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Monetary policy in an era of change.

Monetary Policy in an Era of Change

The pace of change in financial markets and the economy seems to have accelerated over the past decade or so. To the ongoing process of private adaptation and innovation in a dynamic market economy has been added the dismantling of regulations in a number of areas. This article discusses those developments that have been most important from one perspective--that of monetary policy.


The practical question a monetary policymaker must ask constantly is, how do I judge whether the instruments at my disposal are at the right settings to foster national economic objectives? Or, more broadly, is there a system to guide adjustment of those instruments to get them closer to their appropriate settings? Such a system need not involve frequent discretionary changes in the instrument settings in response to a variety of incoming information. Rather, it could be embodied in a policy rule in which the instruments reacted fairly automatically to certain developments, such as changes in demands for money, and in which few, if any, ad hoc adjustments were required.

These questions arise in part out of the uncertainties created by the lags between policy actions and economic results. The lags are inherent in a complex process through which actions to alter policy instruments, such as adjustments to reserve availability through open market operations or changes in the discount rate, are transmitted to the economy. In a simplified description of this process, the central bank alters the cost and quantity of reserves, and those alterations work through the supply of and demand for money and credit to affect interest rates, exchange rates, and other financial variables and to influence the demand for output and the price level. Inevitably, it takes some time for people to recognize that factors important to their spending decisions have changed in more than trivial ways and to alter their behavior accordingly, and then for the full effects of the new behavior to be felt in the economy. In practice, the process involves the simultaneous determination of these variables through complex interactions, affected powerfully by expectations about the future actions of the participants, including those of the central bank. As a consequence, the duration of the lags may vary over time.

Questions about the relation of policy settings to objectives also arise because of the effects of factors outside the direct influence of the monetary policymaker, such as developments abroad or changes in fiscal policy or private spending behavior. These factors could significantly influence the level of economic activity and prices, possibly requiring some reaction by monetary policymakers.

Because of the lags involved, making monetary policy necessarily involves predicting the effects of policy actions and of these other influences. The predictions may be arrived at through formal forecasting exercises. However, the experience of recent decades has reinforced skepticism about detailed forecasts of gross national product that attempt to take explicit account of the interactions over time, a skepticism already present in face of the complexity of the economy and of the transmission of policy actions. That skepticism has prompted a search for intermediate guideposts along the way, so that policymakers can judge whether they are on the right track and the public can judge the direction of policy. It has also prompted a search for policy rules--ways of setting or adjusting the instruments of policy, usually keyed to an intermediate guidepost such as a measure of the money stock--that require little judgment by policymakers. Of course, the use of guideposts and rules itself involves implicit forecasting: the intermediate guide should be related predictably to objectives; and predetermined changes in instruments in reaction to deviations of the guide from its path should be proportioned and timed appropriately to achieve progress toward those objectives.

It is in the context of the need to predict the effect of policy actions that questions arise about how financial and economic changes have affected the transmission of policy and about the implications of these changes for the variables to which the central bank is, or ought to be, paying attention. That is, harking back to the issues facing the policymaker, how have these changes affected the instrument settings needed to achieve ultimate objectives and the criteria for judging whether the settings are appropriate?



A number of developments in the economic and financial environment bear on these questions. Several involved discrete changes in law, regulation, and international agreements. A key series of changes concerned deregulation of interest rates on both sides of the balance sheets of depository institutions: through removal of Regulation Q on deposits and of usury ceilings on loans. In the international arena, the earlier moves to floating exchange rates and freer capital flows seemed to take on greater importance in the past decade.

At the same time, certain evolutionary changes in financial markets and the economy may have affected the way monetary policy works. In financial markets such changes include the greater use of floating-rate financing, and of futures and options and other forms of reallocation of the risks of fluctuations in interest rates or other prices in financial markets. The expansion of markets in derivative instruments has been fostered in part by improvements to information systems, which have facilitated more complex strategies for managing assets and liabilities. Such strategies also have included greater economizing on lower-yielding financial assets, such as transaction deposits, and on lower-yielding real assets in the form of business inventories. In the economy, imports and exports have become more important in variations in domestic spending and production. Deregulation and technological advances have made some of these developments possible, but many have also been impelled by the unusually wide amplitude of cycles in the economy, in inflation, and in financial markets. These swings have reflected in part the supply shocks of the last 15 years as well as unprecedented shifts in monetary and fiscal policy, and they have been associated with huge fluctuations in interest and exchange rates.

Certainly, taken together these developments have mattered for the transmission of monetary policy to the economy. They have altered the responses of certain financial variables to policy impulses and the responses of the economy to those financial variables. And they have changed the importance of particular channels of policy influence as well as the way other variables affect the economy.

The effects can be seen clearly in new behavior patterns of traditional intermediate indicators of policy, both money and interest rates--changes that have been well-documented elsewhere, most recently in articles by William Poole and Benjamin Friedman in the Summer 1988 issue of Journal of Economic Perspectives.

