Monetary institutions and the policy process

and Allan H. Meltzer ~~e~~~ei~on University Institutions are mutable and may eventually adjust to tastes and opportunities, but institutions change slowly so there rre long periods during which existing institutions constrain the choice of policies and policy procedures. The November 1979 meeting of the Carnegie-Rochester Conference: held at Carnegie-Mellon University, considered the role of new and longstanding institutional arrangements in the policy process. The papers suggest that, in tne short run, institutional arrangements and established practices and procedures drrve a large wedge between actual and optimal policy. I. Federal Reserve Procedures Raymond Lombra and Michael Moran were permitted to analyze staff projections of economic activity, prices, monetary and tinsncial variables contained in the internal memoranda .and working papers of the staffs of the Board of Governors and the Federal Open Market Committee (FOMC) for the years 1970-73. These memoranda and papers. known as the Greenbook and the Bluebook, are prepared for eacir meeting of the FOMC. All staff forecasts and projections for the period are included. Lombra and Moran supplement the data from the staff reports with material from the minutes of the FOMC and from published sources. Their findings strengthen established conclusions about the policy process and add new perspectives on the relative roles of the staff and the members of the FOMC. One of the main conclusions is “that in the early 197Os, the Federal %eserve was preoccupied with moderat:‘ng fluctuations in the Federal funds ra*.e.” Table 12 of the text suggests that the FOMC responded to deviations of the real growth. But the from the desired stock an responses were generally too small and too slow to keep money from mcving procyclically or fro9 producing rising rates of inflation. The authors give two CdS0T-E

‘k9r tht2 Zit&Cw

staff and the committee.

Carnegie-Rot on Yub

ONort

hastes

ConC~renee

Series

The staff, Lombra and Moran report, tried to forecast the short-term

interest rate requriled to equate the demand for nomieal money to the nominal sto cl; of money. ‘?h~ staff held th.e view that real output and prices could be taken as givev. Th 2 apparent rationale was that the money stock is chosen to achieve a preselect :d level of norninal income. A combination of model and judgment was used ito forecast income (nominal GNP) and its components. Given this forecast, (3r projection, combinations of the rate of interest (i) and nominal money Ifi ) c~ould be derived from the demand for money using i=

al”-M -,--,

“‘2

where Y is nominal GNP. This procedure explains the frequent emphasis on shifts in the demand for money in explanations of the Federal Reserve’s procyclical policy. Major errors in policy were often followed by a search for shifts in the demand funlticn for money. Suppose
:‘f (1) u and v are purla white noise, (2) UT and u2 are constants, and (3) the staff correctly forecasts Y, there is no major problem in setting f to achieve Ad. Every drawing of u and1 ;‘, given i, produces changes in 44. All of the changes are transitory. Let lp and Y be subject to both permanent and transitory changes that cannot be identifiled quickly (see Brcnner, Cukierman, and Meltzer, 1979). Then the Federal Resewe succeeds in smoothing the effect on t’of all transitory changes in u and IJ, but all permanent changes in u and v change the stock of money. Whenever t:hc,re are incorrectly anticipated permanent changes in productivity, aggregate’ clemand, or the desired demand ftir money, the Federal Reserve increases ( iecreases) the stock of money. The unanticipated c.nange in money increases (re dL ces) nominal spending, so the Federal Raserve eventua.l~y raises (lowers) i. WC know from Tsb !e I2 that the policy response to deviations of output or mane;’ was a :e!ativelv. small change j:n the Federal fun $s rate, The procyclical movement of J4 continued. Money rose more rapidly than expecte

OHSol” e~Q~~rn~~expansion, adding to subsequent jnflatjon, and declined in recessions mode t the staff or the HQMCexpected. Lombra and Moran note at the staff, and most econometric models, The underestimate of inflation meant that te was too low and, consequently, the increase in mrsHtf$fand the rate of monetary expansion was higher than expected. The staff i~te~reted the increase in the stock as the result of an increase in thr; demand for rno~~y Z-recognized the effect on desired borrowing that resulted from mo nsion and never acknowledged that expected growth of cornily income increased desired borrowing and the banks’ demand for reserves at a fixed (or slowly rising) interest rate on Federal funds. The Federal Reserve supplied the reserves, allowed the banks to expand earning assets and money, and thereby strengthened expectations that the rate of growth of nominal income would persist. The FOMC paid little attention to prices,output, and economic activity. Lombra and Moran report that “the formulatien of monetary policy often seemed to be a seat-of-the pants operation.” The members refused to accept the discipline imposed by models or forecasts. “In only 6 of the 37 meetings from January 1971 to December 1973 did the FOMC select one of the staff’s alternatives.... In 20 of 37 meetings, th5 FOMC lowered the staff’s projected Federal funds rate for I given money stock, lowered the targeted money stock growth rate for a given Federal funds rate, or lowered both the staff funds rate and money stock projection.” Lombra and Moran leave no doubt about the principal concern of the FOMC and its principa! consequence. “More than any other issue, the ‘appropriate setting’ of the Federal funds rate dominated discussions at FOMC meetings.” “It seems reasonable to conclude that in the early 197Os, the Federal Reserve was preoccupied with moderating fluctuations in the Federal funds rate” (italics added). “The Committee never selected ultimate objectives :jr policy.... [Their procedures] imparted a short-run bias to policy discussions and thus a fccus on current, rather than projected, economic conditions in deciding among policy alternatives.” Three reasons are given for the preoccupation with the funds rate. One is the inaccuracy o taff’s money stock proJections. Errofs ii1 pro@ of models and reinforce a sel;ondfactor, factor is a~~~~c~~le to the ~0~~~~~s and iannot explain the emphasis given to the edera funds rate in earlier an

