Federal reserve policymaking: an overview and analysis of the policy process

Carnegie.R~hes~r Conference Wries on Public Policy 30 (1989) ~ 6 2 Nor~-Ho/land

FEDERALRESERVEPOL!CYHAKING: AN OVERVIEWAND ANALYSISOF THE POLICY PROCESS NICHOLAS KARAHOUZIS Bank of Greece and RAYMONDLOHBRA* Pennsylvania State University

I.

INTRODUCTION

Reflecting the confluence of various p o l i t i c a l and economic factors, and the natural penchant of policymakers to cover their t r a i l s (and t a i l s ) , understanding what policymakers do or f a i l to do and why is d i f f i c u l t under the best of circumstances. The resulting tendency of economists to abstract from salient features of the process governing the formulation and implementation of policy is thus understandable. The practice is also lamentable, however, for i t tends to l i m i t the robustness, r e l i a b i l i t y and thus usefulness of theoretical and empirical analysis of policy and i t s effects on the economy. Taking account of policymakers' penchant for secrecy and ambiguity and the modeling propensities of economists, Karl Brunner concludes, nA wide gulf separates the r e a l i t y o6 stabilization policy from the o f f i c i a l claims [of policymakers] and academic rhetoric" (Brunner, 1985, p. 224). The purpose of this paper, as was true of i t s predecessor (Lombra and Moran, 1980), is to bridge the gulf between the rigors of monetary theory and the r e a l i t i e s of monetary policy by ~:ocusing on the process governing

*We would l i k e t o express our deep appreciation t o Normand Bernard, Special Assistant t o the Federal Reserve Board, f o r his assistance in securing the Federal Open Narket Committee documents used in t h i s paper, and t o Brian Hadigan of the Federal Reserve Board s t a f f , Roy Webb of the Federal Reserve Bank of Richmond s t a f f , Hark Sniderman of the Federal Reserve Bank of Cleveland s t a f f , and Stephen McNees of the Federal Reserve Bank of Boston s t a f f f o r kindly providing us with some of the key data sets analyzed. We would also l i k e t o thank Adrienne Kearney, J e f f B u t l e r , and Christos Adrovitsaneas f o r h i g h - q u a l i t y and invaluable research assistance. F i n a | l y , we acknowledge the extremely helpful comments of the conference p a r t i c i p a n t s , e s p e c i a l l y our discussants and the e d i t o r s .

0 167--2231/89/$3.50

©1989, Elsevier Science Publishers B.V. (Norlh-Holland)

the actual conduct of U.S. monetary policy.

With a larger slice of history

and longer data sets now available for study, particular emphasis is accorded the economic analysis produced by the s t a f f

of

the Board of

Governors of the Federal Reserve System and the strategy and tactics employed by the Federal Open Market Committee (FOMC).

We proceed on the

premise that by describing, analyzing and evaluating the internal workings of the policy process, a deeper understanding of the uncertainties, constraints, analyses, and procedures which comprise the policymaking process w i l l emerge, thus enhancing the productivity of academic research on monetary policy. The rest of the paper is organized as follows.

Section I i provides an

overview of the s t a f f ' s role in fe:inulating moaetary policy by focusin~ ~n the

major documents prepared for

polic~nnakers - -

the Greenbook and

Bluebook. Section I l l analyzes the s t a f f ' s nonfinancial forecast errors and Section IV examines the s t a f f ' s financial forecast errors. Section V turns to the choices made by polic)~akers and the actual policy.

implementation of

Finally, Section VI summarizes our findings and draws tentative

conclusions.

FORMULATINGMONETARYPOLICY: AN OVERVIEWOF THE PROCESS Much of the data analyzed in subsequent sections are drawn from documents prepared throughout the policy process. Accordingly, a brief review of the various stages of the process and the documents generated therein w i l l provide a context for and perspective on the analysis to follow.

PREPARING FOR AN FOMCMEETING: THE STAFF'S ROLE1 The Fed's staff

is charged with developing an overall,

integrated

assessnmnt of past, present, and future economic and financial developments, laying out feasible policy alternatives for consideration by policymakers and making specific policy recommendations to the FOHC. The staff discharges i t s responsibility by preparing severe] documents for the

1The " s t a f f " r e f e r s t o the s t a f f of the Board o f Governors of the Federal Reserve in Washington, D.C. Regarding t h i s delineation two points should be emphasized: (1) Reserve Bank s t a f f s advise t h e i r respective Reserve Bank Presidents; however, these s t a f f members do not, in general, as sist in the preparation of the analysis presented t o the FOMC by the Board s t a f f ; accordingly, our c h a r a c t e r i z a t i o n of "the s t a f f ' s analysis" should not be a t t r i b u t e d t o

c o M i t t e e p r i o r to an FOMCmeeting. The Greenbook. A document called "Current Economic and Financial Conditions," or the Greenbook for short (because of i t s green cover), lays out the s t a f f ' s analysis of recent and prospective economic developments. More s p e c i f i c a l l y , i t sumarizes recently released economic and financial data, provides any h i s t o r i c a l

perspectives or comparisons which may have

some bearing on the outlook,

lays out the key assumptions underlying the

nonfinancial prices),

forecast

(e.g.,

assumptions

about f i s c a l

and presents the forecast for GNP, i n f l a t i o n ,

policy

and o i l

and unemployment

over the next year or so. The l a t t e r is accompanied by a f u l l explanation of any significant changes in the staff's outlook, given the prevailinq stance of monetary policy, as indexed by the existing set of targets for the various monetary aggregates {more on this below). The process leading to the development of this document begins several weeks before the scheduled FOHC meeting. The Gain task before the staff is to develop a revised nonfinancial forecast. Staff experts on various sectors of the economy first assess the information which has become available since the last FOHC meeting {in recent years the FOHC has been meeting about 8 times a year -- about every 6 weeks or so), including recently released data and, for example, changes in the fiscal policy outlook. This information is then used as an input by the staff's "judgmental" foY ecasters, who develop projectior)s with the aid of surveys of consumer sentiment and capital equipment Sl Jnding plans, leading and lagging indicators, and other business cycle techniques, and by the staff's "econometric" forecasters, who develop projectior~t with the staff's version of the HPS model. 2

Senior staff blend the )~PS model projections

and

judgmental projections into a "consensus forecast" which is then presented

1 continued the Reserve Bank s t a f f s ; (2) th~ " s t a f f view" analyzed is a consensus view developed by s e n i o r a d v i s o r s ; a c c o r d i n g l y , i n d i v i d u a l s t a f f members r o u t i n e l y question v a r i o u s aspects o f t h e procedures, a n a l y s i s , and f o r e c a s t s examined below. U n f o r t u n a t e l y (but u n d e r s t a n d a b l y ) , the s p e c i f i c s surrounding such i n t e r n a l debates are not r e a d i l y a v a i l a b l e f o r examination and a n a l y s i s . 2The words "judgmental" and "econometric H are shown in quotes t o make the p o i n t t h a t judgmental p r o j e c t o r s do u t i l i z e e m p i r i c a l models in the process o f analyzing d a t a , and econometric f o r e c a s t e r s r o u t i n e l y a d j u s t t h e i r models ( t h e s o - c a l l e d "add f a c t o r s " ) in response t o t h e i r judgment about the recent t r a c k i n g o f the model and the perceived reasonableness o f the model-based f o r e c a s t . See Brayton and Hauskopf (1987) where the s t a f f t s v e r s i o n o f the HIT - PENN - SSRC model and i t s r o l e in the p o l i c y process is described in detail.

in the Greenbook.

Exhibit I illustrates the result of t h i s stage of the

process with a synopsis of the Greenbook prepared for the July 6-7, 1981 meeting of the FOMC.3 While the excerpts presented largely speak for themselves, i t is worth noting that the exhibit clearly indicates that the s t a f f ' s analysis is model-based and f a l l s well within the mainstream of economic analysis prevailing at the time. The nonfina~cial economic forecast

appearing

in

the

July

1981

percent midpoint of the Greenbook assumed the Fed would h i t the ~ announced 3~ - 6 percent M1 growth target then in place for 1981. In February and July each year, in conjunction with the preparation of i t s report on monetary policy to the Congress in accordance with the provisions of the Numphrey-Hawkins Act, the FOMCformerly reconsiders i t s longer-term policy stance as indexed by i t s yearly monetary targets. 4 To assist the FOMC, the staff prepares a set of nonfinancial forecasts. More specifically, the staff's base or "no change in poli~y" forecast, which appears in the Greenbook, is supplemented with additional nonfinancial forecasts (usually two) based on alternative monetary policy assumptions. These alternatives, along with the staff's financial analysis, appear in the Bluebook= The Bluebook. The Bluebook (so named for i t s blue cover) was entitled "Monetary Aggregates and Money Market Conditions" for most of the 1973-1982 period

we study.G

The f i r s t

section

reviews recent developments;

deviations of monetary growth from projections are analyzed, changes in

3~ d e t a i l s , including pages of tables and analysis of individual cc~nponents of the f o r e c a s t , have been suppressed to conserve space. However, considerable care has been exercised t o remain f a i t h f u l to the o r i g i n a l t e x t . In a few cases, we have paraphrased t o maintain c o n t i n u i t y and r e a d a b i l i t y ; accordingly, "synopsis" is more accurate than " e x c e r p t . " 4prior to I~78, the FOMC did t h i s three or four times a year. Of course, the FOMC can still reconsider the longer-term t a r g e t s more frequentl~ than twice a year i f conditions warrant. 5 I t s t i t l e was changed t o "Monetary Policy A l t e r n a t i v e s " in e a r l y 1982. We suspect t h i s change was motivated in part by the incipient downgrading of the monetary aggregatesp p a r t i c u l a r l y Mlp in the formulation and implementation of policy° More on t h i s beloWo As f o r our sample period, we begin in 1973 because t h i s is where Lombra and Moran (1980) l e f t o f f and we end in 1982 because the Fed imposes a Y-year delay on access t o the re le va n t documents. Although a respectable argument supporting a delay can be made, we hope Fed Chairman Alan Greenspan w i l i consider a s i g n i f i c a n t shortening of the lag. While the access t o information c u r r e n t l y provided by the Fed places i t at the f o r e f r o n t of central banks, more t im e ly information on policy and policy analysis w i l l help the economics profession produce research of even more use to policymakers and the nation.

10

EXHIBIT I SYNOPSIS OF JULY 1981 GREENBOOK SUHNARY OF DOMESTIC NONFINANCIAL,

FINANCIAL AND |NTERNATIONAL

DEVELOPMENTS The expansion of economic a c t i v i t y apparently was hailed in the second quarter. Housing contracted f u r t h e r , investment outlays receded, and consumer spending weakened. Rates of increase f o r aggregate price measures also have slowed. Reflecting an easing in the demand f o r labor in goodsproducing industries, the unemployment rate rose one-fourth percentage point to 7.6 percent. Interest rates have declined since the mid-May FOMC meeting in response to incoming data indicating soft economic a c t i v i t y , reduced i n f l a t i o n and weak money growth. The weighted-average exchange value of the d o l l a r has appreciated a further 4~ percent since the May Greenbook, registering a cumulative r i s e of 25 percent over the past year.

Economic activity in the major foreign industrial economies remains relatively weak. OUTLOOK Aggregate a c t i v i t y i s expected to remain sluggish through the summer. The near-term i n f l a t i o n outlook has improved, r e f l e c t i n g in large part recent reductions in the prices of petroleum products. The anticipated contour of economic a c t i v i t y through the end of 1982 has been altered somewhat to r e f l e c t revised f i s c a l policy assumptions. The s t a f f now assumes that personal taxes w i l l be cut by 7 purcent on October 1, 1981, rather than the 10 percent shown in the l a s t Greenbook, and that a further tax reduction of lO percent w i l l occur on July l , 1982. A speed up in depreciation allowances is assumed retroactive to March 1, 1981 and the s t a f f assumes that nondefense expenditures w i l l be cut $38 b i l l i o n in f i s c a l year 1982, $5 b i l l i o n more than shown in the l a s t Greenbook~ The financial assumptions underlying the s t a f f ' s economic projections continue to show H1 [as then defined and adjusted f o r the effects of s h i f t s out of savings deposits into NOW accounts, as estimated by the s t a f f ] increasing 4 percent over the four quarters of 1981, and 4~4 percent during 1982o Short-term i n t e r e s t rates are expected to be a b i t higher than in recent months, but expectationa] factors may permit some reduction in long rates over the next year or so. Some boost to a c t i v i t y in response to the tax cut is anticipated but growth i s constrained by the assumed growth of the

11

monetary aggregates.

