Discount rate policy under alternative operating procedures: An empirical investigation

DISCOUNT RATE POLICY UNDER ALTERNATIVE OPERATING PROCEDURES: An Empirical Investigation CRAIG S. HAKKIO, DOUGLAS K. PEARCE

ABSTRACT This paper shows that the Federal Reserve’s discount rate policy changes when the Federal Reserve changes operating procedures. Operating procedures have changed twice in the last 15 years-once in October 1979 and again in October 1982. Using a limited dependent variable approach, we estimate the probability that the Federal Reserve will change its discount rate over a one-week horizon. Discount rate changes were reasonably predictable when the Federal Reserve was targeting the federal funds rate. However, discount rate changes became less predictable when the Federal Reserve changed to a nonborrowed reserves target in October 1979. Furthermore, discount rate changes became even less predictable after October 1982 when the Federal Reserve changed to a borrowed reserves target.

Considerable evidence suggests that the Federal Reserve changed its short-run procedures for open market operations twice over the last decade.’ In October 1979 the Fed moved from targeting the federal funds rate to targeting nonborrowed reserves, supDirect all correspondence to: Douglas K. Pearce, Department of Economics, Campus Box 8109, North Carolina State University, Raleigh, NC 27695-8109. Reserve Bank of Kansas City

l

Craig S. Hakkio, Federal

International Review of Economics and Finance, l(l):%-72 Copyright Ca1992 by JAI Press, Inc. ISSN: 1059-0560 All rights of reoroduction in anv form reserved. 55

56

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

posedly to better control short-run money growth; in October 1982 it moved to targeting borrowed reserves, abandoning its money growth focus. Previous research demonstrates that alternative operating procedures may influence the role of discount rate changes in effecting monetary control and signaling the Fed’s intentions.2 This research also suggests that the Fed may have conducted discount policy differently under the alternative operating procedures. But there has been little or no empirical evidence on whether changes in discount rate policy were part of the regime changes. The purpose of this paper is to examine whether Federal Reserve discount policy changed with the changes in short-run operating procedures. Changes in discount rate policy have important implications for bank borrowing behavior and for asset price reactions to discount rate announcements. Goodfriend (1983) has shown that expectations of future discount rate policy affect optimizing bank behavior with respect to reserve management. Thus changes in discount rate policy should be taken into consideration in modeling bank behavior. Changes in discount policy also influence the reaction of asset prices to discount rate announcements. In efficient capital markets the reaction of asset prices to a discount rate announcement depends on the degree to which markets anticipate the announcement. The degree of anticipation, in turn, depends on the discount rate policy in force. Event studies examining the responses of asset prices to discount rate changes have generally found differences in the responses across operating procedures, as would be the case if discount rate policy changed with changes in operating procedures3 The paper is organized as follows. The next section describes the model chosen to capture the reaction function of the Fed with respect to the discount rate. Because discount rate changes are infrequent and discrete, we employ a limited dependent variable approach that allows us to investigate what variables affect the probability of discount rate changes.4 The third section describes the data and the measurement problems encountered. The fourth section presents empirical results that indicate that discount rate policy did change with changes in operating procedures. Both the relative predictability of discount rate changes and the factors triggering the changes varied across monetary policy regimes, The last section gives our conclusions.

I. A MODEL OF DISCOUNT

RATE CHANGES

In practice, a change in the discount rate involves two steps. First, the board of directors of one of the regional Federal Reserve banks must request approval from the Board of Governors to change the rate for their region. Second, the Board must vote on whether to approve the request. The second step is not perfunctory, since many such requests are denied? The Board is often thought to initiate discount rate changes by letting regional banks know that they would look with favor on a requested change. In this paper, we assume that the Board has complete control over the decision to alter the discount rate. The reasons for the Board’s decisions both to approve or reject requested discount rate changes, given in the Board’s annual reports, center on three types of concerns: (1)

Discount Rate Policy Under Alternative Operating Procedures

57

conditions in the market for bank reserves, as indicated by the spread between the federal funds rate and the discount rate and by changes in the level of borrowing at the discount window; (2) movements in intermediate targets such as the money supply and the foreign exchange value of the dollar; and (3) movements in ultimate targets such as inflation and economic growth. We assume that these concerns do, in fact, dominate the discount rate decision. In addition, we view discount rate changes as playing either of two roles. Changes in the rate because of type (1) factors are likely to be used to complement open market operations, while changes because of type (2) or (3) factors are more likely to be used as signals of future Fed policy. We now examine these concerns in turn.

