Policy advice and policymaking at the federal reserve

POLICY WV’ICE

G AT THE FEDE Raymond Lombra PennsylvaniaState University and Michael Moran * dmsylvania State University I. b&rod&ion

Academic economists actively e;lgaged in monetary research hope to improve the analytic foundations underlying the formulation and execution of monetary policy. AS the ideas in our writings are disseminated, the Federal Reserve staff and, presumably, the policymakers themselves become aware of new findings and critiques of prevailing orthodoxy. Assuming a professiona! consensus begins to emerge regardtig some aspect of policymaking, we would hope that an alteration in the Fed’s approach to policy would follow without a “long and variable” lag. Over the iast twenty years the trend and the rait: of change ia the volume of monetary research have been rising. Yet a logical positivist looking at the decade of the 1970s relative to earlier periods would conclude that actual monetary policy has fallen well short of the idealized optimum so easily derived from economists’ models. In analyzing the problem, Sherman Jfaisel, a former member of the Board of Governors of the Federa! Rrre.lle System, has argued that the surge in monetary research provided little information of use to policymakers: “too many articles appeared completely no+oper&ional, both for the present and the future. 1 could find no reiacronship between them and the info:,mztion required for actual decisions” (1974, p. 3 15, italics added). In Maisel’s view, the principal cause of the problem is that ‘Imany articles and whole series of controversies turn out to be of no help because they are founded on incorrect assumptions of how policy has been managed” (1974, p. 3 19, italics added). The Fed itself, however, may be the ultimate cause cf the problem in that it has failed to reveal the analytic foundations

@ We would like to thank Normand Bernard, Assistant Secretary to the Fe ion in scoring the documents used in the papea, MlcRael and Herb Kaufman, Thomas Mayer, Alian M. Meltzer, Stev e ~o~e~M~~0 Workshop nt Penn State for helpft.2 corn

&et

Committee,

and assumptions und.erlying the formulation of monrtary po:.icy. To his credit, Maisel has noted st!c:h a tendency: “the Fed has always resisted being too specific about its methods and its goals, clothing its operations in a kind of mystique: that left it lrnore freedom for maneuver.” (1973, p. 2 5). ‘With lines c I’communictition clogged, key unresolvzd issues are rarely discussed. As a resul:, the gap between the beleaguered polii:ymakers and their critics appears to hav etwidened over time; policymakers attril lute poor economic outcomes to the fti;ure of economics, while many critics attribute such outcomes to a failure of policymaking. Since its inception, the Carnegie-Rochester Conference Series has sought to encourage research on public policy that would close the information gap thst handicaps ].)folicymakersand researchers. In that tradition, this paper will focus on the economic analysis undertaken by the staff of the Board of Governors of the Fs:cIeral Reserve System and the approach to policymaking employed by the Fezleral Open Market Committee (FOMC). As in the previous papers in the conference series that have exa.mined various aspects of the economic analysis undcrrtaken by the Joint Economic Committee (Christ, 1976) and the Congressional Budget Office (Meiselman and Roberts, 1379), the primary objectives i;tre to identify the modes of analysis which guide policy advice, to compare #and contrast them with “the conventional wisdom,” and to assess the effect OF this pohcy advice on policymaking. ‘Using data heretofore unavailable to those outside ,the Fed, we have examined the accuracy of the Fed’s staff’s real ant’ financial forecasts,’ the implicit or explicit models which underlie these forec:a.sts, the effects of the staff’s forecasts on poliq targets, and a number of ot’qer imporbnt issues relating to the formulation and implementation of manet try policy. It is our hope that this work will help to bridge tine existing gaps bs:Itween the rigors of monetary theory and the realities of monetary policy arrl, thus, facilitate the type of productive research which contributes to imnro\,ed econolmic outcomes. The time p’::riod of our investigation is 1970-73. While a more recent period of study wol Ild be desirable, the FOMC has imposed a five-year lag on the release of our dr:l:a sources, which constrains us to the earl;v 1970s. Despite the limited nature 4 the study, we feel there are many respects in which it is relevant to the ccrrent formulation and implementation of monetary polncy. Years have passed, :lut many od the actors remain the same,2 and the general nature of the polic;.making process has not changed significantly.3 Thus, 01.11 research may provill e _ basis for drawing inferences concerning the current and future formulalion of monetary policy. owever, considerable care must be exercissli. ‘The I:‘criod of investigation may be too early or too short permit a fair evalual IOG of the policymaking proc,ess. In early 1970, the FQ

t to the monetary aggregates in the formulation ubsequent years, the staff and FOMC were trying to develop and refine procedures suited to their shift in emphasis, Thus, we are not evaluative the final fo of po!icymaking, but rather the trials and errors which accompanied the search for appropriate methods and procedures4 As a brief preview, Section II will provide a discussion of the policymaking process that evolved during the early 1970s and the role played by the staff in policy formation, In addition, this section will provide a clearer picture of the exact nature of our data sources. Sections III and IV concentrate on ?he staff’s input in the policymaking process. We first investigate the staff’s forecasts and analysis of the real sector of the economy: then, we discuss their analysis of the financial sector and their input into the process of monetary control. Next, in Section V, we examine the behavior of the FOMC and the factors influencing the Committe c’s short-run decisions. In Section VI, we present our summary and conclusions. In general, we confine ourselves to positive rather than normative analysis. IL An Overview of the Staffs

ole in Formulating Policy

The staff of the Board of Governors of the Federal Reserve System (hereafter, “the Fed’s staff”) includes over 200 economists who directly or indirectly provide policymakers with information used in the formulation of monetary policy. They are organized into domestic and international divisions which, in turn, consist of numero>Js sections that analyze past, present, and prospective developments in specific areas of concern (e.g., capital markets, foreign exchange markets, the banking system and the monetary aggregates, government finance, and national income). The “line economists” in the individual sections provide thr: section chiefs and other senior staff with ongoing analysis of individual areas (e.g., the stock market, economic developments in specific foreign countries, agriculture, nonbank financial intermediaries, consumer credit, and industrial production). The senior staff is charged with developing an overall, integrated assessment of economic and financial davelonments, laying out feasible policy alternatives for consideration by policyrndkers and making specific policy recommendations. In general, the staff discharges its responsibiliti.es in two ways. First, staff prepares sev,eral documents prior to each regular meeting of the FO eeting, several members of the for the committee. Second. during each senior staff will make formal presentations issues.