The demand for narrow money [MI] is likely to begin

expanding more in line with the growth of nominal GNP than in the first half, boosting demands for reserves.

Commercial banks may need to rely

significantly

to finance

expansion.

on managed

liabilities

fairly

buoyant

credit

The Treasury is expected to raise $15~ billion in new money

over the next three months; this turnabout in Treasury financing needs will also work to firm interest rates over the summer. interest dollar.

rates

have contributed

to

substantial

Relatively high U.S.

strength

for the U.S.

However, as the higher dollar begins to have a noticeable negative

impact on trade in 1982, the staff expects a substantial decline in the Real GNP is projected to rise at a ~s percent annual rate

dollar's value.

over the last half of 1981 and I~ percent during 1982. Reflecting this sluggish growth, the unemployment rate is projected to rise from 7% percent in Ig81 Q2 to 8~4 percent by the end of 1982. Continued slack in both labor and product markets, as well as a heightened perception of the credibility of monetary

policy,

expectations

and dampen the rate of increase in wages.

should have further

favorable effects

on inflation As a result,

inflation is expected to slow from an 8~ percent annual rate in the second half of this year to a 7¼ percent rate by the end of 1982.

The trade

deficit is expected to rise to about $27 billion this year; and to $52 billion in 1982.

12

short- and long-term interest rates are summarized, noteworthy developments in other sectors oC the credit markets are reported, and the conduct of open market operations since the last FOHC meeting i s reviewed. The next section (which appears at least twice a year in February and July) presents the alternative longer-run policy options described above (usually for a 67 quarter horizon), and discusses the implications of each alternative for economic and financial developments. The following section (which appears in each Bluebook) presents alternative short-run (usually quarterly) policy options for the FOMC's consideration.

The relationship between each short-

run alternative and the longer-run monetary targets is developed e x p l i c i t l y along with the ramifications of each alternative for market expectations about policy, stock prices, interest rate d i f f e r e n t i a l s and exchange rates, mortgage market a c t i v i t y , and so f o r t h . As was true in the econometric and judgmental

preparation of the nonfinancial forecasts, inputs are used in deriving the s t a f f ' s

financial forecasts (more on t h i s below). Exhibit I I is a synopsis of the Bluebook prepared for the same July 6-7, 1981 meeting of the FOHC. At i t s meeting, the FOHC debates the various alternatives, selects a se_tt of monetary targets - - embracing growth rates for the monetary aggregates, reserve aggregates, an~ levels or ranges of discount window borrowing and the Federal funds rate - - and then issues a Directive to the Federal Reserve Bank of New York regarding the conduct of open market operations over the period u n t i l the next FOHC meeting. Exhibit I I I presents a synopsis of the operative portion of the Directive from the July 6-7, 1981FOHC meeting. For l a t e r reference i t is informative to compare what the FOHC actually decided and s~lected to the alternatives and forecasts presented by the s t a f f in the Greenbook and Bluebook. 6

For 1981, the FOHC l e f t the

range for H1 growth at 3~-6 percent, but expected M1 to grow near the 3~ percent low end of i t s range (actual growth, "shift-adjusted," was 1.1 percent). This, along with the 4 percent midpoint of the 2~-5~ percent H1 range selected for 1982 (actual growth turned out to be 8.5 percent), is

6 I t should be emphasized t h a t t h e r e is nothing " s p e c i a l " about t h i s p a r t i c u l a r FOt4C mceting o r the s t a f f ' s a n a l y s i s f o r i t . Indeed, i t was selected because i t apDears r e p r e s e n t a t i v e of what might be c a l l e d "normal" polictmaking and a n a l y s i s over the period we study ( p a r t i c u l a r l y the l a t e 1979 t o 1982 p e r i o d ) .

13

EXHIBIT I I SYNOPS[S OF JULY 1981 BLUEBOOK RECENT DEVELOP14ENTS R1 (adjusted f o r s h i f t i n g into NOW accounts), contracted at about a 7~ 4 percent annual rate on average in 14ay and June - - well short of the April-to-June growth path set by the Committee at i t s 14ay meeting (of 3 percent or lower). 142 grew at a 4 percent rate on average in 14ay and June, also below the path set f o r t h i s aggregate. that,

in

light

of

the April

surge

in

Given the Committee's decision the monetary aggregates,

shortfall

From the Ml target would be acceptaLl~, the i n i t i a l

path for

nonborrowed reserves was lowered

in

~he F i r s t

some

operating

p~rt

of

the

intermeeting period as t h i s aggregate weakened. Borrowing consequently remained around $2 b i l l i o n and Federal funds generally traded in an 18J~ to 1% percent range. By mid-June the Committee indicated that the emerging weakness [ i n 141] should be allowed to show through in reduced borrowing at the discount window.* Borrowing demand remained s u r p r i s i n g l y strong and the Federal funds rate averaged about 1843- percent in the most recent statement week. Despite the firmness of the Federal funds rate, most other short-term market rates have declined ~ 4 percentage points, on 3 to 1) net, since the Hay meeting. Yields on most long-term securities trended downward through much of the intermeeting period. The d o l l a r has appreciated almost 4 percent since the 14ay F~HC meeting. amounted to net sales of roughly $4 b i l l i o n .

Dollar intervention has

THE MONEY AND CREDIT TARGETS FOR 1981 Under the Humphrey-Hawkins Act, the Federal Reserve must report to the Congress by July 20 i t s updated objectives for money and c r e d i t growth in 1981 and i t s preliminary views about the appropriate objectives f o r 1982. The 141 measure at midyear (2.2%) stands below the lower boundary of i t s 3J~% to 6 percent range, while 142 is at, and 143 above, the upper l i m i t s of t h e i r respective 6-9 percent and 6~ to 9~ percent ranges. The slower R1 growth

mAs explained in Section V below, the nonborrowed reserves o p e r a t i n g s t r a t e g y then in place led in t h i s s i t u a t i o n t o the Desk p r o v i d i n g more reserves through open-market o p e r a t i o n s , expecting the funds r a t e t o drop and borrowing at the discount window t o f a l l in response as the spread between the funds r a t e and discount r a t e narrowed,

14

was accompanied by an unusually rapid two-quarter r i s e in i t s v e l o c i t y - on the order of 10 percent at an annual rate. There appears to have been a pronounced downward s h i f t in the public's demand f o r transactions balances, perhaps associated with the stimulus to more intense cash management provided by extraordinarily high interest rates. The standard formulation of money demand behavior in the Board's quarterly econometric model suggests that the velocity of Ml should have grown around 5 percentage points slower in the first half.

PROJECTED GR~7,fTHOF MONEY IN 1981

Ex;~t(ng Terget f o r Alternative HI ( s h i f t adjusted)

x2 M3

Alternative

1

Alternative 2

1980 IV

-

198l IV

42

3½

3½ -

9½ lO½

8~ 92

6

1 i s the basis f o r

the s t a f f ' s

6½

-

-

Greenbook forecast.

6

9 9½

With

nominal GNP growing at 9 percent over the next two quarters, market i n t e r e s t rates appear l i k e l y to be a b i t higher on average in the next s i x months. Under the more r e s t r i c t i v e monetary assumption of a l t e r n a t i v e 2, short-term interest rates would be under more upward pressure, and nominal GRP growth would be reduced somewhat in the second h a l f . There also would be s u b s t a n t i a l l y greater r i s k of financial dislocations (emphasis added). PREL[H[NARY TARGET RANGES FOR 1982 The table below presents economic projections f o r a few d i f f e r e n t sequences of monetary growth. Estimates of the d i f f e r e n t i a l impact of the various monetary strategies r e l y heavily, though not entirely~ on the Board's quarterly econometric model. [Caveats enumerated.] The f i r s t longer-run strategy f o r money growth i s the basis f o r the Greenbook forecast throughout 1982. A l l these strategies e n t a i l substantial declines in the rate of i n f l a t i o n , but at a cost within the projection period of a considerable r i s e in the unemployment rate. Progress toward price s t a b i l i t y could come more r a p i d l y i f

15

such r e s t r i c t i v e monetary strategies

themselves led to a substantial reduction in inflationary expectations, but i t is an open question whether expectations can be reduced more quickly without even greater weakness in output.

N1 (Percent Change, Q4, to Q4) Strategy I

4.75

4.25

Strategy 2

3.5

4.25

3.75 3.75

Strategy 3

3.5

3.0

2.5

Strategy I

2.5

1.2

1.6

Strategy 2

2.2

0.6

1.6

Strategy 3

2.2

0.0

0.7

Real GNP (Percent Change, 04 to 04)

Implicit Deflator (Percent Change, Q4 to Q4) Strategy I

8.1

7.0

6.0

Strategy 2

8.0

6.8

5.7

Strategy 3

8.0

6.5

5.2

Unemployment Rate (04) Strategy i

7.8

8.3

8.8

Strategy 2

7.9

8.9

9.5

Strategy 3

7.9

q.2

10.5

SHORT-RUN TARGETS FOR THE MONETARY AGGREGATES The table below presents three alternative September) targets for the monetary aggregates.

m NZ Federal

funds range

short-run

(June

Alternative A

Alternative B

lo~ 9~

8~ 8~

8

14 - 20

16 - 22

18 - 24

16

to

Alternative C

Alternative A i(as designed to return MI to the lower end of its existing longer-run range by September+ percent annual rate.

Total reserves might have to expand at a 13

Whether so rapid a growth in total reserves would

entail a drop in interest rates from current levels of course depends on the demand

for money.

If, as the

staff projects, real GNP does not

decline, and the demand for money behaves in a relatively mnormaln f~shion, a considerable

rebound

in MI growth

downward pressure on interest rates.

could occur with

little,

if any,

Under alternative B, MI w~uld grow at

a rate that would leave it below the lower end of th~ FOflC's 1981 rlnge until November. perhaps that

Interest rates would probably rise from recent lev~'s,

substantially as the market

the

funds

institutions

rate would

would

remain

declinnintense,

is disappointed

in its eypectations

The earnin?~

probl~,,~ of thrift

even

under

[Suggested la~u~ge for the Oirective follows.]

17

alternatives

A

~r

B.

verj close to strategy 2 presenteC by the s t a f f

i n the Bluebook (see the

table in E x h i b i t I [ ) . When the FOMC reported i t s economic forecasts to the Congress several weeks a f t e r the July 6-7 meeting, the numbers, as shown i n Table 1 below, were broadly consistent with the s t a f f

forecasts of the implications of

strategy 2 shown in parentheses, a l b e i t a touch more o p t i m i s t i c about 1982. As f o r the short run, the 7 percent R1 growth objective selected f o r the June to September period i s close to a l t e r n a t i v e C presented i n the Bluebook (see E x h i b i t ] I ) . selected

is

seemingly

However, the 15-21 percent funds rate range

between a l t e r n a t i v e s

inconsistent

short-run

A and B.

This tendency to

alternatives

calling

for

select

mlow= money

growth and "low" i n t e r e s t rates i n order to secure a unanimous or near unanimous vote on the D i r e c t i v e seems to be an enduring c h a r a c t e r i s t i c of Fed policymaking (Lombra and Moran, 1980, p. 44) a~d i s subject to more careful s c r u t i n y below.

III,

THE STAFF'S NONFINANCIALFORECASTS

As i s well-known, a necessary condition f o r an e f f e c t i v e s t a b i l i z a t i o n p o l i c y in a world characterized b ) a lag between p o l i c y actions and t h e i r effects on the economy i s a reasonably accurate forecast of f u t u r e economic conditions.

More s p e c i f i c a l l y , as Brunner (1985) and Meltzer (1987) have

recently emphasized, forecast

accuracy and knowledge about "structuralU

r e l a t i o n s h i p s define the l i m i t s of s t a b i l i z a t i o n p o l i c y .

Accordingly, the

logical place to begin our analysis of the p o l i c y process at the Fed i s to examine the p r e d i c t i v e accuracy of the s t a f f ' s nonfinancial forecasts. FORECAST ACCURACY Table 2 p;esents the star~ard set of diagnostic s t a t i s t i c s summarizing the c h a r a c t e r i s t i c s of the Fed s t a f f ' s

nonfinancial forecast e r r o r s .

As

can be seen, the mean absoluLe errors increase as the forecast horizon lengthens, but are reduced somewhat by o f f s e t t i n g q u a r t e r l y errors when the e n t i r e year-ahead ,nterval i n evaluated.