Conditions

in the Market for Bank Reserves

In principle, the role of the discount rate and the timing of changes in the rate depend on the Fed’s short-run operating procedure. 6 Under a federal funds rate targeting procedure, employed prior to October 1979, the Fed sets a narrow federal funds rate target that it believes is consistent with the desired growth in the money supply and effects changes in monetary policy by changing the targeted funds rate. For example, the Fed reduces money growth by raising the targeted funds rate through open market sales. Such a tightening of policy would likely raise the level of borrowing at the discount window by increasing the spread between the funds rate and the discount rate, however. Thus to keep borrowed reserves at a “normal” level, the Fed would have to increase the discount rate. By the same reasoning, the Fed would need to decrease the discount rate when increasing money growth under a federal funds rate targeting procedure. Under the nonborrowed reserves targeting procedure, employed from October 1979 to October 1982, the Fed determines a path for nonborrowed reserves consistent with a desired path for the money supply while allowing the federal funds rate to vary within a wide range. Consequently, changes in the spread, given money growth, are generally poor predictors of the stance of monetary policy and changes in the discount rate are less likely to follow changes in the spread. For example, a wider spread resulting from, say, an increased demand for excess reserves would be accompanied by slower money growth but should not increase the likelihood of a discount rate increase. Broaddus and Cook (1983), in their analysis of the role of the discount rate under the two procedures, assert that if the funds rate was substantially above the discount rate in pre-October 6 regime, one might recommend an increase in the discount rate to bring it into better alignment with the funds rate and other market rates. This rationale, however, would be much less applicable under the new procedure. (p. 14) Under the borrowed reserves procedure adopted in October 1982, the Fed selects a level of borrowing consistent with the desired path of the money supply. When the Fed tightens, it increases the borrowings target and then drains reserves so as to widen the

58

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

spread and induce a higher level of borrowing. Since the wider spread is consistent with the desired policy action, the Fed would not want a discount rate increase. Under some circumstances discount rate policy under a borrowed reserves procedure resembles policy under a federal funds rate procedure. As Sellon (1986) and Thornton (1988) point out, an increase in money demand is likely to be accommodated by an increase in nonborrowed reserves to prevent the spread from rising, hence keeping borrowing at its targeted level. Such accommodation is identical to what occurs under a federal funds rate procedure. It is possible, however, that the increase in the spread could occasionally be dealt with by raising the discount rate to discourage borrowing since the fed funds rate itself is not a target. Moreover, for a given level of the money supply, if banks unexpectedly borrowed less than the targeted level at the discount window, the spread would rise, but there would be no reason to raise the discount rate. In summary, it seems that discount rate changes would also be less reliably linked to changes in the spread under a borrowed reserves procedure than under a federal funds rate procedure. Even though discount rate changes are usually used to complement open market operations, special circumstances may warrant deviations from this practice. Because the discount rate is generally below the federal funds rate, borrowing at the discount window is an attractive option for banks with liquidity problems. It is well understood, however, that borrowing at the discount window is “a privilege not a right” and that the regional Federal Reserve Banks may impose other costs if a bank is thought to be going to the window too frequently. Large increases in borrowing, at given spreads, might indicate a change in the reluctance of banks to use the window and prompt the Fed to raise the discount rate to discourage such behavior.

Movements in Intermediate Targets Movements in such intermediate targets as the foreign exchange value of the dollar and money growth are often cited as factors motivating discount rate changes in the Board’s annual reports. With respect to exchange rate movements, the Fed claims in its official statements to worry about the inflationary consequences of exchange rate movements. Such worries apparently motivated the November 1,1978 increase. Specifically, the Fed feared that the rapid fall in the dollar would raise short-run inflationary pressures and the Fed wanted to signal its resolve to fight inflation by raising the discount rate “thereby to counter continuing inflationary pressures.“( 1978 Annual Report, p. 94.) In general, we expect that rapid decreases in the foreign exchange value of the dollar will increase the probability of a discount rate increase. We also allow for the possibility that exchange rate appreciations are of less concern to the Fed by permitting asymmetric responses to increases and decreases.’ From official statements the Fed also appears to use discount rate increases and decreases to signal its concern about too-fast or too-slow money growth. But this use of the discount rate probably depends on the emphasis that the Fed is placing on money

Discount Rate Policy Under Alternative Operating Procedures

59

growth in its operating procedures. We expect money growth to be more important during the October 1979-October 1982 period when the Fed was focusing on short-run money growth. As in the case of exchange rate movements, we allow for the possibility that deviations from desired money growth may have asymmetric effects on the probability of discount rate changes. When inflation is the primary concern, for example, too-fast money growth will more likely lead to a discount rate increase than too-slow money growth will lead to a discount rate decrease.