6e our

data

are

drawn

frcm

t

and answer ocummts

questions

and fry

on

VafiOUS

of the presentation:, it will be h%:lpful to review briefly the routine follows in preparing lfor an FOMC meetingP

the staff

Nonfinancial Forea !;ts and the Lorrger onetary Targets The now-f; miliar two-stage approach to policy formation at the Federal Reserve has been o .Qacribed in detail elsewhere (Davis, 1973: Friedmarl, 1975, 1977b; Lombra ant:1 ‘r’orto, 1975; Poole, 1975). At the long-run or strategy stage, the FOMC c~:msiders several monetary aggregate trugets and selects the one most consistent with its ultimate stabilization objectives. At the sgort-run or tactics stage, thl.: FOMC will choose an “operating handle” (and associated short-run monetary target) that they believe will lead t; the attainment of their long-run lmone I.ary target.7 Several tinnbes a year, the FOMC formal’y reconsiders its longer-term monetary targets.g To assist the FOMC, the staff ty@lly prepares a set of “consensus” forecsl,;ts for GNP, inflation, unempl~~;_ment, and the components of GNP. The input I considered by the senior staff i A developing the forecasts included projections from the staff’s version of the MPS model, 9 as well as judgmental projectilpns developed with the aid of surveys, leading and lagging indicators, and otl .er business cycle techniques. The staff’s “base” forecast usually assumes th 11 the rate of monetary growth over the coming yenr will be the same as th,: existing long-term money target. In addition to the “no change in policy” f Irecast, there are supplemental forecasts based on alt:rnative monetary policy aljtl fiscal policy assumptions. The FOMC debates the various alternatives and stlects a particular longer-run money growth target. Staff forecasts in subseq znt months will assume money stock growth equal to the new FOMC target. onthly Meeti 3g and the IVonfmancial Forecast We will a! sume that the FOMC selected a set of long-term targets for the monetary aggrtigates (M 1, M 2, and M3) several months ago and that we are approaching a regjdar monthly FOMC meeting. Tha purposes of the meeting are to review an uy dated staff forecast, to assess recent and prospective financial developments, and to adopt a set of short-run targets for the monetary aggreates and the Fedlral funds rate consistent with the ultimate achievement of e longer-run mon :tary targets. e process leadirrg to the development of the staff’s revised forecast all wee!:s before the scheduled meeting. The staff experts on consumption, in’V&Ki :nt, housing, wages, productivity, inventories, net exports, d sea forth aomt together to assess the data wbir:h hnve: been received since e last meeting (e.g., surveys of consumer sentiment, capacity utilization, new

12

orders for capital goods, and price data). The main objective is to decide whether the incoming data or any other new information-such as changes in the fiscal policy outlook-necessitate an adjustment in the staff’s forecasts. Once again, l:he senior staff will blend the MPS model projection (assuming a money stock growth rate equal to the FOMC’s target) and judgmental projections (adjusted to take account of the most recent data) into a “consensus” forecast. The staff summarizes the results of this detailed procedure in a document called “Current Economic and Financial Conditions,” or the Greenbook, for short (because of its green cover). Although the specific format of the Greenbook changed several times during the period we examine (and subsequently), it, in effect, has always had two parts. The first part lays out the assumptions underlying the forecast, particularly any changes in the key assumptions (e.g., changes in assumptions regarding fiscal policy and imported oil prices); sums up the net implications of data received since the last meeting; lays out the revised forecast for GNP, inflation, and unemployment; and explains any significant changes in the staff’s economi,: outlook. The second part contains background material, including details on the most recent economic and financial data (doilieauc and international), and .~ny hiq@ical perspective which may have some bearing on the economic and financial outlook. We used the forecasts in the 1970-73 Greenbooks in this study. The Financial Forecast As the nonfinancial forecasts are being developed and the Greenbook is being prepared, other members of the staff are in the process of develoying financial forecasts which link the near-term (two-month) growth rates of the monetary aggregates to the Federal funds rate, and link the recent and prospective growth of the aggregates to the longer-term monetary targets. 10 As in the preparation of the Greenbook, the staff (supplemented by staff frcm the New York Federal Reserve Bank) gathers to analyze thi: implications elf incoming data, to assess recent forecasting errors, and to develop specific financial forecasts, The objective of the forecasting effort is to produce several alternative near-term courses of action for consideration .by the; FOMC. The staff reports its findings to the FOMC in a document ;;a?!ed “Monetary luebook, for short (because Aggregates dnd Money arket Con.ditions,” of its blue cover). The Bluebook also has two parts. The first section reviews the recent uast In particular, the deviations (if any) of monetary growth from the targets seh~ ied at the previous rnect~~~ are analyze hanges in short- and long-term interest rates are summarized, note ~e~,o~me~ts in other