18

The mean errors suggest t h a t the

EXHIBIT Ill SYNOPSIS OF DIRECTIVE ISSUED

To

FEDERAL RESERVE BANK OF NEW YORK JULY ~,

198l*

The Committee reaffirmed i t s monetary growth objectives for 1981 (3~6)~ for H1, 6-9~ for H2o 6'j-9~ for H3), expecting that growth in M1 for the year would be near the lower end of i t s range, while growth in the broader aggregates may be high in t h e i r ranges. The Committee also tentatively agreed that for the period from the fourth quarter of 1981 to the fourth quarter of 1982 growth of H|, M2, and H3 within ran~*~ of 2~-5)~ percent, 6-9 percent, and 6~ to 9~ percent ~ould be appropriate. In the short-run the Committee seeks growth of H] from June to September at an annual rate of 7 percent, provided that growth of H2 remains around the upper l i m i t , or moves within, i t s range for the year. I f pursuit of the monetary objectives results in a Federal ~unds rate persistently outside a range of 15-2| percent, during the period be6ore the next n~eting, the Chairman may call for Committee consultation.

"Federal Reserve B u l l e t i n , September 1981, p. 718.

19

TABLE I

Economic Forecasts o f FOMCm

1981

Real GNP

1982

3½

(2.2)

[O.lj

i -

I m p l i c i t Price D e f l a t o r

7½ - 9

(8.0)

I8.8]

6½ - 8½ (6.8)

44.5l

Unemployment Rate

7½ - 8¼ 47.9)

[8.31

7

[lO.Tl

!

-

*"Monetary Policy Report t o the Congress," Federal Reserve B u l l e t i n ,

4

- 8½

(0.6)

(8.9)

4-1.2]

August 1981, p. 599.

Real GRP and the d e f l a t o r are percent changes on a f o u r t h q u a r t e r t o f o u r t h q u a r t e r b a s i s . The unemployment r a t ~ is the average level in the f o u r t h q u a r t e r . statf

Numbers in parentheses are

f o r e c a s t s of strategy c l o s e s t t o what FOMC selected and numbers in brackets are the

r~alizations.

staff tl~n~s t~) overestimate real growth and underestimate inflation. 7 This tendency, which has been found by others in their evaluation of other forecasts, 8 is presumably a reflection, at least in ~drt, of the d i f f i c u l t y associated with pinning down the slope and positie;~ of the short-run

/

/

7This i n d i c a t i o n is supported by regressing actual values on predicted values and by computing hTe i l decomposition s t a t i s t i c s . I However, the l a t t e r a l s o i n d i c a t e t h a t the g r e a t e s t proportio~ of the f o r e c a s t e r r o r s is due/~o imperfect c o v a r i a t i o n between actual and predicted values. / / 8See McNees 41985), Zarnowitz //11986), Strongin and Binkley (1988) and the references cited therein. I t should be n o t e d / t h a t Webb (1987) has argued t h a t biased f o r e c a s t s may be somewhat of an i l l u s i o n . For ~ a m p l e , i f the p r e l i m i n a r y , f i r s t published data on GNF' availa31e to f o r e c a s t e r s at t h e / t i m e a r e a biased p r e d i c t o r / i n d l c a t o r of the f i n a l revised / data i~sed in computing the foref~ast errors~ as appears t o be the case, then optimal f o r e c a s t s w i l l produce e r r o r s which disr/lay bias. The key question is whether or not the existence of / . bias indicates t h a t r e a d i l y 3 v a r i a b l e information was not e x p l o i t e d by f o r e c a s t e r s . More on t h i s below. /

/

/

/

zo

TABLE 2

Nonfinancial Forecast Errors by the Fed S t a f f 1973:1 - 1982:4

Mean Mean

Root Mean

Absolute

Error

Square

Error

Error

Theil Coefficient

NGNPO

0.51

3.27

4.20

0.19

NGNPI

0.33

3.62

4.78

0.23

NGNP4

G.55

4.10

5.14

0.24

NGNPO-4

0.16

2.16

2.60

0.26

RGNPO

0.05

3.10

5.72

0.39

RGNP1

-0.§4

3.54

4.39

0.49

RGNP4

-0.62

3.64

4.50

0.51

RGNPO-4

-0.68

2.00

2.53

0.71

INFO

0.50

!.43

1.86

0.11

INF!

0.86

1.68

2.26

0.14

INF4

1.20

2.10

2.78

0,19

INFO-4

0.91

1.55

1.95

0.25

UNO

-0.02

0.24

0.31

0.02

UN!

0.0

0.40

0.56

0.03

UN4

0.14

0.76

1.04

0.06

Notes:

Forecast err ors are defined as ~ctual minus predicted values.

from the Greenbooks prepared f o r the f i r s t

meeting within a quarter.

from the most recent Business Conditions Di~est:

Historical

Series.

Forecasts are taken

Actual values are taken NGNPO r e f e r s t o the

forecast f o r nominal GNP f o r the current quarter, NGNP1 is the forecast f o r next q u a rt e r, NGNP4 is the forecast f o r the single quarter four quarters ahead (say 1978:2 made in 1977:2), and NGNPO-4 is the forecast over the e n t i r e quarters ahead. unemployment r a t e .

interval from the current quarter through four

RGNP is real GNP, INF is the GNP i m p l i c i t p r i c e d e f l a t o r , and UN is the NGNP, RGNP, and INF are expressed as seasonally adjusted annual r a t e s , and

UN is in percentage points.

There are 40 observations f o r each v a r i a b l e and forecast horizon,

21

Phillips

Curve in a world of "complex phenomenona."9

Table 3 provides

further evidence on t h i s tendency and allows us to compare the forecasting performance

of

the

Fed s t a f f

to

the

performance

of

other

well-known

forecasts. Succinctly stated, Table 3 suggests that the Fed s t a f f forecasts are "state of the a r t " ; the various error measures f o r the Fed and the median forecast tracked by McNees (1988) are remarkably similar. 10

While t h i s is

both comforting and not p a r t i c u l a r l y surprising, given the high q u a l i t y of the Fed's s t a f f ,

the mean absolute errors and root mean square errors do

not appear to be "small. m ' The central question is whether they are "too

large" for the formulation of a successful, activist stabilization policy. While this is inherently d i f f i c u l t to answer, so~e suggestive evidence is available from Table 4. The forecasting errors are at least as large as the typical spread encompassing the staff's forecasts of the economic implications of alternative monetary policy strategies, in Exhibit I I , for example, ~he forecast spread over the next eighteen months across the 1~ perce:,~ range of monetary grow~ch sequences encompassing the three strategies is 1.2 percentage points for real GNP and only 0.5 percentage points for inflation. These comparisons strongly suggest that forecast uncertainty, as reflected in easily calculated prediction Cconfidence) intervals, swamps the information value of the staff's forec~st~ a~ their alleged usefulness in the design of an activist policy. The ten-year set of forecasts (1973-1982) examined above cover a period containing two oil price shocks, two serious recessions, widespread

9This term is borrowed from Hayek's seminal essay (1964) and encompasses the f u l l range of real and monetary, supply and demand, permanent and t r a n s i t o r y , d ~ e s t i c and foreign shocks which comprise the core of modern macroeconomics. lOThis generalization holds i f the Fed s t a f f ' s forecasts are cOmpared t o the individual forecasts which comprise McNees' sample. No individual f o re ca st is systematically b e t t e r than the Fed s t a f f t s . The findings are consistent with the e a r l i e r evaluation by Lombra and Moran (1980) of the 1970-73 period. The Fed s t a f f ' s forecasts were also compared t o forecasts produced by a vector-autoregressive model constructed by Roy ~ebb of the Federal Reserve Bank of Richmond. The e r r o r s t a t i s t i c s f o r the VAR forec a st s, graciously supplied by Webb, are quite s i m i l a r t o the Fedts f o r a one-quarter-ahead forecasting horizon, but, as might be expectedp are considerably larger over a four-quarter-ahead horizon. Our discussants fake issue with the " s t a t e of the a r t " g e n e r a l i z a t i o n , contending we should expect the Fad's forecast t o be somewhat b e t t e r than other forecasts because the Fed s t a f f has inside knowledge abOut the course of monetary p o l i c y . O f f s e t t i n g t h i s informational advantage, however, is the f a c t t h a t the s t a f f must assume t h a t the Fed h i t s the monetary t a r g e t s which condition the forecasts; outside forecasters are free t o assume whatever set of values f o r the monetary aggregates and i n t e r e s t rates they believe are l i k e l y t o emerge.

22

TABLE 3

One-Year Ahead N o n f i n a n c i a i

Forecast E r r o r s :

Fed S t a f f and HcNees Sample 1974:2 - 1983:4

Nominal GNP

Fed

HcNees

Mean E r r o r

0.16

-0.35

Mean A b s o l u t e E r r o r

2.16

2.43

Root Hean Square E r r o r

2.60

3.08

-0.68

-0.51

Real GNP Hean E r r o r Mean A b s o l u t ~ E r r o r

2.00

1.85

Roof Hean Square Error

2.53

2.39

Mean Error

0.91

0.31

Mean A b s o l u l e E r r o r

!.55

1.44

Root Mean Square E r r o r

i.95

1.80

GNP D e f l a t o r

Unemployment Rate Mean E r r o r

0.14

0.24

Mean A b s o l u t e Error

0.76

0.78

Roof Mean Square E r r o r

1.04

1.04

Notes:

The Fed data are

~¢Nees d a t a organizations forecasts

from t h e NGNPO-4, GNPO-4p INFO-4=

a r e t h e median o f (such

as

were made in

Chase,

the one-year DRI

1973:2-1982:4

and

forecasts

Nharton)

and

and cover t h e

See a l s o t h e notes t o Table 2.

23

and UN4 rows

in Table

made by eleven well-know~ as

yearly

reported periods

by HcNees ending

in

2.

The

forecasting

(19851o

The

1974:2-1983=4.

financial

innovation and deregulation,

a

change in

monetary policy

operating procedures, increased globalization of the real and financiLl sectors of the U.S. economy, and h i s t o r i c a l l y large fluctuations in money growth,

interest rates, and exchange rates.

Accordingly, treating the

entire period as a homogenous set of observations on Fed staff forecasting may obscure important information.

Figures 1-4 plot the Fed s t a f f ' s errors

for real GNP and the GNP deflator over different forecast horizons.

At a

minimum, the plots suggest the difficulty" created by the o i i price shocks of 1974 and 1979, document the change from a tendency to overestimate i n f l a t i o n in the 1970s to a tendency to underestimate i n f l a t i o n in the 1980s, and reveal the pronounced cyclical character of the forecast errors. The cyclical aspect of the errors is examined more carefully in Table 5.

As can be seen, the s t a f f ' s forecasts tend to be less accurate and more

biased during recessions as compared to expansions.

This finding mirrors

the results reported by Zarnowitz (1986, p. 8), 11 and is further confirmed by a correlation coefficient of 0.86 and 0.89~ respectively, between the Fed s t a f f ' s year-ahead forecast errors for r ~ l

GNP and the GNP deflator,

and the median year-ahead forecast errors for the same variables examined by McNees (1985).

Apparently, forecasters are s i m i l a r l y proficient in

exploiting the systematic information contained in past data and s i m i l a r l y a f f l i c t e d with large cyclical errors. 12

SOURCES OF FORECAST ERROR In general, the errors in the s~aff's forecasts presumably result from some combination

of

incorrect monetary and fiscal

policy

assumptions,

inaccurate assumptions for other allegedly predetermined variables, such as o i l prices and foreign economic a c t i v i t y , flaws in the structure (specification) of the s t a f f ' s model, and any random variation. To check on these p o s s i b i l i t i e s , we f i r s t regressed the s t a f f ' s forecast errors for real GNP and the GNP deflator on the deviations of the actual money stock from i t s assumed longer-run target over the projection interval, the deviation of

t l z a r n o w i t z (1986) c a r e f u l l y examined the records of a wide range of p r i v a t e (cocnmercial) and public f o r e c a s t i n g e n t i t i e s . As suggested by Zarnowitz, we a l s o s p l i t the 1973-1983 period i n t o " h i g h " and "low" growth phases and examined the e r r o r s . The same r e s u l t s were o b t a i n e d - namely, t h a t high-growth periods are forecasted b e t t e r than low-growth per i ods. 12Meltzer (1987, pp. 6-11) develops t h i s l i n e of thought in d e t a i l . A synopsis of the s t a f f ' s forecasts surrounding the 1974, 1980~ and 1981-82 recessions is a v a i l a b l e on request ~rc~n the authors.

