, raising the federal funds rate back to target. In 1966, the FOMC gave the trading desk authority to move the federal funds rate within a narrow band should bank credit be growing more or less rapidly than desired. This gave a degree of feedback in controlling bank credit between FOMC meetings, but the feedback was small because of the narrow range over which the federal funds rate was allowed to fluctuate.

In 1970, the FOMC formally adopted monetary aggregates as intermediate targets, specifying desired growth for one month ahead. Accelerating inflation and frequent excesses in money growth above desired values led the FOMC during the 1970s to shift from focusing almost exclusively on the federal funds rate as its operating target to placing greater emphasis on bank reserves. Many economists, of whom monetarists were most vocal, had long criticized the FOMC's procedures, pointing out that using the federal funds rate as the operating target tended to make reserve and money growth procyclical. It was asserted that if the FOMC used bank reserves rather than the federal funds rate as its operating target, relatively smooth growth in money would occur over the business cycle and interest rates would move procyclically, helping to constrain booms and limit contractions. Historically, the FOMC had resisted this suggestion, fearing instability in money market conditions. But rising inflation gave new weight to the suggestion.

In 1972, the FOMC attempted to set policy in terms of total reserves. Because U.S. government deposits and net interbank deposits were subject to reserve requirements but were not part of the money stock, it was decided to target reserves against private deposits (RPD), defined as total reserves less required reserves against government and net interbank deposits. By setting a desired growth range for RPD it was hoped that closer control could be achieved over the monetary aggregates and ultimately over inflation. This did not occur, however, because the FOMC was not willing to let the federal funds rate change enough to allow RPD targets to be hit. In effect, the FOMC was continuing to peg the federal funds rate. Realizing that it could not achieve close control of reserves with its operating procedures, the FOMC in 1973 relegated RPD to status of an intermediate target and continued with the federal funds rate as its operating target.

After considerable congressional prodding and finally congressional resolution, the Federal Reserve adopted annual targets for the monetary aggregates and announced these intermediate targets publicly. The Humphrey-Hawkins Act of 1978 subsequently required the Fed to set growth targets for the monetary aggregates for calendar years and to explain its misses. The misses were frequently substantial because narrow limits continued to be imposed on allowable movements in the federal funds rate between FOMC meetings, and the FOMC tended to move the level of the interest rate band by too small amounts to produce the reserve growth consistent with its targets for the monetary aggregates.

These procedures remained in effect until October 1979, when the Fed declared war on the double-digit inflation that was occurring. Aware of the political costs of appearing to be the direct cause of the tremendous increases in interest rates were sure to follow, and aware of the conservatism that would prevent FOMC members from voting such sharp and large increases, it was decided to change operating procedures from those that placed primary emphasis on the federal funds rate to those that put virtually total emphasis on controlling bank reserves. The strategy was successful in the sense that increases in interest rates were achieved that could not possibly have been voted for directly by the FOMC; the result was rapid deceleration of growth in the monetary aggregates (on average), a large recession, and a sharp decline in inflation.

During the period that spanned the years 1979-82, there were wide swings in growth of the monetary aggregates and huge fluctuations in interest rates. Both interest rates and growth of money were much more erratic than in the past. Somehow, just focusing on the monetary aggregates did not allow the FOMC to control their growth very accurately, and there was great confusion among market participants concerning what the Fed's policy actually was. Part of the problem stemmed from financial deregulation that produced huge shifts in money demand.(5) But much of the problem involved technical difficulties encountered by an FOMC that was unaccustomed to pursuing a reserve target seriously. The introduction of lagged reserve accounting in 1968 had benign effects as long as the federal funds rate was used as the operating target but had serious deleterious effects when reserves were used. Furthermore, too much emphasis was put on estimates of bank borrowing at the discount window, and attempts to stabilize this borrowing led to substantial volatility in total reserves and interest rates.(6)

In 1982 with inflation reduced, the economy in deep recession, and many borrowers from developed economies threatening to default on their debt to U.S. banks, the Federal Reserve ended its tight-money policy and returned to the federal funds rate as its primary operating target. The FOMC continued to calculate reserve paths while monitoring growth in the monetary aggregates and attempted to hit growth paths for them so long as this was compatible with relatively small movements in the federal funds rate. The usefulness of the monetary aggregates as intermediate targets was reduced, however, by the consequences of interest-rate deregulation of various deposit accounts offered by banks and thrifts. The relationship between the monetary aggregates (particularly Ml) on the one hand and GNP and market interest rates on the other hand became much less predictable than had been the case in the past.(7)

With so much uncertainty surrounding the relationship between the monetary aggregates and ultimate objectives, it is perhaps understandable that the Fed reverted to stabilizing the money market as its primary operating procedure.