13

sectors of the c:;%editmarkets (e.g., rnorig+%, br;&ess ioans, and commercial paperj are repor:ed, and the conduct of open market operations over the intermeeting period is reviewed. The second section presents alternative shoit-run policy options for the FOMC’s consideration, develops the relationship between each alternative and the longer-run monetary targets; and discusses the impiications of each alternative for near-term financial developments. The lattzr might include the ramifications of each alternative for expectations, stock prices, corporate financing sch.eduies, Treasury debt management operations, interest rate differentials and exchange rates, and mortgage market activity. As was the cz%ein the prepamtion of the nonfinancial forecasts, econometric and judgmental inputs are used in deriving the staff’s forecast.1 i Table 1 provitiles an illustration of the alternatives the staff produces and presents to the FOMC in the Biuebook.i2 Table 1

In trytnn to understand how the staff derives data zuch as those shown in Table 1, it is important to recognize that the FOMC and the Fed’s staff embraced the “demand approach” to money stock determination. This approach should be contrasted sharply with the “s~ppiy approach” to money stock determination associated with the ‘work of Brunner and Meitzer (1964b) and others. l3 The demand approach views the determination of, and therefore the control of, the money stock strictly from the demand side. Specifically, the staff’s money demand function, which links money demand, income (a proxy for transactiors in the Fed’s view), and short-teim interest rates (as indexed by the Federal fuvldsrate), is used to derive the aitematives in Table 1.14 in preparing the money stock (demand) projections contained in the hebook, a.key underlying role is played by linal income forecast bei deve’loped fix presentation in the Greenboo mber, the forecasts in t Grienbook are (in theory) ~o~~it~o~a~on a ~~~~ longer-tern1 monetary growth. For purposes ebook (which is supposed to be develcq-ing the means of achieving the longer-run targets), it is assu e r:ci r-perr-i-1 forecast f&r income is n ven,

14

abb in the money demand projections. 15 GiWfi i;ie terminad, exogenous money ferns function, and the Staff’s income forecast (which fixes the position on the demand function in money demand-interest rate space), der+ vation of the alternatives in Table t is straightforward.i 6 At its meeting, the C debates the various alternatives and then selects a particulttr money stoc edaral funds rate combination. O~e~~tio~a~!y, money stoc control is ther& g the Federal. funds rate at the level deemed consistent with the particular money growth rate and supplying reserves o? demand .17

subjected to a variety of criticisms in recent years (see, for example, Friedman, 1975, 1977b; Kareken a:td iher, 1976), many of which were also leveled in review of Fed procedures (Brunner and Meltzer, Brunner and Meitzer’s 1964a). The common trr;ad running through these critiques is that the Fed’s approach to formulating monetary policy is clearly s&optimal under a’ wide range of circumstances. since the Fed staff and the FOMC are well aware of this work, one can only infer that they believe that it is “compietely nonoperational” or that their approach summarized abcve is a go2 “=rcond-best” solution.18 The efficiency of the Fed’s approach depends on a variety of implicit and. explicit linkages underlyin the procedures discussed and on the adequacy of the staff’s forecasts and analysis. The foollowingsections examine these issues in some detail. ies of the Staff’s

ancial Forecasts

The most important facet of the staff’s nonfinancial forecasts is their predictive accuracy. Given the length of the lags in monetary pcdlicy(Hamburger, 1971), reasonably accurate forecasts are a necessary condition for mons:ary tionary policy. Clearly) polic kers policymakers to p ue ‘In effective d that the economy; it is have not been all

heve bsen included in some or‘ these sbr.~dies:.the Fed stsff’s forecasting efforts have not been evaluated pubIicly. 19‘The availability of the Greenbook da@, discussed abvfe, rtllcws us to subject the staff’s [orecasts to &e same detailed analysis accorded the other business forecasters. 2Q We shall be interested in the a:curacy of the forecasts viewed in both a reCutire sense-that is, the staff pertbrmance relative to other well-known forecasts (e.g., ihe D’~“Iand Wharton pr~ojections)---and in arr absoiute sense. If the forecasts are “a:. i:ood” as other forecasts, butt the errors are still “lalge,“’ then t;i; n;;::s&ary cc~ndition~ for effeclive, countc rcyclical policy may be violated. In evaluatirig riie biarf’s relative forecastilrg performance, we ma’re use of t!+qeextensive, carleful, and important work cirried out by McNees r.1974, 1975, 1976a, \9761)). He IZ.S compiled a weallh of information on tl,e performances of the lea,ding busines;s forecasters,2’ which, subject to the usual caveats, we can “compare” with the Fed’s performance. 22 Table f presents the Fed staff’s mean absolute errors (MAE) for nomi.nal
16

Fed Staff GNP2 GNP3 GVPl

1.55 1.93 2.30 f 95

1.60 2.26 2.45 2.61

liQ;NP1 ffGNp 2 RGIW’3 RGW 4

1.73 2.52 2.90 2.68

1.56 2.23 2&J 2.77

ETF 1 INF 2 INF 3 INF4

1.42 2.12

LPN 1

UN 2 UN 3 UN 4 Notes:

11.15

2.50 2.55

l.62 I.96 2.59

0.15 0.18 0.18 0.17

0.11 8.16 9.2~ 0.29

The vsripbl~ are defined es folkwr: GNP1 refen to current quarternominal GNP errors;GNP2 t&en to the next quartet errors;and so on; RGNP = ml GNP;INF = GNPdetlrtor; and UN = unemployment rate. The stat&la, fromMcNedr rtudy (1974) and the rt&ft?statistics are not &ictly comperabk; periods are covered (1970:1-1973:4 t’orrhe Fed and 1970: 3-1974:2 the actual date for GNP, and so forth, used in late enon were more f’inti in the tense th%tthey had beeli rev . lk3caua;e of there incongruencies, my conclu e The McNeer errors mre taken YromMcNeee (1974), The reported errors :arewe ts mede by DEitiReeourceeIbx., Chose Econometric%Inc., the Bureauof I nt the 3.S. Department of Commerce, the Wharton Ihod’8 Economic Porecpai Unit, the General Electric Company, and the median forewet from the Amek+n Stati&ictiilAssocktionNation&IBureauof Economic ‘Rewwch Survey.