24

TABLE 4 Information Content of Fed S t a f f Forecasts 1973-1982

Real GNP Year-Ahead Mean Absolute Error Typical "Spread"

2.0 1-2

Deflator Year-Ahead Mean Absolute Error Typica I "Spread"

1.5 ~-1

Notes: Numbers are percentage points at seasonally adjusted ar,nual r a t e s . "Spread w~ r e f e r s t o the t y p i c a l d i f f e r e n c e s between the s t a i f ~ s f o r e c a s t s alp sayp real GNP a year ahead under the " e a s i e s t " p o l i c y a l t e r n a t i v e presented t o the FONC (say 6 percent M1 growth) and the " t i g h t e s t " p o l i c y a l t e r n a t i v e presented t o the FOI4C (say 4 percent MI growth). The t y p i c a l range o f p o l i c y a l t e r n a t i v e s was !-2 percentage points of monetary growth. "Year-ahead" f i g u r e s are from Table 2.

TABLE 5 Cyclical C h a r a c t e r i s t i c s of Fed S t a f f Fourth-Ouarter-Ahead Nonflnancial Forecast Errors

Nominal GNP Mean Error Mean Absolute Error Real GNP Mean Error Mean Absolute Error GNP D e f l a t o r Mean Error Mean Absolute Error Unemployment Rate Mean Error Mean Absolute Error

Cyclical Contractions ( i n c l u d i n 9 troughs)

Cyclical Expansions ( i n c l u d i n 9 peaks)

E n t i r e Period (Table 2)

-3.45 4.92

2.1 3.8

0.55 4.10

-4.72 4.87

1.0 3.2

-0.62 3~64

1.67 3.34

1.0 1.6

1.20 2.10

0.91 0.92

-0.14 0.70

0.0 0.40

Notes: Contractions ( i n c l u d i n g troughs) are 1974:2-1975:1, 1980:2-1980:3, 1981:4-1~82:4; See ~lso the Expansions ( i n c l u d i n g peaks) are 1975:2-1980:1, 1980:4-1981:3, 1983:1-1983:4. notes t o Table 2.

25

~0

.~0

,""

:

%--'---~--

L tO

\ I

lr-

I

,

1

~_

/

j l

.-J

.-----~ --':-~

L~. L ".

I---'I-"T"-T' l'""l''l'--T"-'l--r'--'l~'~---r-"T----t---1--T-'"1'-"T---r--'+t'--'r'-'r'~ ~. •- 0 ~" '-

T- t~ ~ I I I

26

~ ~ I I

~0 r~ ~ I I I

O~ 0 ~I ~-" 'I I

I

i I i I

r ~

J

5

•

I

I

'

~

74-

NEXT QUAKI U,¢ FOUR QUARTERS AHEAD . . . . . .

--6

--4 --5 75

•

•

I

76

•

""

1 "'-.\q

•

",

o

•

"i I

.....

I

!

i la

2

:5

4

-i

I

8

1019

-

•

i

77

-

•

•

i

•

l

78

•

"

•

|

•

/"

]

..

"79

,

.rs

t

•

'

V

i

~

I

80

•

•

t~

•

]

81

•

l "-.

J"'~

.

•

I

82

•

111 ~ A

ONE AND FOUR QUARTERS AHEAD

v

,

I

8,3

•

FORECAST B=IROR8 FOR GriP DEFLATOR

FIGURE 2

•

•

1 84-

•

i.-id1

I°

I

L

I",,

i

,!"-

.(0

\

.111 I"..

j.,.'

J ~

-t-'r "r~'"l-~"l-

r'or- I- T ' T ~ ; i

"r r"~ ~-r-r-

I"-i"- T-I-- r" 1~1" " r " ~

O~O~O~O~O~O~O~O~O~O~O~O~O~O~O~O~O II

28

II

II

IIII

II

I I II

~

PO

6.0

--3.5 --4-. 0

--1 . 0 --1 .5 --2.0 --2.5 --3.0

--0.5

3 0 2.5 2.0 1.5 1.0 0.5 0.0

4- 0 3 5

5.5 5.0 4- 5

i

FOR QNP 12~'i.ATOR YEAR AHEAD

79

80

81

82

83

'f 't - , • 1 . 3 ~ ' . , | . . . i . I . I - I " ~

~

"•r-"r-7-1--'r'"r-•-r-•-"r'r-l'•7"5 76 77 78 74-

I

I

! i

!

I

~/~.~r

FIGUPJE4

84

several actual measures of fincal

policy (including government spending,

high-emp!o~ment spending, and the high-employment surplus or d e f i c i t )

from

what the s t a f f assumed at the time the forecasts were made, and the actual movement in o i i prices and trade-weighted indices of foreign i n f l a t i o n and real growth. In general, the money stock deviation and foreign real growth were s t a t i s t i c a l l y significant "explainers" of the variance in the s t a f f ' s real GNP errors for the fu11-year-ahead horizon.

None of the explanatory

variables iisted help to explain the GNP deflator errors. Taken together the evidence suggests the existence of

year or more lags connecting

domestic and foreign developments and domestic i n f l a t i o n and shorter lags on the output side.

The real GNP regressions also point to the openness of

the U.S. economy and the benefits,

in terms of

improved predictions,

associated with h i t t i n g rather than missing the monetary targets. 13 To see i f the staff f u l l y exploited a11 information available at the time the forecasts were made, we also regressed the nonfinancial forecast errors for the conte~poraneous quarter and year-ahead period on the most recently observed forecast error for that variable and on the recent, so known at the time, fluctuations in the exchange rate and monetary growth. These regressions suggest the staff used the information contained in the lagged exchange rate and money growth e f f i c i e n t l y - variables were not s t a t i s t i c a l l y significant - unexploited information

in

these explanatory

but that there was some

the most recently observed errors.

Such

indications along with the size and pattern of the errors, as reported in Tables 2 and 5 and Figure~ 1-4, raise questions about the adequacy of the structural model underlying the s t a f f ' s analysis and forecasts, particul a r l y with regard to i n f l a t i o n .

Within the MPS model

Prices are set as a markup over u n i t labor costs.

The ex-

istence of the markup stems from the assumption that firms generally operate as oligopolists, setting prices above the level that would obtain under perfect competition, but not so high as to induce additional firms to enter the market. As specified

in

the equation, the actual markup varies

positively with the degree of u t i l i z a t i o n of capital and

13The d e t a i l s s u r r o u n d i n g these r e g r e s s i o n s are a v a i l a b l e from t h e a u t h o r s on r e q u e s t . We had t o use actual o i l p r i c e s and t h e actual i n d i c e s o f f o r e i g n i n f l a t i o n and real growth r a t h e r than t h e d e v i a t i o n s o f actual values from p r e d i c t e d v a l u e s because t h e s t a f f d i d n o t r e g u l a r l y p r e s e n t t h e i r s p e c i f i c a s s u m p t i o n s / f o r e c a s t s f o r these v a r i a b l e s in t h e Greenbooko

30

labor and inversely with the degree of price competition from foreign goods. . . . The r~te of change in compensation per i=our is explained by an expectations-augmented P h i l l i p s curve. rate

Each percenta~ point decrease in the unemployment is estimated to raise the rate of change in hourly

compensation in the same quarte=- by 0.85 percentage point at an annual rate. The behavior of compensation per hour also depends on the rate of i n f l a t i o gocds,

the

change in

the

in the prices of consumer

minimum wage, the

ratio

of

unemployment benefits to wages, the change in female representation in the labor force, and changes in employer contributions insurance. 14

to

social

security

and

unemployment

There is l i t t l e doubt that t h i s f a m i l i a r description of the proximate deter~ninants of i n f l a t i o n , and the complex and lengthy transmission mechanism linking monetary policy to the proximate determinants, was th__ee foundation of the s t a f f ' s i n f l a t i o n forecasts; taking the relevant HP$ equation and the s t a f f ' s i n f l a t i o n forecast as the dependent variable, we can explain nearly all of the variance in the s t a f f ' s forecast. The potential d i f f i c u l t i e s with such models, and the autoregressive i n f l a t i o n expectation formation mechanism which underlies them, are wellknown. As David Laidler wrote a decade ago, " I f the d i v i s i o n of changes in money income between the price level and output must be regarded as an integral part of the transmission mechanism rather than as a matter that can be analyzed separately from i t , then we must pay particular attention to the way in which endogenous, and variable, i n f l a t i o n a r y expectations impinge upon behavior when we study that transmission mechanism" (Laidler, 1978, p° 174). fie argued that such endogenous and for~vard-looking expect a t i o n mechanisms "short circuited" the transmission mechanism b u i l t into the NPS model (p. 173), and, to a degree, had destructive implications for much of the empirical evidence on the transmission mechanism of monetary policy (p. 174). The Fed staff response to such critiques has been to point to computational difficulties associated with operationalizing rational expectations models, to argue that such approaches to expectation formation are

14Brayton and Mauskopf (1987, pp. 99-100). Several of the thought to influence the economy's natural r a t e of unemployment.

31

later

v a r i a b l e s are a l s o

"extreme," and to appeal to findings such as those presented by Blanchard (1984), suggesting there is l i t t l e empirical evidence that such critiques of autoregressive expectations mechanisms are important in practice. 15 In contrast, the size and pattern of the actual forecasting errors by the staff, reported abovE, suggest that the potential d i f f i c u l t i e s raised by Laidler and others regarding the handling of expectations in MPS-type models may indeed be of considerable prcctical importance.

IV, Within embraced

the

by the

familiar

THE FINANCIAL FORECASTS two=stage

Fed, the first

approach

or

to policy

longer-run

strategy

fo~ation

long

stage entails

selecting a desired and presumably feasible path for the economy over the next 4-6 quCrters and the selection of a set of yearly monetary targets thought consistent with attaining that path. The second or short-run tactics stage entails the development of an operating procedr~e and the selection of near-term monetary, reservE, and money market condition objectives that are expected to lead to the attainment of the longer-run monetary targets, and thus the desired path for the economy. 16 As a glance at Exhibit II confims, the staff's financial forecasts of monetary and reserve aggregates (e.g., MI, M2 and nonbcr~owed reserve growth) and money market conditions {e.g., the Federal funds rate and discount window borrowing) are the connecting link between the two stages of the policy process. More specifically, they link the inflation and real growth objectives embraced by policymakers and day-to-day policy actions, particularly open-market operations, undertaken by policymakers in pursuit of the "ultimate" objectives or goals. To understand how the staff derives the near-term financial forecasts

15See ~rayfon and Nauskopf (1987, pp. 94-95). Blanchard doe~ note (1984, p. 213) t h a t s e r i a l l y correlated forecast e r r o r s from 1981:4 on "might" indicate t h a t something was changing in the P h i l l i p s curve r e l a t i o n s h i p under examination. Nonetheless, he concludes there is no evidence of a "maJor" change. 16See Bryant (1983, chapters 8 and 9) and the references c i t e d t h e r e i n f o r a d e t a i l e d description and discussion ~f the Fed's approach t o policymaking and the surrcunding issues. As Hetzel (1986) and others have pointed o u t , the longer-term monetary t a r g e t s have been abandoned p e r i o d i c a l l y . In such cases, the two-stage approach is more i l l u s i o n than r e a l i t y ; two stages collapse into one with money market conditio n s, p a r t i c u l a r l y the funds r a t e , linked to the real growth and i n f l a t i o n o b j e c t i v e s . More on t h i s below.

32

contained in the Bluebook and the analysis underlying the forecasts, i t w i l l be useful to begin by sketching out the "model" which has long guided the econometric and judgmental inputs which go into the preparation of the s t a f f ' s short-run financial projections. Fortunately, we do not have to guess what the general model looks l i k e -- i t is readily available in a number of s t a f f papers. Table 6, from Tinsley, eL al. (1982), provides the essential features of the monthly money market model used by the Fed's s t a f f . 17

Since t h i s model is an important input into the design of the

short-run

policy

alternatives

shown in the Bluebook

1982), Table 6 also provides the essential Bluebook i t s e l f . 18 Equation stripped-down

(Farr and Porter,

analytical features of the

(1) is the demand for money by the public and, in t h i s version of the model, income or some other proxy for

transactions is embedded in the intercept. This seemingly innocuous detail is important because, for the purpose of short-run forecasting (say 1-3 months out), the near-term forecast for GNP contained in the Greenbook is taken as a given by the s t a f f and treated as a predetermined, exogenous variable in developing near-term financial projections. Equations (2)-(6) comprise the so-called supply of money side of the model: the demand for ~equired reserves (2), depends on deposits and reserve requirements; the demand for excess reserves (3), depends on the Federal funds rate and a scale variable; the total reserves i d e n t i t y (4); the demand f o r borrowed reserves (5), depends on the spread between the funds rate and the discount rate, and a scale variable; and the nonborrowed reserve i d e n t i t y (6).