Movements in Ultimate Targets The Fed also purports to look at the ultimate targets of policy-the inflation rate and real economic activity-when deciding on discount rate changes. We expect that higher inflation or more rapid economic growth, all else equal, will increase the probability of a discount rate increase, while lower inflation or sluggish growth will increase the likelihood of a discount rate cut. To summarize, several variables affect the decision to change the discount rate. These variables can be classified into three groups: variables affecting the market for bank reserves, intermediate target variables, and ultimate target variables. In general terms, we estimate the following model: A (discount rate)

=

a(market for bank reserves) + p(intermediate targets) + y(ultimate targets)

=

al(spread) + az(change in borrowings) + pI(exchange rate depreciation) + Bz(money growth) + yl(CP1 inflation) + yz(PPI inflation) + y$unemployment) + yd(industrial production)

II. THE DATA The period we examine runs from December 1977 through December 1988. During this period there were 38 discount rate changes-19 increases and 19 decreases. We adopt a weekly horizon that begins on Thursday and ends on the following Wednesday. Since most discount rate announcements occur on either Thursday or Friday, a ThursdayWednesday horizon allows the latest information to be available.8 We assume the important decision is the direction of the change rather than its size.g Thus we consider a model for the probability that a discount rate change will occur over the next week. For example, if there was a discount rate increase in the week running from Thursday, January 5, 1978 to Wednesday, January 11, 1978 the binary variable for a discount rate increase is coded one; if no increase occurred, it is coded zero. A similar procedure is used to code a second binary variable for discount rate decreases. The dates of the actual discount rate changes are the dates when they were announced rather than the dates when they became effective.

60

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

Three sample periods were chosen. October 6, 1979 and October 10, 1982 marked the split between sample periods, corresponding to changes in Federal Reserve operating procedures.‘O In the federal funds rate period-December 1977 to October 1979-there were 11 discount rate increases and no decreases; in the non-borrowed reserves periodOctober 1979 to October 1982-there were 5 increases and 10 decreases; and finally, in the borrowed reserves period-October 1982 to December 1988-there were 9 decreases and only three increases.” The independent variables are measured as follows. The spread between the federal funds rate and the discount rate is the average spread, in percentage points, over the last five business days. Using the dating example above, if the dependent variable is for the week January 5 through 11,1978, the spread is for the five business days prior to January 5. The change in borrowing is the percentage change in adjustment borrowing from the prior week and thus is measured over the same period as the spread.‘* The rate of change in the exchange rate is the annualized percentage change in the Federal Reserve Board’s trade-weighted exchange value of the dollar over the last eight weeks, defined so that a positive value corresponds to an appreciation of the dollar. Growth of Ml and M2 is calculated over a one week period and over an eight week period. Inflation is measured by the latest announced monthly percentage changes in the Consumer Price Index and in the Producer Price Index. Real economic activity variables are the latest announced monthly civilian unemployment rate and the latest announced monthly percentage change in the index of industrial production.13 Several comments about the data are in order. First, because we are interested in the relationship between observable variables and discount rate policy, we took care to see that all variables are measured with data available at the time, rather than revisions that were announced later. Second, since the time lags that the Fed considers in evaluating conditions is unknown, rates of growth (of the exchange rate and money) were calculated over different horizons. Finally, some attempt was made to measure explanatory variables as deviations from desired values rather than simply the actual values. This issue seems particularly important for money growth. Consequently, in addition to measuring money growth as the actual growth of money, several other measures were calculated. We measured money growth as deviations from the mid-point of the Fed’s announced long-run target ranges. Furthermore, since the Fed may only respond to money growth outside the targeted ranges, we constructed two variables: one variable equals the annualized growth rate over the last eight weeks if this exceeds the upper limit of the target range and zero otherwise; the second variable equals the annualized growth rate over the last eight weeks if this is less than the lower limit of the range and zero otherwise. With this variable we can also test whether the Fed responds asymmetrically to deviations from the long-run targets.14 We also created separate variables for appreciations and depreciations of the dollar to allow for asymmetric effects. For the other variables, desired values are more difficult

Discount Rate Policy Under Alternative Operating Procedures

61

to quantify. The full-employment unemployment rate, for example, varied little over our sample, so adjusting for this made no difference.

III.

EMPIRICAL

RESULTS

Because the Fed faces three choices in making discount rate policy-increase, decrease, or no change--a multinomial probit or logit procedure would appear appropriate. However, since discount rate changes were mostly made in only one direction during each of the three subperiods examined, we used a simple logit model. A check on whether this might distort the results indicated that the estimates were insensitive to using simple or multinomial logiLl The estimated model is given by A(discount rate) = al( spread) + az( change in borrowings) + pl(exchange rate depreciation - 1 week) + pz(money growth - Ml or M2,l week or 8 weeks) + yl(CP1 inflation) + yz(PPI inflation) + ys(unemployment) + yh(industrial production) The previous section suggested that money growth is an important variable. However, theory does not suggest whether Ml or M2 is the “correct” measure of money; theory also does not suggest over what horizon money growth should be measured. Therefore, we tried Ml and M2 growth, measured over 1 week and 8 week horizons. However, due to multicollinearity, we never included all four measures of money growth. To save space, only two equations are reported for each sample period. The first equation, denoted “full” in Table 1, includes all variables (but only 1 definition of money growth); the second equation, denoted “best” in Table 1, includes only variables that were significant-or close to significant. Table 1 presents the results of estimating the model for discount rate increases. The first two columns correspond to the federal funds rate period-December 1977 to October 1979.16 According to Table 1, an increase in the spread led to a significant increase in the probability of a discount rate increase. The change in borrowing had an insignificant effect on the probability. Money growth also appears to have had no significant influence in this period. Furthermore, including money growth only when outside its long-run ranges did not change this finding. Changes in the exchange rate had a significant effect on the probability of a discount rate increase: exchange rate depreciation increased the probability of a discount rate increase. Tests indicated no evidence for asymmetric responses to exchange rate appreciations versus depreciations. However, since the dollar was trending downwards during this period, most changes in the exchange rate were negative. Finally, only inflation measured by the PPI had a significant effect on the probability of a discount rate increase. The next two columns correspond to the non-borrowed reserves subperiod-October