17

of Fed

An

f Man I970-3 973

::: a91 0*97 0.95

a74 Q 0,:u a26 438

1.1 1.1 1.1 Las* 2,1*

0.72 Q a37 as2 0477,

t”p lull

0.93 1.0 2.1+ 20. 3.1.

0.56 039 O&2 oas7 0.69

a03 a02 037 032 am

093 0.73~ O&e 0.85’ OAPe

0.94 0.05 O&3 0.87 0.38

a20 436

697 -0.22 6.28 -0.78 -198

I&Q

I.98

2.26 IAS 2.6% 2.3S

2974

IkGlM’l RGNP2 RGWJ RGNP4 RGN?Yi

OA4 0.80 1.39 1.49 1.64

1.56 233 2&O 2.7’8 2.54

2.11 2.94 3.48 3.50 3.39

OS41 as3

BNFl I1NF2 INF3 UNF4 INFS

0.86 -1.18 a83 -2A7 &W

1.15 1.62 I.96 259 4.M

L3C

0.01 O.IS

!z 3.38 4a84

0.25 033 OAO 0949 0.56

0.02

0.11 0.16 0.27 a29 0.35

0.15 0.23 a3s OAf 051

0.03 044

lGNIW47,+ GNp2(46) GNP3(43) GNP4041 GNWlBP

:E -0‘02 0.02

3.07 3.33 2R3

2:

di8

KS 0.71

0.07 a07 089

430 4.37 a.19 d10 nm

GNP1 refem to current quutaf no-1 GNF’ecro~ GW2 refsR to the next q on; RGNP = renIGNP; INF mGNP de&tot; and UN = unempkyment rate. The seaIW the numberof obaervaHo&.a

RIME = root meen squareezrot =&&gz Theil = &m

Thlr rtntiaticwea

ted by Henri ‘I’hhel(1366). If the f-t

perfect, the coefficient will equal ze~ro;the n&e “no nh equal to one.

” fount

Ir

will yield a coelticient

BP foeecrsts w~l”e

not maids regularly, tine data axe

perior to a naive (extrapolative) model, The MAE:; of the forecas’:s by the Fed staff (Table 2) are slightly worse than the average of other forecasts. When the nominal GNP forecasts are brckm:n down into their real and solme familiar problems etrq,e. The mean errors an13 reprice components, gression statktics (Table 4) indic-Qe that the stai’f tends to overestimate real GNP and underestimate inflation. in addition, th: Theil coefficients for both RGNP and INF are large. It appears that the :;ta.ff’s nominal GNP for:cast errors reflect large and .partially offsetting error!; in fcrec::ting, real GNP and inflation. Zarnowitz has noted similar problems. in other forer:asts: “nominal GNP changes are predicted directly and relatively well, but their divisior. into real and price changes continues to pose great pl:oblems” (1979, p. 16). ‘When the staff forecasts of RGNP and INF are complared with the average of other forecasts (Table 2), the results indicate that the errors are large but th,it the forecasting performance of the Fed staff is as good, and perhaps slightly better.28 The final variable of interest is the unernpioyment rate, and thf: data indicate that the Fed staff does an excellent jlob, as do orher forecastc:rs, of forecasting movements in this variable. The mean errors are clost: to zero, the Theil coefficients are low, and the mean absolute Grrors for the staff are very similar to the a’veragleerrors in otner fc recasts. Forecast ACCUIacy: Breaking Down the 1970-73 IPeriod Although the data presented above provide many useful insighls into the Feel staff’s forecasting performance, aggregating over the entire 1’570-73 period may abscure importa:nt information. Specifically, given that the time period covered the wage-price controls program, the massive supply-side oil ihock, and tte simultaneous (occurrence of significant inflation and recession, .ihe Fed staff’s performance and reaction to each episode is of considerable nter :st. As ai.)ove, recent w,ork by McNees (1976b) allows us to compare the staff’s perforr lance during some specific subperiods with that of the leading business forec;isters. Iable 4 presents the actual outcomes for real GNP, the (GNP deflator, nominal GNP (GNI?), and the unemployment rate during the 1970 rec:ession. These data crln be compared to the high, median, and low forec:asts compiled by Ivl:Nees, and th.e Fed staff’s forecast. As shown in Table 4, t.he Fed and the low forecask ITwe.re close to the mark for real GNP, and all forec,astl:rs substantially unc erestimated the rate of inflation,, It appeas that this underestimate of inflation, 2nd the associated staff view 01’ the inflation-unel~el~~yrn~~lt t%deoff (ciscussed below), let. the staff to reccm to adopt, progressively !lighe:r ratef, of mone:tary ring this perio’d. The long-

VPrhMe

k------~ lqh

staffForeca9t

Fed

urd the fothwing four wvth rates over the in

t

Actual

1970: 1 is the base 1971: 1 is the termi-

nd forisxwing quarter. The unemployment rate ir the level im the terminal forecasting quarter (1971:l).

term money supply growth target underlying the forecast was 3 to 4 percent in February 1970, and it rose progressively to 6 percent by Jrrnuary 1971. In projecting the strength of the 1971 ante of the forecasters, as shown in Table 5, was however, the staff underestimated the rate of tht mark for real GNP and 0.5 percentage points

recoveq

, the overall ptrform-

remarkably similar. Here again, inflation, but it was rght on off on the unemploytnent rate.