Equation (7) depicts a simple version of a policy

"rule" for the discount rate set by the Fed, and equation (8) is the demand for time and savings deposits which are included in H2. Given the s t a f f ' s income forecast, the FOHC's longer-run monetary aggregate targets, and the noperating procedure" being employed by the Fed

17Needless t o say, the d e t a i l s of the monthly model i t s e l f - - pararaeter estimates, functional form, p r i o r r e s t r i c t i o n s , measurement of key v a r i a b l e s , sample period, e t c . - - are und~ cont~nuaZ r~vic~ ~nd ~ v e been revised numerous times. In f a c t , we doubt i f anyone has f i t more versions of the equations in Table 6 than the Fed~s s t a f f . Such "empiricism" does, of course, r a i s e questions about o v e r f i t t i n g ~nd residual degrees of freedom. 18The s p e c i f i c equations comprising the monthly model as of 1981 are a v a i l a b l e in Anderson and Rasche (~982, Appendix A). Periodic updates are t y p i c a l l y a va ila b le in workingpaper form from the Fed s t a f f .

33

TABLE 6

The S k e l e t a l S t r u c t u r e o f the Monthly Money Market Model

Equation

Description

(1)

~M : a0 - a I ARFF

"Money vv demand (s+ochastic)

(2)

ARR = bO + b 1 AM + b2AT

Required r~serves ( s t o c h a s t i c )

(3)

AEX = c o - c 1 ARFF

(4)

6TR : 6EX + A R R

(5)

ABOR = do + dI(ARFF - ARDIS)

+ C2(AM

+ AT -

ARR)

Excess reserves ( s t o c h a s t i c ) To~al reserves ( i d e n t i t y )

Borrowed reserves ( s t o c h a s t i c )

• d2(AM + AT - ARR) (6)

ANBR = ATR - ABOR

Nonborrowed reserves ( i d e n t i t y )

(7)

ARDIS = e I ARFF

Discount r a t e ( p o l i c y r u l e )

(8)

AT = f o - f t

Time and savings demand ( s t o c h a s t i c )

ARFF

Variable definitions l.

M

Money stock ( t r a n s a c t i o n s balances)

2.

RFF

Federal funds r a t e

3.

RR

Member bank r e q u i r e d reserves

4.

EX

Excess reserves

S.

TR

Total reserves

6.

BOR

Borrowed reserves

7.

NBR

Nonborrowed reserves

8.

RDIS

Federal Reserve discount r a t e

9.

T

Time and savings deposits

Coefficient properties (i)

Slope c o e f f i c i e n t s

(ii)

Discount r a t e r e a c t i o n r u l e

a l , b l , b2, C l , d l , d2, and f l

all

nonnegative

O ~ ei ~ 1 (iii)

Random disturbances ( s t o c h a s t i c

intercepts)

aO, bO, Co, do, and f o have zero means and constant variances

Source:

Tinsley e , e l .

(1982, p. 844).

34

at the time, 19 solving f o r reserves, borrowing, and the funds rate - - long viewed by the Fed as the anchor For the term s t r u c t u r e of i n t e r e s t rates - i s r e ] a t i v e l y straightforward. For example, i f the Fed i s employing a Federal funds rate procedure, equation (1) i s e a s i l y solved f o r the funds rate which w i l l y i e l d the targeted change in money. The rest of the model i s then solved r e c u r s i v e l y : the funds rate derived from equation (1) i s used i n equation (8) to compute the accompanying change in time end saving deposits and thus H2, and the changes i n deposits and the Funds rate, in t u r n , provide the solutions to equations ( 2 ) - ( 6 ) . 20 The r e s u l t i n g

solutions comprise one a l t e r n a t i v e

Bluebook For consideration by policymakers.

presented in

the

This "baseline" forecast i s

then u s u a l l y supplemented by two or so other a l t e r n a t i v e s . More s p e c i f i c a l l y , since the actual level of the money stock at the time the forecasts are being produced i s often above or below the longer-run growth path, polic~nnakers want to consider the ramifications - - p a r t i c u l a r l y the associated movement i n i n t e r e s t rates - - of a fast vs. slow r e t u r n to the longrun t a r g e t path f o r money (the so-called "reentry problem").

For example,

i f the money stock is below the path (as was the case when the Bluebook summarized in E x h i b i t I I was prepared), a l t e r n a t i v e s conditioned on higher or lower Federal funds rates than the baseline forecast, and thus a slower or f a s t e r

return of the money stock to i t s

t y p i c a l l y presented and discussed~ E x h i b i t I I . ) 21

longer-run target path, are

(See the l a s t table and paragraph of

19The term '~perating procedure" r e f e r s t o how the FOHC goes al)out guiding i t s day-to-day open-market operations t o achieve i t s "intermediate" monetary o b j e c t i v e s . From 1970 through e a r l y October 1979 the Fed used a Federal funds r a t e procedure, while from e a r l y October 1979 through the summer of 1982 a nonborrowed reserve procedure was employed. Since the~ a borrowed reserve procedure has allegedly been u t l t i z e d . See Sellon and Teigen (19818, 1981b), Wallich (1984), G i l b e r t (1985), and Heller (1988) f o r a complete discussion. 20In general, cq~dtion (7) comes into play f o r longer-run simulations or forecasts and f o r large changes in the funds r a t e . In such situationsp however, only the composition of reserve growth - - i . e . , nonberrowed vs. borrowed reserves - - is altered~ t o t a l reserve demand (equations 2 and 3) and supply are unaffected. 21The funds rates shown in the Bluebook are t y p i c a l l y in the form of ranges, with the midpoints of the ranges (17, 18, and 21 percent in the la st t a b le in Exhibit I I ) representing tile staffWs point estimates of the rates which coincide with the accompanying money growth rates shown in each column.

35

FORECAST ACCURACY As discussed above, the s t a f f produced several sets of monetary aggregate, reserve aggregate, money market condition alternatives f o r each FOHC meeting. and quarterly)

To measure the accuracy of the s t a f f ' s short-run (monthly monetary aggregate projections, we generally selected the

alternative conditioned on the level of the federal funds rate closest to the actual federal funds rate obtained over the forecasting period. 22 The resulting error s t a t i s t i c s for onr_*-month-ahead forecasts computed using " f i n a l " revised data and the d e f i n i t i o n s of the monetary aggregates in place at the time are reported in Table 7. The results over the 1973-79 period for M1 (row 2) are similar to those reported by Lombra and Horan (1980, Table 10) for 1970-73. The mean error for M1 for 1974-76 (row 4) suggests the much v ~ i t t e n about "missing money" problem (predicted greater than actual on average) also a f f l i c t e d the s t a f f ' s forecasts. 23 The errors over 1980-82, following the switch to a nonborrowed reserves operating procedure in October 1979, and during a period characterized by ongoing financial innovation, deregulation and an abortive axperiment in 1980 with credit controls, were unusua]ly large. 24 Finally,

the 142 projection

errors are smaller than those f o r M1.

In

general, however, the errors f o r both t41 and t42 for the whole period as well as for selected subperiods, seem large, especially in comparison to the range encompassing a l l the short-run money growth t y p i c a l l y presented to and considered by the FOHC.25

alternatives

221f the actual funds r a t e deviated from the midpoints of the Bluebook funds r a t e ternativesp we interpolated accordingly among the monetary aggregate a l t e r n a t i v e s . Over October 1 9 7 9 - December 1982 period when the funds r a t e was downplayed and varied w id e ly, selected the monthly projection which accompanied the q u a r t e r l y a l t e r n a t i v e selected by FOf4C.

althe we the

23See Rasche (1987) and the references cited t h e r e i n . 24The large 1980-82 e r r o r s reported in Table 7 in the t e x t also conform t o the large e r r o r s computed by Lindsey, e t a l . (1984, Tables 1 and 7) over roughly the same period. 251t is i n t e r e s t i n g t o note, however, t h a t the s t a f f t s one°month-ahead forecast e r r o r s are smaller than those generated by Rasche and Johannes (1987) u t i l i z i n g the f a m i l i a r m u l t i p l i e r approach and s t a t e of the a r t time series techniques. This is q u i t e i r o n i c since Rasche and Johannes argue t h a t t h e i r medei3 are s u f f i c i e n t l y accurate over a 6-12 month horizon (given the lack of s e r i a l c o r r e l a t i o n in the m u l t i p l i e r e r r o r s ) t o control money in a ± one percent band - - a proposition the Fed often seems t o dispute.

36

TABLE 7

Monetary Aggregate Forecast Errors: One-Honth Ahead 1973:1 - 1982:12

Time Period ( I ) 1973:1-1982:12 (2) 1973:1-1979:12 (3) 1980:1-1982:12 (4) 1974:1-1976:12

(5) (6)

(7) (8)

1973:1-1982:!2 1973:i-1979:12 1980:1-1982:!2 1974:!-1976:12

Mean Error 0.54 -0.04 1.92 -!.92

0.42 0.11 1.05 0.84

M! Mean Absolute Error 5.17 3.93 8.06 3.56 M2 3.05 2.71 3.72 2.70

Root Mean Square Error 7.02 4.78 10.52 4.38

3.99 3.54 4.78 3.51

Theil

Coefficient 0.73 0.64 0.78 0.67

0.41 0.38 0.45 0.41

Notes: Data are actual minus predicted values a t seasonally adjusted annual r a t e s . " F i n a l " revised data f o r the definition of HI and H2 in place a t the time were used f o r the realizations.

SOURCES OF FORECAST ERROR Since the monthly model is a major input into the Bluebook, the forecasting results may in part reflect problems with the model.26 This conjecture is supported by the extensive diagnostic analysis of the s t a f f ' s monthly model carried out by Anderson and Rasche; they conclude that such models "provide l i t t l e reliable information regarding monetary control" (1982, p. 816). Interestingly enough, some key members of the staff seem to agree: the results from stochastic simulations led TJnsley et al. to the conclusion that "a substantial proportion of the uncertainty of the dependent variables of the monthly model originates in the uncertainty of the

26Using the s t a f f forecasts f o r money as the dependent v a r i a b l e and the 1981 specification of the demand f o r money in the s t a f f ' s monthly model, we are able t o " e x p l a i n " nearly a l l the variance in the s t a f f t s forecasts. The estimated coefficients closely m irro r those reported by Anderson and Rasche (1982, Table I , p. 805).

37

'slope' coefficients of the time-varying regressors" (1982, pp. 851-852).27 Against this

background, we thought i t

useful

to explore several

explanations for the monthly money forecast errors. First, we regressed the errors on the s t a f f ' s forecast error for nominal GNP for the quarter in which the monthly forecast for money f e l l .

Recall that the income pro-

jection was treated as a predetermined variable used to proxy the transactions demand for money in the development of the financial forecasts. a result,

errors in projecting

income, assuming the financial

As

and non-

financial forecasts are consistent, should help to explain a portion of the money forecast errors.

The results suggest the income error can at best

explain 6-8 percent of the monthly money forecast error for the whole 19731982 period or for subperiods thereof. Secondly, since the s t a f f ' s model did not account e x p l i c i t l y for international effects -- i t merely includes domestic income and interest rates

--

we tested

for currency and portfolio

substitution effects

by

regressing the money forecast errors on foreign interest rates, the change in the exchange rate, and the forward premium or discount on the dollar. 28 In no case were consistent, s t a t i s t i c a l l y significant results obtained. Apparently, such international influences - - emphasized by McKinnon (1982), in particular - - were not systematically

important over our sample period.