3

stubbornly avoided the discussion and establishment of policy objectives for output, inflation, and uraemploymt:nt. An examination of the record wit%indicate that each member ~m)j” the F0ht.C made a little speech about the economy, and then the Committee !ztt!ed down to address the ‘major’ issue, which was what should happen to t!tm$Federal funds rate until the Committee met again in a month. Likely behavior of the monetary aggregates over the next month was discussed but alwajp!; within the context of a Federal funds rate constraint.” Jordan adds th3t the FQMC procedure had a basic aw. The market’s responses were ignored. “It was understood that if the financial market participants knew: the rat!:! that the Federal Open Market Cornmitree had chosen to peg, then behavior of security dealers and financial institutions would be influenced in such a v’ray as to cause money, credit, and reserve projections by the staff to be wron,g. But there was no way for the staff to incorporate this effect in their projei; ::ions.” The prevailing belief was that the market would not know the Federal flunds rate target “even though the daily (:>perations of the trading desk immediately transmitted to the market the upper and lower intervention levels of the I’unds rate.” Although t11e staff’s techniques have changed markedly, readers of the Lombra and Moran ?aper and the comments by Jordan and Pierce will find, in broad outlines, the same criticisms of the FOMC that we made fifteen years ago (Brunner :md M :\tzer, 1464). The focus of the Committee remained on the near-term behavior c>rthe money market. The Federal funds iate replaced free reserves as the central object of interest, a shift from the qua.;rtity to the price axis of the sa,ne mar:‘ret demand curve. The FOMC did not dvelop a coherent framework linking ;rlterest rates, money, economic activity. and prices. The forecasting record o ’ economic activity and prices, by the sta.ff, was at least as good as other foreca.:;ters. The principizl problem was not a failure to act promptly but a fai’iure to act appropriately-principally a failure to choose policies consistent with statetl goals. Why, dsspilc substantial change in the methods and techniques employed by l;he staff, was there so little change in the FOMC’s conduct? We speculated in 1964 that the use of vague language-tighter, easier tone and feelcreased the dliscrelionary authority of the New York Bank and allowed the manager of the accoLtnt to dominate the FOMC. By tht: 197Os, this charge could not be sustained. ?+S’S:w York had much less discretion. Yet, money market conditions remained lthe prncipal concern, and money growth continued to be procyclical. This imp xtnnt question remains unanswered.

“‘To ii~n~~ the ffmou~f of~~apey issued and to resort for this pwpose, whenever the

to borrow is stro to some ej~eciual of ~~~t~~t~~~~ IfQ case, kowever, serially to diminish t tt3let it vibrate only witlaincertain limits; the general trade of e special, though tempor~,i~~re~e irathe event of any ex~~~r~i~ ~1~~ or di$ficubty... this seems to be the true poltcy of an institution circumstanced like that of the Bank of Eng&nd. To suffer either the solicitations of merchants, or the wishes of ~ove~~~e~t, to determine the rne~~re of the bank issues, is ~n~t~estio~ab~yto adopt a very false principle of conduc f ” (Thorn ton, 1802, p. 259). in the early 1970s, a new procedure was adopted by some of the principal central banks of the world. The central banks in Canada, France, Germany, Spain, Switzerland, the United Kingdom, and the United States announced the expected, planned, of desired growth rate of some monetary aggregate. MT. Sumner’s paper “The Operation of Monetary Targzts,” which is discussed by James L. Pierce and Jerry L. Jordan, considers the background of, and early experience with, the USEof monetary “targets.” The experience is not encouraging. “The cautious operation...eliminated any recognizable permanent effect they [targets] might otherwise have had....” In the U.S., Sumner finds that an “inverse relation between the downward revision of the targets and the upward trend of the actual growth rates during Burns’s era is well-known. In the United Kingdom, the target2 have been reduced only marginally, and the record includes a major above-target miss in 1977-78. In Germany, the target was exceeded in the fist four cases.... The French target was reduced slightly for each successive year until 198Q...but it has been consistently exceeded. The Swiss registered three excesses after an initial short-fall....”