Table 5 A Comptin

of Forecasts of the 1971 Recovery

1970:4-1971:4

Variable Real GNP GNP lkflmtor GNP Unemployment Rnte

-8

5.2 4A 91 63

36 a3 zL.8

3.3 8.2 5.5

4.0

--

8.d 6.5

Note: gee notes to l-able ‘8.

As everyone know.~, the 19’71 recovery a as ~l~lsatisfa~to~ L and inl~atio~ in ~~ern~~oy Exxon, ~~1aiFrna~

4.7 9.5 6.0

followed by sets+ra1lsubsequent “phases ” , 2g altered she near-term economic oul:look in a variety! of ways, It is instructive ,to examine how forecasters reacted to the announcement of the program. and how well their forecasts turned out. Ta’ble 6 has two parts: the upper portion shows the relevant data for the two sets of forecasts before the controls pro ‘am was announlced, and the lower portion shows how the forecasts were revised iafter the program was announced. In general, the staff (and other forecasten:] reacted by raising their forecasts of real GNP growth, lowering the unemplccyment rate, and lowering their projections of the rate of inflation: The most likely prospect resultiag from the President’s new program, accepting the promise of effective wage and price restraint after the frf:eze and the other assumptions outlined b’y Mr. Parree, is a more rigorous rebound in economic activity than seemed likely earlier. (FOMC? September 1971, p. 34, Murray Wernick) As it turned out the st.aff’s forecasts were comparatively good; the projections for real GN:IPand the unemployment rate were near perfect, but the rate of inflation was again underestimated by almost a full percentage point. A reading of the Memorandum of Discussion and the Greenbooks during this period indicates that: the staff believed the controls progaam was ha!vlng a “real” as opposed to a cosmetic effect.3* Against this background, it was believed thar any given policy-induced increase in aggregate demand would lead to a lar:;er rise in real output and a sm,aller rise in prices than would otherwise have been the case. This ‘encouraged the staff to recommend, and the POMC to adopt (at least i;rmplicitly), a lor,$,eriun money growth target of 7 Percent in early 1972. Note tl.at in a 1itt;e over twa years the targeted (or [acceptable) rate of monetary grosvth had doubled! The degree of the ecor omit s!owdown and the increase in prices that began co occur in 1973 was not well ar ticipated by business forecasters. Table 7 shows that all real GNP predicions were well above the ?.ctual outcome, with the staff’s being the furthest :.‘romthe mark.’ As in previous subperiods, the actual rate of inflation was underestimated, but tb:: 1973 er.rors, reflecting, in part, ?he b&\llooningof prices following the end of Phase III, were much larger ose experienced earlier.

22

iteal GNP GNP Deflatm

Note:

6.3 3.0 9.1 56

6.1 26 8.9 5.5

4.8 2.5 7A 5.3

!&a notw to Table 4.

24

5.9 3.0 9*1 5.9

5.4 3.9 5.5 5.7

Tsble i A Comparison

of T%xewts

Cwerhg the Lhkr Controls Period P972:4-1973 :4

I-----fiber

'Jsrinble

-m&9

Ited GNF’ GNP Def’kor GNP Unemployment Rate Note:

49 45 9.2 5.0

_

Forecasts

Medisn

Low i

Fed Stat3 Yorecast

Actual

4.8 3*8 8.9 4.9

4.5 3.5 8.6 4.8

5.5 4.6 10.4 4.7

3.4 7.5 11.1 4.8 “I

_I

See notes to Table 4.

After 1973, the quality of the forecasts deteriorated further as the OPEC oil embargo and subsequent quadrupling of imported crude oil prices disrupted the U.S. economy ancl the models of the leading business fcrecasters. Table 8 presents the unflattering results. The staff’s post-embargo underestimate of nominal GNP was the product of an overestimate of real GNP and a dramatic underestimate of inflation. The pattern of errors for other forecasters was similar. Clearly, a subs+antiaP portion of the errors resulted from being unable to anticipate OPEC’s actions: a four-fold increase in the price of oil was beyond imagination in late 1973. In ad.dition., some of ltbP ICIe_rrors may be attributed to aggregate-demand models being unable to handle the massive supply.~de shock initiated by the OPEC oil1ministers. On balance, an evaluation of the staff’:5 relative and absolute forecasting performance during thie subperiods mirrors the findings reported above for the entire period: although the errors are large, other forecasters did not consistently outperform the Fed staff, and there was a notable tendency for all to underestimate inflation. Our results are buttressed by reliable reports that analyses of forecasting errors Icarried out within the Federal Reserve System, rb>verinl; most of the 197Os, have reached similar conclusions: the Fed’s nonrinancial forecasting effort is “state: of the art.” In general, it is reasonab.le to presume that the errors observed in the staff’s forecasts result from some combination of incorrect monetary and fiscal policy assumptions (and assumptions for other predetermined variables), the structural characteristics of the staff’s model, and any random variation. reenbook data allow us, to explore the relationship between some of ossible sources of ezor a~ndthe staff’s forecasts,

revisions of forecasts) were constraine

Table 8 ken d ForecmistaCovering the Oil Shock ?rr73:3-1974:3

RealGNP GNP Deflator GNP Unemployment R&e

34 54 8.1 55

PA 4b 7A 5.2

2.1 4.4 6.7 52

2.8 5.7 8.8 5.0

-1.9 1Q.S 8.7 5.6

Other Porecmsta Post-Embargo Variable Real GNP GNP Deflator GNP Unemployment Rate IWez

See notes to Table 4.