(This, of course, does not rule out episodic or expectational effects which are not picked up in the regressions we estimated). What is one to conclude? ~ r c e standard deviations

(1980, Table 1) estimates that the

of monthly M1 and M2 growth rates due to purely

transitory variations are 3.6 and 2.9 percentage points (annually rated),

27We have a l s o computed t h e i n t e r e s t e l a s t i c i t y of money demand implied by t h e v a r i o u s s h o r t - r u n a l t e r n a t i v e s shown in t h e Bluebook. More s p e c i f i c a l l y , as shown in t h e l a s t t a b l e in E x h i b i t Jle a l t e r n a t i v e s A and B e n t a i l d i f f e r e n t money growth , a r e s and a d i f f e r e n t m i d p o i n t f o r t h e Federal funds r a t e range; t h e n e a r - t e r m motion of income ( t h e s c a l e o r c o n s t r a i n t v a r i a b l e in t h e demand f o r money) i s , as e x p l a i n e d in t h e t e x t p assumed c o n s t a n t across t h e alternatives. A c c o r d i n g l y , one can e a s i l y compute, f o r each a l t e r n a t i v e in each Bluelxx~kp t h e implied interest elasticity o f money demand. For M I , t h e y g e n e r a l l y range between .01 and .02 =- v e r y c l o s e t o the e l a s t i c i t y Anderson and Rasche (1982) r e p o r t f o r t h e monthly model. The month-to-month v a r i a b i l i t y we uncover is presumably a r e f l e c t i o n o f t h e =~judgment ~1 a p p l i e d by t h e Board s t a f f t o t h e model-based econometric f o r e c a s t s in c o n s t r u c t i n g t h e actual a l t e r n a t i v e s appearing in the Bluebook. 28This l i n e o f i n q u i r y is suggested by McKinnon (1982), B e r g s t r a n d ( 1 9 8 5 ) , and t h e references cited therein. C o u n t r y - s p e c i f i c i n t e r e s t r a t e s and exchange r a t e s from Canada, Germany, Japan and t h e United Kingdomp as well as t r a d e - w e i g h t e d i n t e r e s t r a t e and exchange r a t e i n d i c e s , were u t i l i z e d .

38

respectively.

This estimate, along with the forecasting errors reported i n

Table 7 above, suggests there is very l i t t l e

information i n the monthly

projections or in t h e m o n t h l y data i t s e l f . 29 Not s u r p r i s i n g l y , the FOMC and the s t a f f were p a i n f u l l y aware of the difficulties associated with p r o j e c t i n g , monitoring, i n t e r p r e t i n g , and reacting to the monthly data. below,

For i t s part,

the FOMC seldom adjusted i t s

policy

as discussed in Section V instruments - -

particularly

open-market operations - - or i t s short-run operating guide (the Cunds rate, nonborrowed data.

reserves,

By the

or borrowed reserves)

late

1970s,

in f a c t ,

in response to one month's

the 9 i r e c t i v e

issued by the FOMC

e x p l i c i t l y focused on q u a r t e r l y growth rates for the monetary aggregates i n contrast to the one- to two=month horizons which had previously appeared. Since

the

somewhere in

staff the

had always presented q u a r t e r l y

Bluebook,

it

is

possible

to

forecasts

construct

for

R1

a series of

q u a r t e r l y forecast errors akin to the monthly errors reported in Table 7. Not s u r p r i s i n g l y , as the s t a t i s t i c s in Table 8 i n d i c a t e , the q u a r t e r l y g l errors are considerably smaller than the monthly e r r o r s ; i n p a r t i c u l a r , f o r the e n t i r e period, as well as the various subperiods, the errors are about 50 percent smaller. component i n

In part, t h i s r e f l e c t s the fact that the t r a n s i t o r y

q u a r t e r l y data i s much smaller;

Pierce's

(1980) estimates

imply that the t r a n s i t o r y component f a l l s by nearly t w o - t h i r d s when moving from monthly to q u a r t e r l y data. absolute e r r o r

is

Nonetheless, the 2½ percentage point mean

large r e l a t i v e

to the 2-4 percentage point range of

p o l i c y options f o r q u a r t e r l y N1 growth t y p i c a l l y considered by the FOHC. Once again, we also checked to see i f various i n t e r n a t i o n a l variables (foreign i n t e r e s t rates and exchange rates) or the s t a f f ' s

income forecast

e r r o r helped to explain the q u a r t e r l y money forecast errors. of

the

monthly e r r o r s ,

such v a r i a b l e s ,

individually

or

As was true collectively,

"explained" less than ten percent of the q u a r t e r l y errors. Since the weak r e l a t i o n s h i p between the income and money forecast errors does raise questions about the consistency of the nonfinancial and financial

forecasts,

analysis

in

analyzed

the

the

and the

relationship

Bluebook and the

velocity

forecasts

more generally

Greenbook,

implied

by

we have constructed the

staff's

29The e r r o r analysis in the t e x t is based on f i n a l revised data. (1986) show t h a t there is even less information in the p re lim in a ry, available t o the s t a f f and policymakers at the time.

39

between the and

nonfinancial

Siegel and Strongin f i r s t - p u b l i s h e d data

TABLE 8

N! F o r e c a s t E r r o r s : O u a r t e r l y 19731 - 19821V

Time (I) (2) (3) (4)

Period 19731-19821V 19751-197911t 19791V-19821V 19741-19761V

Hean E r r o r 0.24 0.25 0.20 -1.03

He.an Absolute Error 2.44 1.64 4.10 1.73

Root Hean Square E r r o r 3.58 2.05 5.54 2.19

Theil Coefficient 0.25 0.16 0.53 0.19

See notes t o Table 7.

forecasts and the money growth assumption underlying them. VELOCITY FORECASTS In general, the s t a f f did not present e x p l i c i t forecasts f o r v e l o c i t y , although p e r i o d i c a l l y in the late 1970s an appendix t a b l e on the growth rates of v e l o c i t y staff

did

appear.

implied by the various a l t e r n a t i v e s presented by the Accordingly,

we constructed

the

staff's

i~licit

v e l o c i t y forecast f o r the current quarter ~)r the e n t i r e 1973-1982 period by taking the nominal GNP forecast made i n the f i r s t

month of that quarter

and subtracting from i t the rate of Mi growth assumed by the s t a f f constructing the GNP forecast. 30

in

The top h a l f of Table 9 presents the summary e r r o r s t a t i s t i c s f o r the i m p l i c i t s t a f f forecasts of v e l o c i t y .

For comparison, we also constructed

simple "random walk with d r i f t " v e l o c i t y forecasts - - the generic type of model implied by the recent extensive and careful work by Rasche (1987)o The same set of e r r o r s t a t i s t i c s f o r t h i s "model" are shown i n the bottom h a l f of the Table.

The r e s u l t s show t h a t f o r the period as a whole, as

30In some cases t h e HI growth assumption aopears e x p l i c i t l y in t h e Greenbook. When i t d i d n o t , we used t h e m i d p o i n t o f t h e MI t a r g e t growth range s e l e c t e d by t h e FOMC in t h e l a s t meeting o f t h e p r e v i o u s q u a r t e r p e r t a i n i n g t o t h e n e x t q u a r t e r and sometimes beyond. While some judgment was o b v i o u s l y r e q u i r e d h e r e , we have been c a r e f u l t o be as c o n s i s t e n t as t h e data sources a l l o w . I t should be noted t h a t t h e m~ney g r ~ t h a s s u n p t l o n here d i f f e r s from t h a t used in c o n s t r u c t i n g t h e e r r o r s summarized in Table 8; t h e r e we used t h e s t a f f f o r e c a s t c o n d i t i o n e d on t h e funds r a t e c l o s e s t t o t h a t a c t u a l l y o b t a i n e d o v e r t h e q u a r t e r .

40

TABLE 9

Velocity Forecast Errors: Current Quarter 19731 - 19821V

I m p l i c i t Forecasts by Fed Staff Root Mean

Mean Time Period

Mean Error

Absolute E r r o r

.... $ q u a r e . . E r r o r

(1)

19731-1982lV

-0.78

4.01

5.26

(2)

19731-19791V

-0.66

3.10

3.90

(3)

19801-19821V

-1.07

6.12

7.53

Random Walk ~ i t h D ~ i f t Forecasts (4)

19731-19821V

-0.80

6.29

4.76

(5)

19731-19791V

-0.05

3.53

4.48

(6)

19801-$9821V

-2.56

7.62

9.22

Notes:

Following J o n s s ~

(1986),

we a r b i t * a r l a l l y

assumed the d r l f f

parameter was equal t o

the averaga percentage change in v e l o c i t y ovar the previous eight quarters. time series a~deling mlght well the s t a f f

Some e x p l i c i t

produce forecasts which ~J*nerform the Fed s t a f f .

For both

and random walk a ~ d e l s , we usc flnal revised data for the MI d e f i n i t i o n applicable

at the time the forecasts were made to compute the e r r o r s .

All

data

are

seasonally adjusted

annual r a t e s °

well

as for

the

subperiods shown, the s t a f f ' s

implicit

forecasts

are

s l i g h t l y better than the extremely simple random walk model we se:.~cted for benchmark purposes. Figure 5 shows the deviations of actual velocity growth from that implied by the s t a f f ' s GNP forecasts and money growth assumptions, and the deviations of actual H1 growth from that underlying the GNP forecast. The data clearly suggest t h a t , on average, actual money growth exceeded that assumed (and targeted).

Hore often than not, the Fed argues that such

deviations of money growth from target paths are the necessary result of random or persistent fluctuations in velocity, and thus in money demand - that i s , sure,

p o r t f o l i o disturbances - - which should be accommodated.

as the plots

suggest, the deviations of

velocity

To be

and money are

negatively correlated (correlation coefficient = - 0 . 6 5 ) . However, causation 41

can run the other way; a surge in money growth, for e x i l e , temporary deceleration in velocity growth.

can cause a

Moreover, the excess of actual

money growth, on average, over that assumed and targeted (moan deviation = I.~ percentage points at an annual rate), and the positive correlation between these deviations and the deviations of actual GNP growth from that forecast by the staff (correlation coefficient = 0.30), are s~nnptomsof an inflationary and procyclical policy rather than the s t a b i l i z a t i o n policy supposedly in place! 31

Against tt~Ts background, the next section examines

in more detail what in fact polic~nnakers do and how t h e i r actions are influenced by the s t a f f ' s projections and analysis.

V, IMPLEMENTINGMONETARYPOLICY: DECISIONS AND ACTIONSOF THE FOMC Experts on policy analysis have long argued that the economist's ideal, s c i e n t i f i c approach to polic~nnaking - - specify objectives, develop alternatives, assess costs and benefits of options, choose "optimal" policy - - is unreasonable, unnecessary, and unattainable; within the context of complex policy problems, a l l

analysis w i l l

be "incomplete. "32

Thus,

"disjointed incrementalism" - - a kind of enlightened "muddling through" =is perhaps the most that can be hoped for, and calls for complete policy processes firmly grounded in economic analysis are viewed as naive. I f "good" policymaking consists only uf being able to make decisions, the virtues of

ambiguity and incompleteness follow.

However, i f

the

standard against which policy actions are to be judged is defined in terms of the economic outcomes such actions help to produce, then ambiguity, along with a s h i f t i n g compromise among ~ l t i p l e

goals, and the associated

confusion of moans and ends would seem to impede rather than f a c i l i t a t e the making of "good" policy. The problem is perhaps best i l l u s t r a t e d by the everchanging role of the monetary aggregates in the design and implementation of policy.

3tThis r e s u l t is c o n s i s t e n t with the f i n d i n g s of Brunner and N e l t z e r (1983)p suggesting t h a t Fed p o l i c y increases the variance o f GNP. 32See, f o r example, Lindbloom (1979), Wildavsky (1979), and the r e f e r e n c e s c i t e d t h e r e i n ,

42

I

~,~i ~,

"0

~,;

re- :.'Z.2 . . . . . . . . . . . . .

--~-.~,

ib

,i

~--~

•

..,...........

I

i

,

'

,~.

U'l p.

%

~P

o

~"i-~

i-r

~"~'~''-'-

i i "~"-i , " r " i " i

~ 4"-~--'r'-,'-~"i-i-i" ,

i "~ "i" i '~"~-

I I i i i I I i i . . . . . . . "'I I I i I

I I I

POLICY DECISIONS AND

THE

CHANGING ROLE OF

THE

MONETARY

AGGREGATES An examination of the policy process -- through the FOMC's Memorandum of Discussion (available through early 1976), the Record of Policy Actions, the Bluebook, Greenbook, and the weekly "Retort of Open Market Operations and Money Market Conditions" prepared by the Trading Desk at the Federal Reserve Bank of New York -- indicates that the FOMC and the staff frequently vacillate on the analytical significance of the monetary aggregates. Sometimes the monetary aggregates (individually or collectively) are alleged to be important strategic variables to be controlled.