62

CRAIG S. HAKKIO and DOUGLAS Table 1.

Logit Estimates for Discount Rate Increases Dee 77 - Ocf 79

Ott 79 -

“jidl ‘>

“bed ”

-30.73 (2.24)

-13.57 (3.76)

-13.46

Spread

13.92

11.50 (3.37)

-0.29

Change in borrowing

(2.27) 0.013 (1.01)

Constant

K. PEARCE

“fill ”

(1.40)

act 82 “bed -7.19 (3.34)

Ocl82 “fill”

- Dee88 “best ”

4.16 (0.75)

1.28 (0.32)

1.47 (1.61)

1.03 (1.37)

Bank reserves market:

Intermediate

(0.47) 0.016 (1.64)

0.013 (1.76)

0.005 (1.11)

targets:

Ex rate change (8 weeks)

-0.096 (2.10)

Ml growth (1 week)

(1.06)

-0.096 (2.37)

-0.027 (0.54)

-0.017 (0.56) -0.032 (0.97)

0.015 0.14 (1.43)

Ml growth (8 weeks)

0.18 (2.17)

Ultimate targets: CPI inflation

-1.45 (0.52)

PPI inflation

3.66 (1.81)

Unemployment Industrial production

Summary

-10.52

1.98 (0.82) 3.50

1.30

(1.46) 3.42

(1.90)

(0.88) 0.57 (0.59)

(0.90) -2.20 (1.92)

2.74 (1.46) -0.68 (0.87)

-1.54

3.91 (1.92)

2.58 (2.16)

8.21

(1.86) 4.54

(1.86)

(1.86)

statistics:

x2

34.50

28.58

18.02

15.64

13.54

9.18

R2

0.46

0.40

0.37

0.34

0.38

0.26

Note:

Asymptotic t-values are in parentheses under the estimated coefftcients. x2 is the likelihood ratio statistic for the test that all slope coefficients are jointly zero; the degrees of freedom are the number of estimated coefficients. R2 is McFadden’s pseudo-R2 corrected for degrees of freedom.

1979 to October 1982. As expected, the estimates change dramatically from those for the federal funds rate period. Neither the spread nor movements in the exchange rate were related to the probability of a discount rate increase.” Changes in adjustment borrowing were positively related to the probability of a discount rate increase. Money growth-using Ml and an 8 week horizon-was also positively related to discount rate increases, giving some support to the assumption that the Fed did focus more on money growth during this period. As in the earlier period, tests for asymmetrical responses to money growth above or below its long-run target indicated no evidence of asymmetry.

Discount Rate Policy Under Alternative Operating Procedures

63

With respect to general economic conditions, both PPI inflation and growth in industrial production had the anticipated positive relationships with the probability of discount rate increases.‘* Finally, the last two columns correspond to the borrowed reserves subperiod--October 1982 to December 1988. The results should be taken cautiously because there were only three increases during this period. Regardless, the results suggest that the spread was again positively related to discount rate increases but much more weakly than in the federal funds rate period. lg The only other factors that appeared to influence the decision to raise the discount rate were the measures of real activity, with lower unemployment and faster growth increasing the probability of a discount rate rise. Table 2 reports the logit estimates for discount rate decreases for only two subperiods-October 1979 to October 1982 and October 1982 through December 1988since there were no discount rate cuts in the earlier subperiod. The results indicate differences across operating regimes. The first two columns of Table 2 report the estimates for the nonborrowed reserves period-October 1979 to October 1982. A decrease in the spread and a smaller increase in borrowing leads to an increase in the probability of a discount rate cut. There is no evidence, however, that changes in the exchange rate or money growth affect the probability. As was true for discount rate increases, allowing for asymmetrical responses did not change this result. Of the ultimate targets of monetary policy, only the unemployment rate had a systematic effect with higher unemployment raising the probability of a cut. The last two columns of Table 2 report the estimates for the borrowed reserves subperiod-October 1982 to December 1988. These results indicate that decreases in the spread had a significantly negative effect on the probability of a discount rate decrease. Moreover, the effect, in terms of basis points, was greater than in the nonborrowed reserve subperiod. u, Neither the borrowing variable nor the exchange rate measure appeared to influence discount rate decisions. One puzzling result is that the last observed weekly change in Ml appeared to have a negative effect on the probability of a discount rate cut, even though this period was one in which such short-run fluctuations were supposed to be ignored. Money growth over the last eight weeks, however, did not appear to be a factor. With respect to the economic conditions variables, only the growth in industrial production had the expected effect.21 Since the estimated coefficients from logit models are not readily interpretable apart from their signs, Table 3 gives the predicted change in the probability of a discount rate increase or decrease for discrete movements in the independent variables. Because the logit model is nonlinear, changes have to be calculated from a specific starting point. Our benchmark is the estimated probability of a discount rate change when the explanatory variables take on their sample means. The reported changes are the increases in the probability for one- and two-standard deviation changes in the independent variables from their means. The nonlinearity of the model is illustrated by the much larger increases associated with two-standard deviation changes. For the federal funds rate period- December 1977 to October 1979-Table 3 reports