Fed Staff Forecasts 1.8 8.3 8.3 6.2

0.6 6.6 76 5.3

-0.1 56 6.4 5.7

(a.3 6. 6. 5.8

ACtLd -1.9 10.8 8.1 5.6

of ways. Few should be surprised to learn that Chairman Burns “influenced” the forecasts. For nexanrple, in discussing the format and content of the Bluebook at the January 19’12 meeting Bu.ms said “he migkt have had some influence on the staff’s procedures” (FOMC, January 1972, p. 21). While the nature aad extent of the constraints imposed 1511the staff by policymakers cannot be a&-*1 ,,&ely documented, one should not underestimate the role of such CONstrdints on the staff% analysis. Regarding monetary policy, the staff had to assume that the FOMC would in fact achieve its longer-term monetary targets. Private forecasters were nr;t so constrained and thus were free to predicate their forecasts on monetary policy assumptions which differed significantly from those of the Fed staff.31 A5 for fiscal policy, the staff was forced to use tax and expenditure projections which did not differ significantly from those being used by the Treasury, the Office of Management and Budget, and the Council of Economic Advisers. The rationale was partly pragmatic-it was felt that these other groups had superior information and a comparative (advantage in developing such projections. Political factors also played a role; since the staff’s forecasts were typically shared with the Secretary of the Treasury, for exa&nple, fiscal poiicy assumptions which differed markedly from the Administration’s could have raised serious questions.3Z Given the ;tbove constraints, and the fact that the policy assumptions were often wide of the mark, it is possible that the staff’s nonfinancial forecasting errors were iat par! a reflection of inaccurate policy assumptions. To test for this possibility, ‘Meestimated a series of equations relating the staff’s GNP forecasting errors to the deviations of the aci:ual money stock from its longer-run target over the projection interval and to 1:he de:viation of actual government spending over the same interval from what 1:ke stdff assumed at the time of the forecast. The fo!lowing equation estimated over the 1970-73 period, is representative of our findings: f2IVPER.R =

0.61 + 0.76 MsDw (1.03) (2.38) R2 =

0.13

- 0. I2 GDev (-1. ! 0)

D-W:= 1.O333

(1)

SE. = 2.96

GNPERR

=:

3 quarter out GNP forecasting (predicted-actual).

MsDev

=

assumed money stock growth-actual growth over the forecas’t korizon.

24

error money

stock

=

forecasted growth of government growth of government spending cast horizon.

spending-actual over the fore-

In general, the failure of the FOMC to achieve its monetary target did explain part of the variance in the staff’s GNP forecasting error. Misestimates of fiscal policy-as reflected in the projtictions of government spending-consistently failed to explain any of th.e GNP forecasting errors. Evidently, the major sour& or s&?‘A&Lasting errors are to be found elsewhere. “Structural” Characteristics of the “Model” Generating the Staff’s Forecasts As di.scussed in Section II, the staff’s forecasts were the outcome of a complex interaction between econometric and judgmental projection efforts. We do know th.at the econometric effort (which itself contained a heavy amount of judgmental adjustment of constant terms in various equations-the so-called “add factors”) was based on the staff’s version of the MPS model. Furthermore, a careful reading of the Memorandzam of Discussion suggests clearly that the implicit model guiding the staff’s presentations to the FOMC was neo-Keynesian in flavor and thus similar to the MPS model. Quantitative evidence on the parameters of the staff’s “m.odel” as they relate to the lags in the effect of policy, the mu.ltipliers f-Jr fiscal and monetary policy, and the infation-unemployment tradeoff is afailable in the Greenbook and the Memcnmh.m of Discussion. Gualitative evidence on the staf?s view of the nature Gf the transmission mechanism is also available in these scsurces. Policy Lags and Policy Impacts In adrising the FOMC, the staff cle.!liy End consistently argued that the outside lag in monetary policy was quite long and complicated: 34 . ..there is substantial evidence that the real sectors of th.e economy do not even begin to respond significa.ntly to a monetary stimulus !Yor6 to 9 months unless expectations change drastic:aj’ly in the meantime. (FOMC, March 1973, p. 13, James Pierce) Mr. P;lrtee replied that the staff tended to think in terms of a variety of lags, dif.Tering in length ‘for d:lfferenr sectors rather than aal alrerage lag for the whole economy. ln some cases, such as plant and equipment expenditures, the lag v~as quite long; in

27

such as mortgage flows and others, residential corAruction) it was much shorter. (FOMC, May 1972, p. 2) However, the full e “fects of the higher or lower rates \of monetary growth would not be felt within 1973 but wouloi be spread over a longer period. The uttrefiried results of the model suggested that, during the first year. a higher rate of monetary growth would have its major impact on real GNP, the effect on prices was moderate. (FOMC, Septemoer 1972, pp. 17-18, Lyle Gramley) In sum, the staff believed that the effects of a change in monetary policy bep.n to appear in 6 to 9 months, affected different sectors wi,th varying speed:;, and continued to cumulate for several years, ,with the real effelcts usually dominating in the “short run’“.35 Furthermore, the staff believed that the effect of monetary policy varied with the state of the economy; passages in the Memcwndwn of Discussion indicate that a l-percentage point increa,se in the growth rate of thr money stock over a 12. to 15month period would raise neimittal GhlP by 0.3 to 0.8 percentage points.. depending on the level of resource utilization. Consistent with the standard neo-Keynl:sian view, the staff believed that fiscal policy had a substantial effect on economic activity over the “short run.” In acl.htion, the impact lag associated with fiscal policy was thought to be somewhat shorter than that associated with monetary policy: “Monetary :lolicy worked with. long and >variablelags; i:j a si’uation like the present, when 1111.need was for a sharp, temporary stimu! is., the appropriate source of that stimulus was in the fiscal area” (FOMC, June 29, 1971, p. 39, Lyle Gramley). “Once in effect: fiscal policies have a more rapid impact on spending” (FOMC, March 1971, p. 33, Lyle Gramely). As was true for monetary policy, the impact of fiscal policy vdried somewhat with the :;tate of the economy. On average, the nornina: GNP multiplier for a $!-billion change in government spending was about 1 over a 9 ‘10 12 ;nonih period, building to about 2 over 24 months. Th:: synff’s judgments on lags and 1:ahcy impacts, l.+*hencombined with the usual 3- to 4quarter horizon covered by their forecasts, are somewhat pnradoxical. The F,OMC typically selected monetary 1:argets for the coming 6 to 12 months ir light of the staff’s forecasts, even though the staff believed that by far the most significant ;ffects of any piicy action would be felt over a &on,:er time p~rlod. Occasi~c:a~ly, members of the FOMC wondered about the longer-term effects of 0.u-tent lpolicy alAions:

