A History of the Federal Reserve, Volume 2 (55 page)

Discussion of the proposal at the May 1976 meeting kept sunshine legislation in the background though it was clearly the main force for change. Thomas O’Connell, the Board’s counsel, expected that the sunshine legislation would not apply to the Federal Reserve. Burns urged members not to discuss applicability of the legislation to reduce the risk that Congress would remove the “ambiguity” in the legislation, on which the Board believed its exemption rested (Burns papers, May 18, 1976, tape 1, 4).

Practice changed less than the discussion suggests. The manager continued to give primary attention to control of the federal funds rate. This was explicit when the manager described his operations. “Incoming data on, and projections of the aggregates are compared with the [FOMC’s] ranges each week to determine the Desk’s posture with respect to reserve provision and the federal funds rate. The Manager’s response to undesired behavior is constrained by a range of permissible variation in the weekly average federal funds rate” (Holmes, 1976, 413).

Burns proposed setting 4 percent bands for money growth rates and an inside (say) 2 percent band that he called a “zone of indifference.” The manager could ignore money growth rates in the zone of indifference but was to respond outside the band. Burns hoped in this way to allow for the imprecision of the money growth estimates and their short-run variability (Burns papers, FOMC, February 17, 1976, 9–13).
¹⁷⁰
The FOMC referred to the “range of indifference” at a few subsequent meetings. Within a few months, it disappeared from the discussion. FOMC members did not agree on the appropriate size of the range or how to use it.

170. The FOMC based the wide range chosen for the money growth rates on staff work reporting on thirty different seasonal adjustment techniques. They suggested a range of uncertainty about the “true” seasonally adjusted value.

Burns commented that the imprecision of the two-month ranges led him to question their usefulness. He proposed lengthening the period to up to six months. Others responded that his proposal put more weight on uncertain projections (ibid., 15–16). Burns’s proposal suggested more attention to the medium-term and sustained changes. The members did not reach consensus or agree to change.

Operating
Procedures

As inflation rose, the FOMC recognized more fully than earlier that targeting the federal funds rate did not achieve its objectives. They experimented over the decade with different ways of reducing or controlling inflation by including in the directive targets for measures of reserves and money. Dissatisfaction with outcomes and problems in reconciling the interest rate and aggregate targets brought the topic back to their agenda several times.

The staff concluded that responding to monthly data was unwise. It reached a correct and long-delayed conclusion that to control inflation and improve outcomes the FOMC had to take a longer view and pay more attention to persistent evidence showing money growth rates above or below target (memo, staff to FOMC, Board Records, February 10, 1976). This was an opportunity to shift more emphasis to longer-term consequences. There is no evidence that the FOMC agreed.

A separate staff report also considered the effect of legislative changes and market innovations on the composition of financial balances. Some of the changes relaxed regulation to help thrift institutions adjust to inflation and regulation Q ceilings. The report concluded that the introduction of NOW accounts and other changes in saving accounts to make them more like transaction balances had reduced demand deposits. The staff proposed that the FOMC should give more weight to the broader aggregates without abandoning M
₁
(memo, staff to FOMC, Board Records, February 10, 1976).

At a special meeting in March 1976, Governor Robert Holland, as chairman of the Subcommittee on the Directive, proposed replacing the target for RPDs (reserves against private deposits) with nonborrowed reserves (total reserves minus member bank borrowing). Since required reserves depended on lagged deposits, this proposal would renew the role of free reserves (excess reserves minus borrowing) for a short period. The federal funds rate would be a constraint; the manager would target nonborrowed reserves as long as the funds rate remained within the target range. The FOMC would resolve conflicts or inconsistencies by revising instructions.

Following his report, an exchange with Chairman Burns suggests that members of the FOMC did not agree on the operating target. Holland said it was the funds rate.

Burns objected. “That is not our operating target—we use the federal funds rate with a view to reaching certain monetary aggregates.” Holland replied, “I think it is in practice our
only
operating target and that we need to have a structure that has a reserve measure in it, that is a workable one that the committee can work towards” (FOMC Minutes, special meeting, March 29, 1976, tape 2; emphasis added). Volcker agreed with Holland. “As long as the Federal Reserve used it [the funds rate] as its mechanism for implementing policy, the market would continue to interpret any move in the funds rate as an indication of a change in policy” (Burns papers, FOMC, March 15–16, 1976, 82).