64

CRAIG S. HAKKIO and DOUGLAS Logit Estimates for Discount Rate Decreases

Table 2.

Ott 79 -0ct “fill ” Constant

K. PEARCE

82

Ott 82 -

“best ”

Dee88

“fill ”

“best ”

3.75 (0.94)

-2.18 (4.75)

-11.34 (1.51)

-12.26 (2.91)

-1.21 (1.94)

-1.03

-4.45

-3.10

(3.04)

(2.80)

-0.015 (1.42)

(2.99) -0.016 (0.78)

0.013 (0.43)

-0.016 (0.78)

Bank resetves market: Spread Change in borrowing Intermediate

targets:

Ex rate change (8 weeks) Ml growth (1 w=Q Ml growth (8 weeks)

-0.032 (1.98) -0.026 (0.37)

Ultimate targets: CPI inflation

0.46

-0.4s (0.21)

(0.20) PPI inflation

-0.95

Unemployment

(0.64) 1.13 (1.55)

Industrial production Summary

x2 R2 Note:

0.85 (0.70) -0.74

1.19 (2.55)

(1.44) -3.23 (1.89)

0.16 (0.21)

-1.57 (1.85)

statistics: 35.27

33.39

34.31

23.44

0.45

0.44

0.40

0.28

Asymptotic bvalues are in parentheses under the estimated coefficients. x2 is the likelihood ratio statistic for the test that all slope coefficients are jointly zero; the degrees of freedom are the number of estimated coefficients. R2 is McFadden’s pseudo-R2 corrected for degrees of freedom.

the changes in the probability of a discount rate increase associated with changes in the spread, the exchange rate, and the producer price index, using the estimates from the column labeled “best” in Table 1. A two-standard deviation increase in the spread increases the probability of a discount rate increase by about 67 percentage points if all other variables remained at their means. The model predicts that large changes in the exchange rate or PPI inflation (“large” means two standard deviations) would have raised the probability of a discount rate rise by about 27 and 15 percentage points respectively.

65

Discount Rate Policy Under Alternative Operating Procedures Table 3.

Effects of Discrete Changes in Independent Variables on the Probability of a Discount Rate Change Increase inprobability (inpercentagepoints) Standard deviation

Variable

Direction of change

I std dev

Zstdakv

Discount rate increase: December 1977 to October 1979 Spread

20 basis pts

increase

15.7

66.9

Ex rate change

15.4 percent

decrease

6.4

26.9

increase

4.0

14.5

PPI inflation

0.32 percent

Discount rate increase: October 1979 to October 1982 Ch in borrowing

%.3 percent

increase

0.4

1.6

Ml growth (8 wks)

8.66 percent

increase

0.5

3.1

Ind prod growth

1.44 percent

increase

2.6

35.0

Discount rate increase: October 1982 to December 1988 Spread

increase

0.05

0.15

Unemployment

68 basis pts 1.48 percent

decrease

0.44

4.6

Ind prod growth

0.55 percent

increase

0.56

6.9

Discount rate decrease: October 1979 to October 1982 Spread Ch in borrowing Unemployment

220 basis pts

decrease

3.3

%.3 percent

decrease

1.3

1.9

increase

1.1

5.3

1.14 percent

Discount rate decrease: October 1982 to December Spread Ind prod growth Note:

Probability means.