The FOMC has continued to focus on the federal funds rate as its operating target, moving it up and down but by relatively small amounts. In effect, the FOMC has returned to the familiar practice of stabilizing money-market conditions. This reversion to form has not caused any substantial problems to date except that the Bush administration and others were unhappy that the Fed did not reduce short-term interest rates more quickly and to a greater extent when the economy dipped into recession. Whatever the merits of this position, it does underscore that by focusing on an interest rate rather than reserves as its operating target, the FOMC will likely be too slow in reacting to either recessions or inflationary periods. Use of the federal funds rate caused such problems in the past and it could cause them in the future.

The federal funds rate or other indicator of money market conditions works well if most of the shocks to the system come from shifts in financial markets that are unrelated to real GNP and the price level. Until the economy moved into recession, most of the shocks since 1982 did come from the financial side of the economy, so that the Fed's operating procedure helped insulate the real economy and the price level from these shocks. But there can be little doubt that market interest rates would have fallen faster and farther during the recession had the FOMC been using reserves rather than the federal funds rate as its operating target. Furthermore, should the economy experience a boom in the future, use of the federal funds rate would all but assure that reserve availability will not be constrained enough and short-term interest rates will not be allowed to rise sufficiently to avert an inflationary spiral.

Can the Fed be depended upon to shift its operating procedures to put more weight on bank reserves should inflationary pressures reappear? It is difficult to know, but past experience suggests that it will not change its procedures until substantial inflation materializes. The FOMC's proclivity is to cling to money market conditions as its operating guide until forced to change to a reserve target by substantial inflationary pressures. When inflation is under control, the FOMC will use money market conditions; when inflation is clearly too high it will shift to reserves.

Switching back and forth between money market conditions and bank reserves as operating targets creates substantial problems of policy credibility. When interest-rate movements are constrained by policy and when monetary aggregates move procyclically, there is good reason to fear that the Federal Reserve will end up underwriting yet another inflation. Its past policy mistakes tend to reduce its credibility and to make its job more difficult in attending to special problems that develop in financial and foreign exchange markets. The central banks of Switzerland and Germany are able to stabilize their financial and foreign exchange markets without raising fears of inflation because historically they have been effective inflation fighters. They have credibility. Their primary operating procedure is to obtain a relative slow and steady growth in a reserve or monetary aggregate. When some disturbance occurs, they depart from this procedure to stabilize their money or foreign exchange markets and explain what they are doing. Once the problem has passed they return to the inflation-control strategy. This gives these central banks credibility and with it the ability to act forcefully to avert emergencies.

The FOMC's approach is quite different. Its default option is to stabilize the money market with occasional shifts to inflation or recession fighting. This increases the chances of having increased economic instability and builds inflationary expectation into the system, making it more difficult to fight inflation. If the Fed followed the model offered by the Swiss or the Germans, it would find that inflation fighting would become easier and that departures from its basic policy to stabilize financial or foreign exchange markets would not kindle expectations of future inflation.

It is unlikely that the FOMC will change its spots by adhering to a "mechanical" basic policy in spite of the success of such policies in other countries. More likely the choice of operating target will continue to vary with prevailing conditions and with the personalities of policy makers. This will continue to make it difficult to determine what the Fed is up to, which may be bad news for the economy, but good news for the employment of Fed watchers.


1 For details see James L. Pierce and Thomas D. Thomson, "Some Issues on Controlling the Stock of Money," in Controlling Monetary Aggregates II: The Implementation. Federal Reserve Bank of Boston, Conference Series No. 9, 1972.

2 Reserve requirements and the discount rate are set by the Federal Reserve Board. They are not used nearly as actively as open-market operations, and, when they are changed, open market operations are altered to allow for their effects.

3 For the role of indicator or information variables see John Kareken, Thomas Muench and Neil Wallace, Optimal Open Market Strategy: The Use of Information Variables," American Economic Review, March 1973, and Peter Tinsley, Paul Spindt and Maria Friar, "Indicator and Filter Attributes of Monetary Aggregates: A Nit-Picking Case for Desegregation," Journal of Econometrics, September 1980.

4 For a more detailed account, see Anne-Marie Meulendyke, A Review of Federal Reserve Policy Targets and Operating Guides in Recent Decades," in Intermediate Targets and Indicators for Monetary Policy, Federal Reserve Bank of New York, 1990.

5 John D. Paulus, "Comment on Federal Reserve Operating Procedures: A Survey and Evaluation of the Historical Record Since October, 1979," Journal of Money, credit, and Banking, November 1982, Part 2.

6 William Poole, "Federal Reserve Operating Procedures: A Survey and Evaluation of the Historical Record since October 1979," Journal of Money, Credit, and Banking, op. cit. and Paul A. Spindt and Vefa Tarharo, "The Federal Reserve's New Operating Procedures: A Post Mortem," Journal of Monetary Economics, January 1989.

7 John Wenninger, "Monetary Aggregates as Intermediate Targets," in Intermediate Targets and Indicators for Monetary Policy, op. cit.
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Title Annotation:A Review of Federal Reserve Policy
Author:Pierce, James L.
Publication:Business Economics
Date:Jul 1, 1991
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