k4r. castburn said he would like to pursue the question of prices. He noted that Mr. Partee had expressed the opinion in his earlier statsment that there would be little risk in an acceleratec’ growth in the money supply at present. He (Mr. Eastburn) agreed with the view that in the short run the main effect of rapid monetary expansion would be to reduce unemployment. However, he wondered whether the staff thought the same trade-off would prevail in the longer run. (FOMC, January 19 71, p. 26) Sometimes the staff response was too general to be helpful: Wh.at the longer-run consequenses would tmewou!d depend oil the rate of economic recovery; if GNP rose rapidly and unemployment dropped very sharply, lsonditlons could be created under which sellers would ask for higher prices and even unorganized labor would ask for higher wages than otherwise. But the question iof the appropriate speed of a recovery was distinct from the immediate question of whether a recovery was L desirable current objective. (FOMC, Jii\nuary 197 1, p, 2i, J. Charles Partee) At other times, -the staff argued that longer-term projecti0n.r were unlikely to be of much use: “jr-rview of all the uncertainties in the present situation, projections for more than four quarters ahead were especially tenuous, and the staff hl:ld not attempted to make any” (FOMC, February 1973, p. 4, Lyle Gramely). The uncertainty associated with longer-term forecasts is an empirical question wlucJ. cannot be answered, given the staff”s forecasting horizon. It should be noted, however, that over a longer time horizan the inflationary effects of a given policy action w-ouBdb; more evident and more certain from a forecasting perspective. From a policymaking perspective, it seems like!.y that these procedure; contributed to a failure to adequately assess the longer-run cumulative effects of past, current, and planned policy actions. The stafil”s tendency to und.:re!:timate inflation (described above) may be one manifestation of the short-n n focus.

The realities of inflation and ~~e~~~ioyrne~t hicve ahays

29

posed vexing

Figure 1

Implicjt Phill?;;;Curve in Fed Staff Forecasts

Inflation Rate (Percent) 7

74.2 6

5

4

7: 3

f wT-+m-3

4

5

6

7

Ihemployment Rate (Percent)

are three quarter ahead Fed1 staff forecasts of the rate and the rate of 'inflation. The dates shown ters to whiclh the forecasts apply.

political-econ omk problems for policy- .,&errs, especially over the shast-run horizons that ap’pear to dominate (and dictate) their actions, In addition, the Phillips curvy ha,s been an active area of research and controversy in mc,>dern macroeconomics. As Barro and Fischer have argued, “many of the outsta,nding questions in r ,:ccatary theory and macroeconomics more generally are related to the Phillips Curve” (1976, p. 164). The Fed staff’s estimates of tka short-run Phillips curve are embeded in the nonfinancial forecask We have subjected these data to a fairly exhaustive set of empiricaY tests. The results, supported by comments in theMemomn&um of Discussion, can be summarized briefly: a percentage point fall (rise) in the unemployment rate will on average be associated with a 3/4- to 1 percentage point rise (fall) in the inflation rate;36 Phases I and II of the wage-price cont.rols program reduceld the inflation rate by about one oercentage point relative: to what would have been expected, given actual uner.lployment and other forces affecting the inflation rate; the staff’s inflation-unemployment projections were influenced by mrovements in a wide range of variables and subject to considerable judgmental adjustmerk We could find no evidence that the staff believed a stable, short-run Phillips curve existed ovel time. It i,s true that the forecasts prepared for each FQMC meeting contained an implicit tradeoff covering the near term. I-Iowev~!r_ as Figure 1 vividly Nustrates, there was :30 consistency In the nature of the tradeoff embedded in these forecask3’ The Determinants of Inflation The staff viewed inflation as ;S long-run phenomenon, remotely related to monetary policy, Policy-induced alterations in aggregate demand first affected capacity utilization and unemployment; with a lag, changes in labor market conditions affected wag,e demiands, and therefore unit labor costs; changes in unit labor costs, in turn, explained ays,tematic (as opposed to transitory) variations in the inflation rate?8 When *he economy was operating below its potential, demand-side pressures were only remotely related to inflationary developments. In fact, the staff felt on occasion thalt larger money stock growth was necessary to validate wage increases to avoid even slower economic growth that might result fram a decline in real cash balances; the in~ationa~ consequences of mo~‘c’ rapid monetary grotith in such cases were thought to be minimal: . ..when price rkes are stem ing esse~t~a~~y fro cost-push ,pressLife:s, and when demand is lagging, a money .su~:ply growth rate above bistor~~aI standards