Effects on the Monetary Aggregates

As the character of monetary assets has changed with innovation and deregulation, so has the way these assets have been supplied and demanded in financial markets. In effect, new instruments have been created bearing old names, and quite naturally they do not behave in the old ways.

The most important effect of deregulation on the monetary aggregates has been on their interest elasticity over the short and intermediate terms. Many observers expected that, when deposit rates were deregulated, adjustment of these rates to market yields would forestall widespread reallocation of asset portfolios in the wake of changes in market interest rates. Instead, demands for the aggregates remain quite sensitive to movements in market interest rates; indeed, the interest sensitivity of the narrow aggregates has increased. As anticipated, since deregulation the opportunity costs of holding deposits have fallen as deposit rates have moved up toward market rates. Yet, for many household deposits opportunity costs continue to fluctuate over a wide range in response to changes in market rates, and on average, for periods of a year or two, may be relatively as variable as before.

The behavior of opportunity costs results from the tendency for depository institutions to adjust many of their retail deposit rates only sluggishly. The effects have been greatest on M1, since yields on NOW accounts, which are an important component of that aggregate, move much more slowly than short-term market rates or yields on small time deposits do. Also, NOW accounts have attracted considerable savings funds, which may be particularly sensitive to changes in interest differentials. The lag in adjustment of rates on NOW accounts has occasioned substantial shifts of funds between these accounts and small time deposits as yield relationships have changed. Such shifts would be subsumed within M2, but even demands for this aggregate seem to exhibit substantial interest sensitivity over the periods of a year or so that are relevant to standard targeting exercises.

For the policymaker, the practical effect of an interest-sensitive money demand is a loose tie between money and income within a business cycle. The amount of money the public wishes to hold at any level of income or spending can vary substantially depending on the interest rates prevailing. For example, strong growth of income might be associated with fairly subdied monetary expansion if the robust behavior of the economy were accompanied by higher interest rates, whose depressing effects on money demand could more than offset the boost from money growth in a strong economy might well signal a monetary policy that had been too easy, weak money growth would not necessarily suggest that policy was too tight and might lead to a downturn. In fact, such a path for money might be an aspect of a prescient and appropriate policy that had moved toward restraint to head off inflationary pressures. Similar problems could cloud the interpretation of opposite movements of money supply indicators if the economy were weak and interest rates had fallen substantially.

As a consequence of deregulation, these problems have become so serious for M1 that this aggregate, which formerly was considered the most reliable intermediate guide, has not been able to serve as a useful indicator or target for policy. M2 has not been affected in this way, but it remains sufficiently interest sensitive that it is difficult to judge the import of a path for this aggregate without reference to the surrounding economic situation.

Effects on Interest Rates and Spending

The natural inclination in such circumstances is to pay closer attention directly to spending trends, relating them to such determinants as interest rates. But, even that relationship has been affected by deregulation and innovation in recent years.

In particular, removal of Regulation Q ceilings on deposists and of usury ceilings on loans has meant that financial intermediaries no longer abruptly reduce the supply of mortgage credit and certain other types of credit, with effects on associated spending, when interest rates reach certain levels. Moreover, new financial instruments, markets, and techniques have broadened the choices available to savers, spenders, and intermediaries for structuring their assets and liabilities. Small savers have many more opportunities to earn market-related rates of return, and investors can adjust the liquidity and other risk characteristics of their portfolios at lower transaction costs. Borrowers have new, inexpensive channels for liquefying fixed assets and for tapping savings flows--for example, through home equity lines of credit and securitized mortgages. Financial intermediaries have gained greater flexibility for asset and liability management. The result has been to reduce quantity or liquidity constraints in financial markets, and thus to elevate rate movements as a transmission channel for monetary policy and other influences in the economy. In turn, this development means that real interest rates now may vary more as economic conditions change and in particular they may need to rise to higher levels than previously to provide equivalent restraint on spending during "booms" in business activity.

International Considerations

At the same time, judgments about what policy settings are appropriate for the desired results with respect to prices and output have been affected by the growing need to take account of international considerations. This need reflects the shift to floating exchange rates and the increasing mobility of capital, as well as the greater proportion of imports and exports in spending and production. Changes in interest rates, for example, may have a significant effect on the economy through their influence on capital flows, exchange rates, and the competitive position of domestic versus foreign providers of goods and services, as well as through their direct effect on spending and saving decisions. In addition, wide variations in exchange rates in recent years--under the influence of a variety of factors besides monetary policy--have had major effects on the economy.

One consequence of this confluence of international factors has been increasing attention to the exchange rate as an influence on prices and output and as a channel through which various forces, including monetary policy, affect the economy. A related consequence has been heightened sensitivity to foreign economic developments and policies as influences on the exchange rate, financial markets, and the economy in the United States. Recognition of these interdependencies has argued strongly that policy can be improved through more regular and more systematic exchanges of information about economic developments and policy intentions with foreign authorities. And, it has prompted exploration of the potential benefits from more formal schemes for policy cooperation or coordination.