Surprisingly, the FOMC did not explore the range on the target federal funds rate required to keep the monetary aggregates within their bounds most of the time. Nor did most members accept that to control monetary growth they would have to permit more frequent changes in the funds rate. Instead, Burns asked the staff to report on the forecast error in the aggregates under prevailing conditions. The reports showed large shortterm errors, two-thirds of the time as much as 4 percentage points around the two-month money growth rate (ibid). Governor Wallich concluded the discussion again by pointing out that the System could improve control of the aggregates by permitting greater variability in the funds rate. The FOMC was not ready to accept this proposal.

Holland explained that the main reason for rejecting RPDs was that the manager could not control them effectively. Governor Partee pointed out that the data did not show that a nonborrowed reserves (NBR) target would be better. The staff agreed, but Axilrod said that NBR could be controlled better. Governor Holland said that politics, more than economics, was the reason “for not naming federal funds as the FOMC exclusive operating target” (ibid., tapes 3 and 4). Setting an interest rate “is a kind of lightning rod in terms of some of the public discussion” (ibid.). He might have added that the problem of choosing a nominal short rate was more acute during an inflation when nominal interest rates reached unprecedented levels. He favored allowing the funds rate to move within a one percentage point band adjusted up or down by 0.25 percentage points as growth of monetary aggregates changed. Contrary to the evidence presented earlier, this proposal put excessive weight on short-term, often random changes in the aggregates.

Governor Jackson and President Balles proposed the opposite alter
native—controlling longer-term measures of money growth.
¹⁷¹
Governor Wallich suggested that this would have a better chance of success if the FOMC would permit the funds rate target to change more often. He thought that the funds rate should not be an objective of policy; it would become an instrument. He doubted that this could be done (ibid.).

The discussion did not reach a firm conclusion, but it showed that several FOMC members understood why their operating procedures did not control inflation. Burns and others were not willing to make the necessary changes, so policy continued much as before. Burns concluded that both monetary aggregates and interest rates mattered for monetary policy.

Vice Chairman Volcker pointed out that the FOMC did not know whether failure to control the aggregates resulted from the reserves multiplier or the funds rate constraint. He wanted better information (ibid., tape 5).

Burns ended the meeting by eliminating RPDs and telling Axilrod to prepare an article for the Bulletin. Axilrod replied that “the evidence would show that the committee chose to adhere to the FF [federal funds] rate constraint rather than the RPD target” (ibid.). This statement seemed to infuriate Burns. He replied sharply that “this was not a criticism of the Committee; it was evidence of the Committee’s practical wisdom” (ibid.). He told Axilrod to write it objectively and to recognize that the FOMC acted wisely!

Neither Burns nor a majority of the committee accepted nonborrowed reserves as replacement for RPDs. They postponed a decision. Burns did not think much would change. The concerned public already believed that they did not give enough attention to reserve growth.
¹⁷²

171. President Balles’s position was based on research at the San Francisco reserve bank. Balles asked his staff to determine whether the relation of M
₁
to GNP had deteriorated. To his expressed surprise, the staff presented evidence that “all of the monetary aggregates tested gave roughly similar results in predicting both nominal and real GNP for the period 1960–74 as a whole. In this sense no other aggregate was significantly superior to M
₁
” (memo, James L. Pierce to Burns, Burns papers Box B-B81, April 3, 1974, 1). The memo concluded that the Board’s staff obtained the same result using other techniques. Later, San Francisco repeated its study and concluded that emphasis should shift to M
₂
. The Board’s staff repeated the test. The Board’s equations show very little deterioration in either M
₁
or M
₂
variants (memo, staff to James Kichline, Burns papers, Box B_B114, June 3, 1977, 2).

172. Burns then asked whether monetarist economists would criticize the decision to drop RPDs. He accepted that they would. “We’ve gotten criticism from the monetarists no matter what we do. It’s their destiny to criticize, it’s their place in life” (FOMC Minutes, special meeting, March 29, 1976, tape 5). Also at the April 1976 meeting, Burns asked Holland to find an economic historian to write the Federal Reserve’s history. Holland left the Board the next month to become president of the Committee for Economic Development without completing the assignment.

Reserve
Management

As part of the reconsideration of operating procedures, the System revisited lagged reserve accounting. Two main questions arose. First, would a return of contemporaneous reserve accounting improve control of the monetary aggregates? Second, would this change be costly to banks and discourage membership in the System?