24.1

1988

68 basis points

decrease

3.1

22.3

0.55 percent

decrease

0.6

2.0

changes ate measured from the estimated probabilities

when all variables are at their sample

For the nonborrowed reserves regime-October 1979 to October 1982-only large changes in industrial production (two standard deviations) seem quantitatively important for discount rate increases. A two-standard deviation increase in money growth (using Ml and an 8 week horizon) would have raised the probability of a discount rate increase only by about 3 percentage points. In the borrowed reserves period, large changes in the variables that appeared to be statistically significant had only minor quantitative impacts on the probability of a discount rate increase. Turning to the models for discount rate decreases, Table 3 reports that changes in the spread were much larger during the nonborrowed reserves period, but, as expected, had

66

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

substantially less effect on the probability of a discount rate change compared to the federal funds rate period. Although increases in the unemployment rate had a statistically significant effect on the probability of a discount rate cut, a two-standard deviation increase in the unemployment rate is associated with a rise in the probability of a discount rate cut of only about 5 percentage points. Finally, for the borrowed reserves period, the spread was less variable than in the nonborrowed reserves period but remained more variable than in the federal funds rate period. Although the absolute value of the coefficient on the spread was significantly larger in the borrowed reserves period than in the nonborrowed reserves period, its effect on the probability of a discount rate decrease stayed roughly the same in the sense that the model predicts that a two-standard deviation fall in the spread would raise the probability of a discount rate cut by roughly the same amount as in the nonborrowed reserves period. Figures 1 through 4 plot the estimated probabilities of discount rate changes over the three periods using the estimates labeled “best” in Tables 1 and 2.** The vertical lines indicate discount rate announcements. As Figure 1 illustrates, the model for the first period performs reasonably well, with spikes at most of the discount rate increases. There are, however, some false signals, particularly in the first half of 1979, when the model produces relatively high estimated probabilities but no increase was announced. These spikes reflect weeks when the spread was relatively high but did not trigger a discount rate increase. Figure 2 shows that the increases that occurred in the second

J

: Jan ‘1978 Figure

I.

July

? 1978

Jan 1979

July

1979

date

Probability of a Discount Rate Increase, December 1977 to October 1979

Discount Rate Policy Under Alternative Operating Procedures

IL

k 1

Jan

1980

I

July

I

1980

Jan

n

A I

i9ai

July

67

A

I

i9ai

Jan

1982

I

July

1982

date

Figure 2.

Probability of a Discount Rate Increase, October 1979 to October 1982

.a

.2

0

_J Jan

isao

July

‘1980

Jan

;9al

July

‘1981

Jan

11982

JULY

i9a2

date

Figure 3.

Probability of Discount Rate Decrease, October 1979 to October 1982

CRAIG S. HAKKIO

68

and DOUGLAS K. PEARCE

l-

.8 -

c._

.6

2 a

.4-

._ D ,"

I .2 -

J

OI

I

Jan 1983

Figure 4.

I

Jan 1984

I

I

Jan 1985

I

I

I

Jan 1986 date

,

Jan 1987

I

I

I

Jan 1988

Probability of Discount Rate Decrease, October 1982 to December 1988

period were much less well explained by the model, with no estimated probabilities exceeding 50 percent. Figure 3 shows the estimated probabilities of discount rate decreases in the second period. Again the model does quite well, producing estimated probabilities exceeding .5 for four of the ten actual discount rate cuts. Figure 4 indicates that discount rate cuts after October 1982 were not well explained by the model with no predicted probabilities over S. The last five discount rate decreases were particularly poorly predicted.

IV. CONCLUSION This paper addressed the question of whether the October 1979 and October 1982 changes in Federal Reserve operating procedures were accompanied by changes in its discount rate policy. Changes in the discount rate were assumed to be triggered by three types of concerns: (1) developments in the market for bank reserves, namely changes in the spread between the federal funds rate and the discount rate and changes in borrowing at the discount window; (2) movements in such intermediate targets as the exchange rate and the money supply; and (3) changes in the ultimate goals of inflation and real economic activity. Using a limited dependent variable approach, we estimated models for the probability that the Federal Reserve will change its discount rate over a one-week horizon. Our results indicate that there were significant changes in the

Discount Rate Policy Under Alternative Operating Procedures

69

estimated effects of the three types of factors across the alternative policy regimes that characterize our sample. When the Fed was targeting the federal funds rate, discount rate changes were reasonably predictable and were very sensitive to movements in the spread between the federal funds rate and the discount rate. Only during this period is there evidence that changes in the exchange rate were an important factor in discount rate policy. When the Fed changed to a nonborrowed reserves target in October 1979, discount rate increases became much less predictable and were insensitive to the spread. There is only weak support for the hypothesis that discount rate policy was influenced by excessive money growth during this period. Discount rate decreases during this regime were related to changes in the spread, but the connection appeared much looser than in the prior regime. Discount rate’changes became even less predictable after October 1982 when the Fed moved to a borrowed reserves target, even though this procedure resembles the federal funds targeting procedure in accommodating money demand shocks. We conclude that discount rate policy changed when the Fed changed its short-run operating procedures.