Further Research

Together, these changes in the transmission of policy to the economy probably have added to the uncertainty associated with predicting the effects of particular policy actions. Certainly, projections made using older relationships--based on either the money stock or interest rates--have foundered at one time or another in recent years. These failures have spurred a fresh examination of the fundamental relationships among financial and real variables. The U.S. economy probably never was so orderly or so easily described as implied by the settled relationships that, until the mid-1970s, seemed to emerge from the data of the postwar era, with its damped business cycles and stable exchange rates. Attempts to respecify the rethink these relationships are clearly desirable from the perspective of the policymaker.

Important aspects of this work, and, indeed, good indicators of the unsettled nature of the debate, have been the renewed attention to the value of particular intermediate targets or indicators for policy and the proposals of new candidates. Many of those who would run policy according to a rule for money stock growth have acknowledged the disturbances to deposits that accompanied deregualtion and are looking to the monetary base as a guide. Those who focus on interest rates have acknowledged the difficulty of determining their appropriate level without reference to numerous other factors. Recently, commodity prices, exchange rates, the slope of the yield curve, and various leading indicators of real activity all have been mentioned for use as intermediate guides to policy in combination with each other or with other variables, such as the money supply and interest rates. Given the added uncertainty, this discussion takes on greater significance, though perhaps with even less chance of successful conclusion than before.


At the same time, we should be careful not to overstate the effects of changes in the economic and financial environment on the policy process. Monetary policy seems to have done reasonably well in fostering progress toward national economic goals in recent years. One reason for this relative success may be that, although the precise specifications of key relationships have changed, many of the changes have been more evolutionary than revolutionary, leaving longer-term and more fundamental relationships essentially intact. Policymakers have, with due caution, been able to take advantage of the lessons of history.

The monetary aggregates, for example, always have had some interest sensitivity that policymakers needed to be aware of when interpreting their movements. In fact, deregulation probably has enhanced the monetary aggregates as nominal anchors for policy over the long run, by diluting the incentives for financial innovation that would facilitate economizing on holdings of monetary assets.

Although the fading of credit-availability effects undoubtedly has lifted equilibrium real interest rates under certain circumstances, it has not altered the fundamental comparison of cost, including interest rates, with return when deciding whether to spend. This decision also has been basically unaffected by the use of variable-rate loans, futures, swaps, and the like. These instruments serve primarily to redistribute cash flow and wealth when interest rates, exchange rates, or stock prices change; they do not alter the prospective profitability of a capital project.

Moreover, attention to international considerations is not a new aspect of monetary policy. Even before the gyrations of exchange markets and trade balances of recent years, movements of the dollar, and before that of international reserves, were taken as indicators of underlying conditions in the economy and prices and as influences on future developments. As such, they frequently have had a bearing on the stance of policy.

A recent twist for the United States has been concern that the move from net creditor to net debtor status internationally will constrain monetary policy. The underlying hypothesis, it seems, is that crossing that essentially unknowable line heightens the risk of shifts out of dollar claims that would cause conflicts between the need to stabilize the dollar to prevent inflation and the need to supply sufficient liquidity to sustain growth. But, a large volume of liquid dollar claims has long been held in internationally mobile portfolios, and an exogenous impulse to flee from these assets could be just as serious for the United States whether it is a net creditor or a net debtor. Furthermore, in the last few years the Federal Reserve has not encountered prolonged or disruptive conflict between the needs of internal and external balance. Nevertheless, the deterioration in our external position is a serious problem: it represents an underlying imbalance between domestic spending and production that is not sustainable. Reliance on monetary policy alone to address this problem will damp growth of capital and add to strains in our financial markets. We need, instead, to augment national savings by bringing down our federal budget deficit.

With all the changes in the financial and economic system, monetary policy continues to work through the same basic mechanisms that alter the incentives to save and to spend and that shift the locus of such spending. Many of these changes arise in the natural evolution of a dynamic economic and financial system to which a central bank must learn to adapt. Some of them may have weakened the effectiveness of policy--defined narrowly as the impact of a given twist of the instrument dials--while others have probably strengthened it. On balance, they do not justify holding policymakers any less accountable for results today than they were 10,20, or 30 years ago.

Even so, the system is changing, and along with that, so are the answers to the policymakers' questions about the relationship of instrument settings to ultimate outcomes. To enable policy to adapt to the changes in the system, we must find out as much about their effects as possible.
COPYRIGHT 1989 Board of Governors of the Federal Reserve System
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Author:Kohn, Donald L.
Publication:Federal Reserve Bulletin
Date:Feb 1, 1989
Previous Article:Directors of Federal Reserve Banks and Branches.
Next Article:Treasury and Federal Reserve foreign exchange operations.

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