The answers to both questions were yes, although arguments were made on the other side. Staff of the New York bank argued that elimination of lagged reserve accounting would increase interest rate variability. Market participants judged policy stance by the level of the funds rate, so their information would be less certain, and monetary control would suffer (memo, Paul Meek and Charles Lucas to FOMC, Board Records, February 17, 1976). Board staff reached the opposite conclusion. “For the purpose of controlling the monetary aggregates in the short run of a month or two via reserves, theoretical considerations and empirical evidence suggest that contemporaneous reserve accounting would be more effective than the existing reserve accounting system with a two-week lag. Linkages between reserves and the monetary aggregates in the short-run are loose in both cases, though less so without lagged reserve accounting” (memo, Reserve Requirement Policy Group to Board of Governors, Board Records, April 13, 1976, 1). The memo added that contemporaneous accounting would “probably reduce somewhat the amplitudes of movements in the funds rate over the longer run” (ibid., 1). Then it added that it had taken a survey of bank attitudes. Large banks with many branches strongly opposed a return to contemporaneous reserve requirements because it increased their costs of reserve management. They would likely hold more reserves.
¹⁷³
It cost nothing to provide them.

The staff favored contemporaneous reserve requirements whenever they considered or reconsidered the issue. The Board always rejected their advice until 1984, when they returned to contemporary reserve accounting after it no longer mattered for control. The issue was important only during periods of monetary control using a reserve target. The record suggests
that at the FOMC banks’ opposition to their higher costs outweighed the social benefit of improved monetary control. This was clearly a misreading of Federal Reserve responsibilities.

173. The Federal Reserve introduced the two-week lag in 1968. The main reasons were (1) to moderate the decline in the funds rate on Wednesday settlement days caused by banks selling their surplus reserves and (2) difficulties in hitting the free reserve target because of large revisions in required reserves and vault cash after settlement. Prior to the change, member banks could offset reserve deficiencies in one settlement period up to 2 percent of required reserves by carrying the deficiency over to the next period, but there was no carryover provision for surplus reserves.

The New York staff also ran an experiment on the use of a nonborrowed reserve target. Based on its findings, the Subcommittee on the Directive recommended against using a reserve objective in the directive because it “would not improve the Committee’s ability to achieve short-run objectives for the monetary aggregates” (memo, Subcommittee on the Directive, Board Records, December 15, 1976, 5–6). The subcommittee recognized, however, that the main problem was failure to change the funds rate. Governor Wallich pointed out again that the System treated the funds rate target as a policy objective, not as an instrument for achieving control of monetary aggregates consistent with stable growth and low inflation. Further, Wallich said, these System actions encourage the market to put excessive weight on changes in the funds rate as policy indicators. Using the funds rate as an instrument, he said, would increase its volatility. Then he concluded, “I believe that good control of the aggregates, even at the cost of an unstable funds rate, would be superior to a well-controlled funds rate with the aggregates in danger of going out of control” (ibid., 2). President Balles agreed and added: “The pendulum has shifted too far towards interest rate stability at the cost of significant undershoots or overshoots from time to time in our twelve-month growth range for the monetary aggregates” (ibid.). He favored a nonborrowed reserves target.

Burns devoted much attention to the size of errors made in forecasts of reserve and money growth. Stephen Axilrod disagreed. A large part of the Board’s problem came from its short-term focus. He claimed that if the objective was to have 6 percent M 1 growth six months ahead, “I could do it better by telling you what nonborrowed reserves to hit than what FF [federal funds] rates to hit” (FOMC Minutes, March 29, 1976, tape 3).

The staff of the Philadelphia Reserve bank also studied the reasons the FOMC found it difficult to control money growth reliably. It concluded that the main problems were weak linkage between the short-term and medium-term targets and large errors in the two-month projections for the aggregates. Underlying the short-term monetary control problem were “the constraints of modest week-to-week changes in the federal funds rate” (memo, “Perspectives on Controlling Monetary Aggregates Over Time,” New York Reserve Bank, Box 110282, November 21, 1978, 4).
¹⁷⁴

174. The memo cites a study by Gary Gillum, then at the Philadelphia bank, that showed that M 1 projections for 1973 to 1977 appeared unbiased but had an average absolute error of 3 percentage points at annual rates.