At other

times, the monetary aggregates are viewed as information (indicator) variables to be used along with other data in setting policy instruments. Distinguishing clearly between these alternative roles for the aggregates would seem to be logically prior to the formulation and implementation of policy. I f the aggregates are to be controlled, policymakers should respond to a divergence of actual monetary growth from target by resetting their instruments accordingly. I f , in contrast, the aggregates are information variables, then a deviation of actual monetary jrowth from target might be tolerated. Absent an analytical consensus, the resulting ambiguity and vacillation frustrated communication among policymakers and their principals and contributed to inconsistencies and circularities in policy formation. The periodic widening of target ranges for the monetary aggregates, proliferation of targets, shifting emphasis accorded particular aggregates, several redefinitions of the aggregates, and adjustments to the base periods from which target paths are computed, however technically motivated, are manifestations, in part, of the shifting role of monetary growth in guiding policy decisions. In assessing the role of the staff, the decisions of policymakers, and the role of the monetary aggregates, i t

is instructive to examine the

extent to which the short-run targets adopted by the FOMCover the 1974-79 period were consistent with any particular money stock-interest rate alternative from the menu of alternatives in the Bluebook. Over the 197173 period, Lombra and Moran (1980, p. 44) found that in the majority of cases, the FOMCchose inconsistent alternatives by "adjusting" the staff's menu of alterna~;._s in the process of selecting their short-run (monthly

44

or quarterly) targets. 33

The predominant adjustments by the FOMCcan be

broadly classified as "rate-smoothing adjustments."

More specifically, the

FOMC tended to lower the s t a f f ' s projected Federal funds rate for a given money stock or lower both Lhe funds rate and the money stock projected by the staff. Such adjustments occurred in 20 of 37 meetings, or 54 percent of the time, over the 3-year period. Remarkably, over the 1974-1979 period, we find precisely the same type of adjustments in a nearly identical 55 percent of the cases (39 of 71 meetings). Needless to say, such adjustments, given that the s t a f f ' s forecasts were consistent (as indicated in Table 1 for the 1973-79 period), along with the reluctance to allow the Federal funds rate to move very much between FOMC meetings, v i r t u a l l y guarantees actual average.34

money growth exceeding targeted

money growth,

on

Over the October 1979 through October 1982 period when the Fed a11egedly sought closer control over MI growth with a nonborrowed reserves operating strategy, simi1~r adjustments also occurred.

Feinman (1987, p.

54) reports that between October 1979 and December 1981 the Fed "adjusted" i t s reserve paths and borrowing assumptions in 39 percent of the weeks. Of these adjustments, 93 percent served to reduce the weekly fluctuation in the funa~ rate.

The result of such alterations is clear; i t "effectively

weakened the interest rate response to off-path money growth" (Feinman,

1987, p. 55). 35 The primary rationales for the Fed's behavior are f a i r l y clear. F i r s t , the modifications of the s t a f f ' s Bluebook alternatives usually helped to secure a clear consensus among FOMCmembers; they could go on record as desiring lower money growth and lower interest rates!

Second, the FOMCand

33As explained in note 21, the s t a f f t y p i c a l l y presented the FONC with i n d i v i d u a l a l t e r n a t i v e s , each of which consisted of ranges of growth f o r the money stock and the Federal funds r a t e (say, 6-8 percent M1 growth Bnd 5-£ percent for the funds rate)~ wherein the midpoints of the ranges (7 percent Hi growth and ~ 5½ percent funds rate) represented the staff's p o i n t estimates of a consistent p o t i c y choice; the FOHC's adjustments t y p i c a l l y involved m o d i f i c a t i o n of one or both ranges (say 6-8 percent MI growth and 4½-5½ percent f o r the funds r a t e ) , thereby producing an inconsistent money growth-funds r a t e c o n f i g u r a t i o n . 341n the other meetings over the 1971-1979 period (approximately 45 percent of the ~ o t a l ) , the FONC t y p i c a l l y selected one of the s t a f f ' s a l t e r n a t i v e s ; there are very few instances of the FOHC a d j u s t i n g the staffWs a l t e r n a t i v e s in a way l i k e l y t o amplify the movement in the funds r a t e . 35Such a l t e r a t i o n s were even more frequent in 1982 as the Fed moved toward abandonment of the nonborrowed reserves operating s t r a t e g y l a t e r in the year.

45

formal

staff believed that the demand for money was extremely unstable and that inflationary expectations adjusted

very slowly over time.

The l a t t e r

implied that, as a f i r s t approximation, such expectatiG~is could be treated as fixed o w r the relevant policy horizon. Taken together, such beliefs, within Poole's familiar optimal policy framework (19/0), imply that shortrun deviations of monetary growth from targeted and projected rates should more often than not be accommodated, with a stable nominal interest rate proxying for a stable real interest rate, given the assumption of s t a t i c inflationary expectations.

Third, interest rate v o l a t i l i t y per sc was

viewed as "costly" in the financial system and the economy.36 Without denying that randomness exists and that financial innovation and deregulation have been associated

with

transitory

and permanent

portfolio shifts from time to time, the potential problems with the Fed's priors and resulting policy " f l e x i b i l i t y " are obvious. argued twenty years ago, i f

As Milton Friedman

the monetary authority uses nominal interest

rates as i t s primary guide for policy actions, " i t w i l l be l i k e a space veh~:~ that has taken a f i x on the wrong star. No matter how sensitive and sophisticated i t s guiding apparatus, the space vehicle w i l l go astray.

And

so w i l l the monetary authority" (1968, p. 15). The various Fed documents we examine make i t

abundantly clear that

there was a f a i l u r e to consistently and clearly distinguish between nominal and real interest rates and to distinguish between monitoring and cont r o l l i n g money. This, along with the actual performance of the economy over the period we study, suggests that there has been a real-world counterpart to the potential problems associated with the Fed's priors and flexibility;

simply put, and in contrast to Friedman's hoped-for lesson

from history (1968, p. 12), monetary policy has not consistently prevented money i t s e l f from being an important source of or propagation mechanism for economic fluctuations.

THE ROLE OF MONETARY TARGETS, CURRENT ECONOMIC CONDITIONS, AND NONFINANCIAL FORECASTS IN EXPLAINING FED ACTIONS The single variable which best captures the Fed's conscious and intended policy actions over the period we examine is the Federal funds rate. Of course, other variables, such as the monetary aggregates, and

36See Lombra and Struble (197g), and the references c i t e d thereine f o r d e t a i l s .

46

reseT~es or the base, may well be better measures of the effect of the /

/

Fed's actions. Movements in such measures, however, are the byproduct of the actual conduct of policy we are focusing on. In making decisions, the FOMC and the staff continued to view the f~nds rate as the anchor for the t~,;~ structure of interest rates.

More specifically, movements in the

funds rate were believed to cause movements in other rates which were translated into commensurate changes in real rates, given static price expectations, financial

thereby affecting

claims,

the

including money.

supplies and demands for

various

The resulting changes in wealth

valuations and the cost and a v a i l a b i l i t y of credit, in turn, affected economic a c t i v i t y . adjustment of

the

More than any other issue, the appropriate setting and Federal funds rate

dominated discussions at

FOMC

meetings, especially through October 1979, and dominated discussions of how best to adjust the weekly reserve paths and borrowing assumptions after October 1979. As was noted above, the Fed's operating strategy for implemer~ting monetary policy passed through several stages over the 1973-82 period, and the role of the monetary aggregates in guiding policy actions fluctuated over time.

To get some feel for how empirically significant such changes

have been, we have adopted the "reaction function" approach.37 We started out by simply regressing the quarterly average of the Federal funds rate (FFR) on the lagged funds rate and the difference between the actual growth of M1 (as f i r s t published) and the targeted growth of M1 last quarter (MDEV). This partial-adjustment specification is motivated by substantial evidence indicating that the Fed believed there were costs associated with a rapid adjustment of the funds rate.

The

lagged deviation of quarterly r~ney growth from target is suggested by numerous indications that single deviations from monthly targets were viewed by policymakers as the result of random variations in money demand which could be largely ignored. The results (with t - s t a t i s t i c s in parenthesis) over the 19831-19821V period were:

37See Lombra and Moran (1980), McNees (1986), and the l i t e r a t u r e c i t e d t h e r e i n . As is w e l l - k n o w n , one must be c a u t i o u s in i n t e r p r e t i n g t h e r e s u l t s from such equations because, among o~her t h i n g s , t h e e s t i m a t e d c o e f f i c i e n t s are complex combinations o f t h e weights in policymaker o b j e c t i v e f u n c t i o n s and t h e " s t r u c t u r a l " parameters. Moreover, t o the e x t e n t t h a t the "structural" parameters themselves depend on p o l i c y parameters, and changes t h e r e i n - - t h e "Lucas c r i t i q u e " - - i n t e r p r e t a t i o n is f r a u g h t w i t h even more d i f f i c u l t y .

47

FFRt =

0.98 +

~2 = 0.87

0.89 FFRt_ 1

(15.49)

+

0 . 3 3 muL,t_ 1

(1)

(5.27)

SEE = 1.39

To check for the temporal s t a b i l i t y of the coefficient on MDEV, we reestimated the above equation using the TVARYINGprocedure witL t h filter

algorithm

in

RATS (Version 2.0). 38

coefficient on MDEV is plotted in Figure 6.

Xalman

The resulting time-vary1,~ Taken together, the two models

suggest the FOMCdid indeed ~djust the funds rate in response to deviations of money growth From target and that the magnitude of such adjustments varied considerably across time in a way broadly consistent with the Fed's announced changes in i t s operating strategy, particularly the move to and then away from tighter

short-run control

announced in October 1979 and the f a l l minimum, such resu]ts

suggest that

o v e r the monetary agc~egates

of 1982, respectively. 39

the

variance-covariance

At a

structure

linking reserves, money and interest rates is ncL stable across time and is dependent, Fed.

in part, on the particular operating regime employed by the

Put another way, the Fed's approach to the short-run implementation

of policy affects the way in which shocks are absorbed and transmitted within the financial system. The implications for applied work in nr~netary economics are obvious. 40 Since any time-varying model may simply be an i11usion - - in effect, a subset of a larger, more complete model with fixed coefficients - - we a!so estimated equations which included various measures of "current" economic conditions (e.g., the growth of real GNP, the unemployment rate, the tradeweighted exchange rate, and the rate of change in the G~P deflator, a l l lagged one quarter) next,

and future economic conditions

and year-ahead staff

prices).

forecasts

for

real

(e.g., the current,

GNP, unemployment and

The equation below summarizes the most reliable and durable

38The transition equation for the coefficient on NDEV is bt = bt_ I + v t , with bt assumed to follow a f i r s t - o r d e r Markov process. The results were not very sensitive to the initialization procedure, a f i r s t - d i f f e r e n c e specification, or a logarithmic transformation. The B o x - P i e r c e Q s t a t i s t i c does not r e j e c t t h e h y p o t h e s i s o f no a u t o c . o r r e l a t i o n o f t h e residuals. F u r t h e r d e ~ a i l s are a v a i l a b l e on r e q u e s t . 39See also Hoehn (1983). 40See Kaufman and Lombra (1986) for elaboratic,.

48

J~ ~D

I i j

0.30

]

ooo

74.

J

i!

7,5

~ ' ~

0.05

0.10-4

0.15J

i

oo~o 4

0 25 I

0 . 3 5 -i

1! q

I

o.40

0.45

0.50 I . . . .

76

77

~-~

78 W

lrlME V A R Y I N G ~

79

80

RGURE8

a

a

81

82

ON ~

83

!

I 84.

results of the OLS estimates we found: FFRt = 4.97

+ 0.73 FFRt_I

0.57 (3.06) ut-1 ~2 = 0.90

+ 0.30 MDEVt_1 -

(8.79)

(5.11)

0.10

(0.91) Pt-1

(2)

+ 0.24 Pt_l-D (2.71)

SEE = 1.24

where Pt-1 = f i r s t published rate of change in GNP deflator for previous quarter, Ut_1 = f i r s t

published unemployment rate for previous quarter

(quarterly average), and D = dummy variable ( i from 19791V through 1982IV, 0 elsewhere). The coefficient on money is very close to the OLS estimate reported in equation ( i ) .

The coefficient on unemployment is s t a t i s t i c a l l y significant

(at the one-percent level) and implies that the Fed i n i t i a l l y lowers the funds rate by about half a percentage point for every one-percentage-point rise in the unemployment rate.