Sumner discusses these reasons and suggests others, but he does not reach a fii conclusi dn. He notes, however, that at some central ba tk:e Federal Reserve-he decision was imposed, and there is not much evidence that the targets had n such effect on policy pracedures. Su&w examines some of the operating problems and s reasons that targets waii:renot achieved, He discusses, also, the choi gates and time perio:ls of control. He concludes that optimism about the effec’tivenessaf target.s :,I; premature. The quotati,!m at the beginning of this section shows that rules for gukiing the conduct of monetary policy have been proposed for more than a century. Recent wo ?k on the theory of expect,ations provides a more rigorous foundation for reli:~nce on preannounced growth of money as a means of implementing moneta ‘v policy and providing information about the future. Yet, cpntral banks have r #,t adopted rules or proced>ures of this kind. They have squandered their creccbility, in recent years, by not achieving the targets they annclunced. The distance between practice and stabilizing policy seems viery large. l~!lII.The European _MonetarySystem In separate lapers. Michele Fratianni and Roland Vaubel analyze a new institutional a~rangement-the European Monetary System. Fratianni sket&es the historic II development of the system and analyzes the expec:ed effecsts, including effs:r,ts on price and exchange rate stability. Vaubel emphasizes the incentives creatcj by Ihe system. Both authols are skeptical about the oper ition of the syst :t-n ant. concerned about the probable effects on inflation and ‘exchange rates. Fratianni’s ccmclusion is based on a discussion of the use of money as a store of value and as a mediurn of exchange. He finds that the European Monetary System has produced “a fictitious current; c!erised by politicians to solve an economic pr )blem.” The money to be produced-called ECU-is 1ikAy to bit a relatively cost y store of value and “is much less promising as a means of exchange and a numh:r iire than as a store of value. ” 0th author!, note that the rules of the European Monet;uy System designed to raise the inflation rate in the countries with “low inflation and ?o redLt[:e the rate of inflation in countries with high inflat9on. bts thilt this will occur. The more likely outcome, he be will ft:nc*zion like the system of adjustable pe courltries will periotii :ally change their exchange rates rat rommunity’s average rate of inflation. Vaubel agrees that the

will fafi. He believes that t aghast infiation and e

two economic r~~~~~

foi- the

developmens

Wuntries chcM%eto fix

exchange rates with urn, and Denmark are exas before. Italy and d th ~ra~§fers from the richer

members. Both authors and one of the discussants, Dale Henderson, raise the issue of -/icious and virtuous circles. A vicious circle is said to occur if devaluation causes the domestic rate of price change to increase relative to fo=ign rates of change, thereby inducing subsequent deva~~ati~~~,Iienderso a model with shocks in the financial and output markets to-show the effects of shocks on prices and exchange rates and to demonstrate conditions under which vicious circles arise. Ralph Bryant also discusses the papers by Fratianni and Vaubel tiryaalt. is more positive about the prospects for the EMS, in part because he wants to state the opposing view for the benefit of readers of this volume. Bryant believes, however, that the proponents of the EMS have a broader purposepolitical and economic integration. He belieces that tlte political ends have been neglected by economists with the result that economists’ evaluations of the EMS are partial. Bryant’s comment suggests that a more integrated European approach to world economic issues will face changes m political institutidirs and hring the issue of intra-European redistribution of income, discussed bv Fratianni, into the center of the discussion. IV. The International The last paper in the volume, by John Williamson, discusses the purposes, policies, and procedures of the IMF. H. Robert Heller and Jacob FrenkeI comment on Williamson’s paper.

References Brunner, K, Cukiermrcl~,A., and Meltzer, A.H. (1979) Sty flation, Persistent Unemplovment and the Permanence of E#i,onomicShocks (Manuscript, . larmegie-MellonUniversity). Brunner, K. and Meltz,:r, A.H. (1964) The IiFederal Reserve’s Attachme’nt to the Free Reserve Concept ,,An Analysti of Federal Reserve MonetrxryPolicymaking, Part 2. Washington, D.C.: Committee on Banking and Currencir , U.S. House of Representatives. Tltornton, H. (1802)

An :fnquiry into the Nature and Effects of the Paper Credit of G:‘reatB~titcdn.Reprinted, 1965. New York, X.Y.: Kelley.