ACKNOWLEDGMENTS The authors are grateful to Doug Fisher, Marvin Goodfriend, Rik Hafer, John Lapp, Karlyn Mitchell, Gordon Sellon, Dick Sylla, and Dan Thornton for helpful comments. The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

NOTES 1. See, for example, papers by Wallich (1984) and Spindt and Tarhan (1987). 2. See the papers by Sellon (1980, 1986), Sellon and Seibert (1982), Goodfriend (1983), and Thornton (1986,198s) for detailed discussions of the role of discount policy under different operating procedures. 3. Roley and Troll (1984) examine the interest rate response, Pearce and Roley (1985) look at stock prices, and Smirlock and Yawitz (1985) investigate both. Batten and Thornton (1984) report that some discount rate announcements, those categorized as nontechnical, did affect exchange rates prior to October 1979 and Cook and Hahn (1988), using a similar approach, report that interest rates also responded to nontechnical changes. Changes were labeled as nontechnical if the wording of the announcement mentioned factors other than a desire to return the spread between the federal funds rate and the discount rate to a more normal level. 4. Smith and Aquais (1985) also estimate probabilities of discount rate changes, but they use a different model and only consider the period from October 1979 to December 1983. An earlier paper by Froyen (1975) estimated monthly models for the level of the discount rate. 5. For example, there were eleven times during 1979 when the Board disapproved regional bank requests for discount rate changes. These discount rate decisions are chronicled in the Annual Report of the Board of Governors. 6. The following discussion draws on the analysis of Sellon (1980, 1986) and Thornton (1986, 1988).

70

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

7. Exchange rate movements might also reflect movements in foreign interest rates. If real rates abroad rise, the dollar is likely to depreciate and the Fed might respond by raising the discount rate to signal its intention to raise real rates in the U.S. 8. Of the 38 discount rate announcements in our sample, 18 were made on Thursday and 13 were made on Friday. 9. Of the 38 announced changes, 24 were 50 basis points, 12 were 100 basis points, and 2 were 25 basis points. 10. There is some uncertainty about the timing of the switch to the borrowed reserves procedure. Huizinga and Mishkin (1986) report time series evidence indicating that the switch was in October 1982. 11. During 1980 and 1981, discount rate policy was complicated by the occasional use of surcharges to the basic rate for large banks that were frequent borrowers. Changes in the surcharge on six occasions usually accompanied changes in the discount rate- in the same direction-but they were announced separately. We examine this issue below. 12. Two outliers in the adjustment borrowing series were eliminated since they were known to be temporary and should have had no effect on discount rate policy. The first occurred in late May 1984 when the Continental Bank of Illinois run resulted in that bank borrowing heavily and the second in late November 1985 when the Bank of New York had a computer failure that forced it to borrow a substantial amount. See Thornton (1986, p. 9). 13. Timing of the discount rate announcements is obtained from telegrams to regional bank presidents informing them of when the announcement would be made. The data on the daily federal funds rate, the daily exchange rate, and the level of adjustment borrowing were supplied by the Federal Reserve Bank of Kansas City. The Ml money supply growth measures were computed from the weekly H.6 Release of the Board of Governors of the Federal Reserve System. The latest announced figures for the percentage changes in the CPI and PPI came from the BLS press releases. The civilian unemployment rate is from the BLS press release, The Employment Situation. The percentage change in the index of industrial production is from Statistical Release G.12.3 of the Board of Governors. All data are available from the authors. 14. Deviations from the mid-points of the ranges were computed using the growth rate over the last eight weeks. The long-run target ranges are from the April issues of the Review of the Federal Reserve Bank of St. Louis. 15. We estimated models for increases and decreases during the NBR period and found that the multinomial logit estimates were essentially identical to the estimates from separate logit estimates for increases and decreases. 16. Results using measures of the exchange rate variable over shorter periods were similar but these models had slightly worse fits. The growth rate of M2 over one week was never significant and so estimates using this measure are not reported. 17. A series of likelihood ratio tests were performed to test the hypothesis of parameter stability across operating regimes and this hypothesis was generally rejected. For example, for the complete model using the 8 week measure of money growth, the likelihood ratio test statistic for the hy othesis that all coefficients are constant is 57.43 with 18 degrees of freedom while the critical x ? value is 28.87 at the .05 level. Similarly, the same test for the federal funds rate versus the nonborrowed reserves period produced a test statistic of 35.95 with 9 degrees of freedom while the .05 critical value is 16.92, and the test for the federal funds rate versus borrowed reserves periods produced a test statistic of 41.67 with 9 degrees of freedom. 18. In the “full” model, Ml growth and PPI inflation were individually insignificant. However, when Ml growth is included and PPI inflation is excluded, Ml growth is significant. In addition, when Ml growth is excluded and PPI inflation is included, PPI inflation is significant.