The coefficient on i n f l a t i o n for the whole

period is not s t a t i s t i c a l l y si£ i i f i c a n t , but the coefficient on the dummy indicates that i n f l a t i o n played some role in explaining post-1979 movements in the funds rate. 41 We could not uncover a systematic, durable r e l a t i o n ship between the funds rate and the lagged exchange rate therein), or ferecasts for prices,

~nd

(or changes

next quarter or a year ahead of real GNP,

unemployment.42

This

strongly

suggests

that

current

conditions, rather than forecasts, drive FOMCbehavior.43 Finally, as a check on the time-varying estimates reported e a r l i e r , we

41McNees (1986) uses a du~:,=y for the 19791V-19821V period on money growth. His r e s u l t s , as indicated by our time-varying parameter estimates shown in Figure 6, suggest t h a t f l u c t u a t i o n s in money growth e l i c i t e d larger responses of the funds r a t e in the post-1979 period. More on t h i s below. 420f course, i t is possible t h a t by including the monetary t a r g e t in the regression (when constructing MDEV) t h i s proxies to some extent for the FOMC's ~esponse t o the nonfinancial forecasts. 43McNees (1986) found t h a t the current quarter forecasts over a longer sample period (1970-1985) had expla~atory po~er. While we also found t h i s r e l a t i o n s h i p , the high c o r r e l a t i o n between l a s t q u a r t e r ' s data, employed in the regression in the t e x t , and t h i s q u a r t e r ' s forecasts makes i t d i f f i c u l t t o distingu ish e m p i r i c a l l y between them. More importantly, the s p i r i t of the exercise is consistent with c l a s s i f y i n g funds r a t e movements in response t o current quarter forecasts as a response t o " c u r r e n t c o n d i t i o n s , n

50

reestimated equation (2) with the same procedure.

The time p r o f i l e of the

coefficient on MDEV mirrored that plotted in Figure 6 for the simplier model.

In addition, the movement of the coefficient on i n f l a t i o n supported

the inference suggested by the dummy variable in equation (2) - - i n f l a t i o n appears to play a more important role in explaining the movement in the funds rate after the October 197g change in the Fed's operating procedure. While i t seems d i f f i c u l t to distinguish empirically between the increased role of money and prices, given the ]imit~cions of the data and empirical techniques employeJ, such patterns do .uggest son.thing about what guides Fed policy, how the guides change over time, and the possible significance of October 1979o

THE NONBORROWEDRESERVES OPERATING PROCEDURE: OCTOBER !979SUMMER1982 The general features of the )979 change in Fed procedures, like many such reforms, were conceived e a r l i e r and born in a c r i s i s setting.

~he

perception of p o l i t i c a l and economic observers and policymakers was thet i n f l a t i o n , and perhaps policy, was out of control.

Focusing. on the near

term, the Fed believed that a substantial rise in interest rates would be needed to slow down monetary growth and reduce inflationary pressures and inflationary expectations.

Viewed against t h i s background, the change in

procedures was a t a c t i c to engineer a significant reduction in monetary growth and increase in interest rates, and, at the same time, put some distance between the

Fed's

p o l i t i c a l repercussions.

actions and the financial,

economic, and

Focusing on the longer term, the change can be

viewed, in part, as another step toward finding " p o l i t i c a l shelter" or "a better

place

to

stand"

to

more effectively

f e n d off

expansionary

pressures.44 I t i s interesting to note that several members of the FOMC(in private communications with the authors) have indicated that the details and f u l l ramifications of the changes in procedures (especially the role of the discount rate and changes therein) were not clear to them, nor, in t h e i r judgment, to most FOMCmembers at the time or for months thereafter. Such contentions, along with the observable swings in policy since 1979, raise important questions about the real significance of, motivation for, and

44For e l a b o r a t i o n , see E~uey (1982,~, M o r r i s (1982), and the ie~ormatlve p~per by Hetzel ( t986).

51

permanence of t h i s , or indeed, any change in Fed procedures. Reportedly designed to improve the Fed's cont~-ol over monetary growth, the volume of nonborrowed reserves (that i s , total reserves ~inus borrowed reserves) thought to be consistent with the Fed's money stock target became the proximate guide for policy actions. Analytically, the volume of nonborrowed reserves was derived by solving equation ( I ) in Table 6 for the funds rate consistent with the monetary target and using t h i s derived funds rate to estimate the demand for total reserves and, importantly, the demand for borrowed reserves.

Subtracting total

reserve demand from borrowed

rescr,'~ demand yielded the nonborrowed reserve path which guided daily open market operations.

Subsequently, instead of deliberating the "appropriate"

change in the funds rate whenever the ,~oney stock deviated from i t s target as shocks h i t the system, adhering to the given nonborrowed reserve path in the face of such deviations was supposed to lead to an automatic adjustment in the funds rate.

Simply put, i f money and total reserve demand rose, for

example, the funds rate - - the "price" of reserves - - would have to rise to produce a large enough spread of the funds rate over the discount rate to induce enough borrowing at the discount window to equilibrate the supply • and demand for reserves.

During the 1970s, in contrast, the supply of

reserves was usually adjusted e l a s t i c a l l y to moderate or eliminate the near-term effect of a s h i f t in money demand on the funds rate.

Within the

nonborrowed reserve operating procedure, the automatic adjustment in the funds rate in response to disturbances was in turn expected to lead to a quicker return of the actual money stock to i t s target path by inducing appropriate changes in the quantity of money demanded. Over the period, the variance of the money stock and interest rates increased, the economy experienced two recessions, and the i n f l a t i o n rate f e l l dramatically.

Such outcomes, against the background of what on the

surface seems l i k e a significant change in Fed procedures, has prompted numerous studies of the procedures and the period. and carefully done is that of Feinman (1987). Fed documents he could get access to,

The most informative

U t i l i z i n g a l l the internal

including especially the weekly

report of the Manager of the Trading Desk at the Federal Reserve Bank of New York (called the "Report of Open Market Operations and Money Market Conditions") and various daily worksheets used by the s t a f f ,

he has

examined the analytical foundation, projections, judgments, and day-t~-day and weekly execution of the nonborrowed reserves strategy. Quoting selectively from his summary of results (pp. 8-10): Over an operating

horizon of 52

eight

weeks, nonborrowed

reserves were the operating target.

However, deviations

from the algorithm were pervasive and were caused primarily by the

System's desire

to

reduce the fluctuations

in

borrowed reserves and the funds rate. The increased variability of money growth may have been due, in part, to the monetary control weaknesses inherent in the procedures themselves, and partly to frequent deviations from the algorithm designed to reduce the short-run v o l a t i l i t y of the funds rate. Expectational issues may also have played a role in interest

the increased v o l a t i l i t y of money growth and rates; frequent departures from the stated

procedures, coupled with the System's refusal to divulge the essence of i t s operating policy, may actually have made i t more d i f f i c u l t for market participants to form accurate expectations of Fed policy. Since changing market expectations cause shifts in the bank borrowing function and in the money demand function, i t became more d i f f i c u l t for the System to estimate the functions that are so critical to monetary control under the new procedures. Volatile market expectations may a l s o have heightened interest v o l a t i l i t y across the maturity spectrum.

rate

In effect, the nonborrowed reserve procedure represented a middleground between the perfectly interest elastic (horizontal) short-run s~pply of reserves under the old funds rate procedure and a completely interest inelastic (vertical) short-run supply of reserves (or the monetary base) often advocated by those embracing the well-known multiplier approach to money stock control. The resulting positively sloped supply of reserves and money, which within the Fed's conceptualization flowed mainly from the interest elasticity of the borrowing demand function, was viewed by the staff and policymakers (at least those who understood i t ) as a sensible hedge. The degree of accommodation and thus procyclical impulses delivered by policy in the face of systematic changes in the uemands for money and credit would be reduced a~d, at the same time, the instability of money demand, and portfolio shocks more generally, would s t i l l be partially

53

accommodated, thereby moderating interest rate v o l a t i l i t y to a degree. 45 In one important sense, the "experiment" - - i t s technical as well as political

dimensions - -

flationary policy.

worked; the Fed did pursue a sustained d i s i n -

At the same time, however, the means used to implement

the policy, as traced and analyzed by Feinman and Brunner and Meltzer (1983),

clearly

worked in

the

direction

v o l a t i l i t y and the costs of d i s i n f l a t i o n . the Fed's frequent departures

of

increasing

uncertainty,

Thus, i t is ironic indeed that

f r o m the reserve paths implied by the

procedure, which were almost always designed to stabilize the financial system in the face of allegedly pervasive portfolio shocks, had the effect of shifting the position and slope of the reserve-supply function in ways few could anticipate. Thus, here, as elsewhere, the Fed's " f l e x i b i l i t y " produced costs as well as benefits. 46

VI, We h a v e exa,'~ined

SUMMARYAND CONCLUSIONS the

process governing

the

formulation

and

implementation of monetary policy over the 1973-82 period in some d e t a i l . Our major findings can be summarized as follows. 1.

The Fed's nonfinancial forecasts are "state of the a r t . "

The

errors display the same pattern and amplitude, and indeed are highly correlated with the errors produced by other leading forecasters.

However,

the errors are large relative to the typical spread between the s t a f f ' s forecasts of the economic implications of alternative policy strategies, and, as argued by Meltzer, "neither the Federal Reserve staff nor private forecasters, using the techniques currently available, has been able to forecast, on average, whether the economy w i l l be in a boom or a recession one or four quarters ahead" (1987, p. 6). All in a l l , the information value of the forecasts seems to be extremely limited. 2.

The bias and serial correlation in the nonfinancial forecast

errors noint toward the limitations of

the s t a f f ' s

mostly s t a t i c and

backward-looking treatment of price expectations.

45Thus, the nonborrowed procedure was not a return to the IgSOs free-reserves d o c t r i n e , analyzed and convincingly c r i t i q u e d by Brunner and 14eltzer (1964). Both Feinman (1987) and Kaufman and Lombra (1986) provide considerable empirical evidence bearing on t h i s p o i n t . 46See also the informative paper by Cook (1988).

54

3.

The forecast errors in the s t a f f ' s money projections are ~so

large relative to the range encompassing a l l t~,~ ~hort-run money grewth alternatives t y p i c a l l y presented to and considered by the FOHC. Fhe size of these errors, along with the estimates of the large transitory component in short-run fluctuations in the money stock, suggest here too there is l i t t l e "information" for policymakers. 4.

The excess of actual money growth, on average, over that

assumed and targeted, and the positive correlation between deviations of money and deviations of actual GNP growth from that forecasted by the s t a f f , are symptoms of an inflationary and procyclical policy rather than the s t a b i l i z a t i o n policy supposedly in place. 5.

The short-run monetary-interest-rate targets adopted by the

FOMC over the 19/4-79 period, as over the 19/1-73 period, tended, on average,

to

be

inconsistent

with

the

sLaFf's

projections.

The

inconsistency, along with the reluctance to allow the Federal funds rate to move much between FOMC meetings over t h i s period, v i r t u a l l y guaranteed excess money growth relative to targeted growth, on average.

The Fed's

adjustments to the ~eserve paths and borrowing assumptions over the October 1979-1982 period, which were also t y p i c a l l y designed to reduce the weekly fluctuation in the funds rate, worked in the same direction. 6.

The attachment to nominal interest-rate smoothing - - which

has persisted across time and various changes in operating procedures - can be derived d i r e c t l y fr~a the belief of the FOMC and staff that the deman~ for money is extremely unstable, that inflationary expectations adjust slowly, and that interest-rate v o l a t i l i t y is "costly." 7.

The

Fed's

adjustment

of

the

Federal funds

rate

~luctuations in the money stock varied considerably across time.

to This

suggests the variance-covariance structure linking reserves, money, and interest rates is not temporally stable and is dependent, in part, o~ tfhe particular operating regime employed by the Fed. 8. Our empirical work strongly suggests that current economic and financial conditions rather than forecasts drive FOMCbehavior.

Such a

backward-looking, reactive policy, while understandable given the quality of the forecasts and the p o l i t i c a l milieu within which the Fed operates, can easily turn out to be unduly procyclical. A wise person onc~ said that knowing what you do not know is the f i r s t step to kr~wledge.

At a minimum, our examination of the policy process at

the Fed suggests that there are significant limitations to the analysis, data,

and forecasts underlying policy deliberations. 55

As Brunner and

Meltzer argued in t h e i r seminal study a quarter of a century ago (1964), such knowledge deficiencies, along with an abiding focus on the short run, severely l i m i t the p o s s i b i l i t y that the Fed's f l e x i b l e approach to policy w i l l prevent money i t s e l f from being an important source or propagation mechanism of economic fluctuations and inflation. Against this background, the lack of correspondence between the Fed's rhetoric and its record is more easily understood.

At the same time, our study suggests that the

realities of Fed policy do not correspond closely to assumptions about policy usually embedded in theoretical and empirical work in monetary economics.

Since the results of such work are unlikely to be invariant

with respect to policy, facing rather than finessing the details of the policy process could well yield significant returns.

56

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