Discount Rate Policy Under Alternative Operating Procedures

71

Apparently, including both Ml growth and PPI inflation introduces enough multicollinearity to make it difficult to separate their influences. 19. Parameter stability across the NBR and BR periods was not rejected for the full model, but was rejected for the more parsimonious model for the NBR period with a x2 value of 10.75 with 4 degrees of freedom while the critical value is 9.49 at the .05 level. 20. The likelihood ratio test for the NBR and BR periods using the full model with the 8 week measure of Ml growth rejects the hypothesis of parameter stability, producing a test statistic of 23.73 with 9 degrees of freedom while the .OS critical x2 value is 16.92. 21. As mentioned in note 11, during the NBR period there were also six surcharge announcements. Five of these were surcharge decreases. To test if these announcements should be treated as discount rate announcements, separate logit models were estimated but the models were unsuccessful in explaining these announcements. 22. The estimated probabilities of discount rate increases in the BR period were all very low so no plot is given.

REFERENCES Broaddus, A. and T. Cook. “The Relationship between the Discount Rate and the Federal Funds Rate under the Federal Reserve’s Post-October 6, 1979 Operating Procedure.” Economic Review, Federal Reserve Bank of Richmond, 69 (January/February 1983): 12-15. Batten, D. S. and D.L. Thornton. “Discount Rate Changes and the Foreign Exchange Market.” Journal of International Money and Finance 3 (December 1984): 279-292. Brown, K.H. “Effects of Changes in the Discount Rate on the Foreign Exchange Value of the Dollar: 1973 to 1978.” QuarterZy Journal ofEconomics XCVI (August 1981): 551-558. Cook, T. and T. Hahn. “The Information Content of Discount Rate Announcements and their Effect on Market Interest Rates.” Journal of Money, Credit and Banking 20 (May 1988): 167-180. Froyen, R. T. “The Determinants of the Federal Reserve Discount Rate Policy.” Southern Economic Journal 42 (October 1975): 193-200. Gilbert, R.A. “Operating Procedures for Conducting Monetary Policy.” Review, Federal Reserve Bank of St. Louis, 67 (February 1985): 13-21. Goodfriend, M. “Discount Window Borrowing, Monetary Policy, and the Post-October 1979 Federal Reserve Operating Procedure.” Journal of Monetary Economics 12 (September 1983): 343-356. Huizinga, J. and F.S. Mishkin. “Monetary Policy Regime Shifts and the Unusual Behavior of Real Exchange Rates.” Carnegie-Rochester Series on Public Policy 24 (Spring 1986): 231-274. Lombra, R.E. and R.G. Torto. “Discount Rate Changes and Announcement Effects.” Quarterly Journal ofEconomics XC1 (February 1977): 171-176. Pearce, D.K. and V.V. Roley. “Stock Prices and Economic News.” Journal of Business 58 (January 1985): 4968. Purposes andFunctions, Board of Governors of the Federal Reserve System, Washington, D.C., 1984. Roley, V.V. and R. Troll. “The Impact of Discount Rate Changes on Market Interest Rates.” Economic Review, Federal Reserve Bank of Kansas City, 69 (January 1984): 27-39. Santomero, A.M. “Controlling Monetary Aggregates: The Discount Window.” Journal of Finance 38 (June 1983): 827-843.

72

CRAIG S. HAKKIO and DOUGLAS

K. PEARCE

Sellon, Gordon H. “The Role of the Discount Rate in Monetary Policy: A Theoretical Analysis.” EconomicReview, Federal Reserve Bank of Kansas City, 65 (June 1980): 3-15. . “The Recent Evolution of Federal Reserve Operating Procedures.” Research Working Paper 86-13, Federal Reserve Bank of Kansas City, December 1986. Sellon, G.H. and D. Seibert. “The Discount Rate: Experience under Reserves Targeting.” Economic Review, Federal Reserve Bank of Kansas City, 67 (September-October 1982): 3-18. Smirlock, M. and J. Yawitz. “Asset Returns, Discount Rate Changes, and Market Efficiency.” Journaf ofFinance 40 (September 1985): 1141-1158. Smith, D.J. and S.D. Aquais. “A Qualitative Choice Model of Federal Reserve Discount Rate Changes in the Post-October 1979 Period,” Working Paper, Boston University, May 1985. Spindt, P.A. and V. Tarhan. “The Federal Reserve’s New Operating Procedures: A Post Mortem.” Journal ofMonetary Economics 19 (January 1987): 107-123. Thornton, D.L. “The Discount Rate and Market Interest Rates: Theory and Evidence.” Review, Federal Reserve Bank of St. Louis, 68 (August/September 1986): 5-21. “The Borrowed-Reserves Operating Procedure: Theory and Evidence.” Review, Federal Reserve Bank of St. Louis, 70 (January/February 1988): 30-54. Wallich, H. “Recent Techniques of Monetary Policy.” Economic Review, Federal Reserve Bank of Kansas City, 69 (May 1984): 21-30. White, Kenneth J., “SHAZAM: A General Computer Program for Econometric Methods (Version S).“Americun Statistician (January 1987): 239-240.