is not likely to lead to inflationary pressures in the future. Rather, the higher growth rate would mainly reflect I;he cost-push pressures that exist and the need to provide more money than usual i.n order to maintain tile growth in reczl cash balances necessary tcl permit a reasonable level of interest rates and a reasonable pace of economic recovery. (FOMC, June 8, 1971, p. 26, Stephen Axilrod) If growth in the narrowly defined money supply is permitted to accelerate to around an 8 percent rate, moreover, our economic projections-whether judgmental or econolmetric-indicate tha.t the Committee can safely be prepared to live with1 such a rate extending well into 1972. (FOMC, February 1972, p. 26, J. Charles Partee) In the later part of the period (late 1972 and 1973), as the economy began to approach capacity constraints, overly expansionary policies became a significant factor in contributing to price increases: “it seems critically important to avoid abrupt increases in monetaq] aggregates that would help ;Lef excessive spending later on” (FOXC , October 1972: p. 7, J, Charles :drte:). However, while the staff viewed excessive money creation as increasing ..nflationary pressures, they te:nded to doubt the effectiveness elf restrictive policjes in moderating inflation over the short-run: It is difficult to see how aggregate demand management policies could make much diffference in this short-term price outlook. Influencing prices through aggregate deman,d, as the experience of recent years has indicated, ta.kes a great deal of patience.(FOMC, March 1973, pp. 7-8, J. Charies Partee) Due tc the slug&b responsrr of wage and price igfiztionI a restrictive monetary policy for 1973 will have its primary impact in 1974 on real output and empf.oyment, not on wages and lpriccs. Our model, like others, indiicatc:s that &ages and prices possess so much inertia that they arc relatively insensitive to mlonetary (or fiscal) pressures unless these pressures ined for several years. Hm the interim, real

32

output

and employment bear the brunt of adjustment. arch, 1973, p, 14, James Fierce)

The P~SU~ presented in Table 9 ili!ustrate the relal;ionships among the key variables discussed above. Recent increases in unit labor costs, wholesale prices, the growth of the money stock over the past yaar or so, and the rate of capacity utilization all help to explain the variation in lthe staff’s inflation forecast.39 Furthermore, Phases I and 11 of the controls progam led the staff to reduce its infiation forecast about 1 percentage paint, given the values of the other variables. At a minimum, the evidence suggests that the staff did not i,gnore the effects of monetary growthP0 To summarize, the ~:raff”s view of the inflatio WJJ process in the early 1970s seems to contain four important elements: first, increasing unit labor costs are the primary source of upward pressures on prices (especially when the economy is not operating in the neighborhood of full employment); second, as the pace of economic activity increases, inflation :is explained by the _ teraction af excess demand and rising unit labor costs; third, Phases I and II of the controls program were effective; and finally, ante an inflationary spiral is underway, it will take years of restrictive stabilization policies to bring it under control. IV. Properties of the Staff3 Financial Forecasts The efficacy of the Fed’s intermr:diate target approach to stabilization policy depends on a variety of factors (see, for example, Friedman, 1975, 1977b). Here we focus on the accuracy of the staff’s fina?icial forecasts (contained in the Bluebook described above), the models underlying the development of the forecasts, and the factors that may account for at least part of the staff’s projection errors. Accuracy of the Farecasts As discussed in Set-tion II, the staff produced several sets of money sczck-Federal funds rate alternatives for each FOMG meeting. The i~di~idu~Z mane;; stock proje&ons were conditioned on a ~~~t~l~u~~~ Federal funds rate and an the money stock projections were conditioned on the Same near-ter order to measure income forecast (derived from the ~on~~a~ci oney sl:ock prqjectians, we selected the the accLi*acy of the staff’s short-;.Un alternati\,e

closest to the actual

Federal funds rate

&tamed

B

casting p:r~od. The forecasting

error summary

33

statistics (using

over the

‘fore-

Table 9 Staff htlatlon Forwastsz 1970-1973

1.75 (2.76)

XL08 (-3.05)

0.21 (4.93)

0.36 (330)

2.18 (3.4’))

8.05 (-l&l)

0.18 ((4.2)

0.33 (3.35)

0.56

0.24 (5.3)

0.17 (la91

0.39

1.09

1.O2

2.6 I4A)

0.18 (4.2)

0.22 (2.7)

0.53

1.32

0.90

3.02 (12.7)

0.16 (4.2)

0.54

1.25

0.18

3.49 /I 1.7)

0.13 (3.2)

Q.60

1.3,6

0.84

0.40

0.98

1.0

-13.8 I-1.7)

0.21 42.2)

-1.1 (-3.5) 0.10 (4.41 0.7(B (-2.41

0.14 (2.39)

I-

Nates: The dependent vatible in all equations is the sMf’s current quarterinflation forecast. UN6

= Aversp unemployment rpte over the past 6 months.

cu3

= Averagevalue of capacity utilization rate over previous 3 quarters.

UC

= Percentthan@ in unit Laborcwts ln previous quarter.

Jwl2

= Money stock growth over the pxevious 12 mtulrths.

WI 4

= Rate of change in wholesale prices ovw previous 4 months.

Dummy 12 = Oae daring Phase I and Phase II, zero

a’therwlse.

final dala) for the one-month

ahead money stock growth rate projections are reported in Table 10. It is difficult to know what to make of the errors or what types of conclusions should be drawn. In general, the errors seem very large. For example, the mean absolute error (MAE) indicates that the staff’s short-run (onemonth) money stock forecasts were, on average more than 3 percentage points off the mark. However, considering evidence provided by the Bach Committee on the monetary aggregates (Bach, 1976), the staff’s performance might be considered respetitable. This distinguished committee estimated that the month-to-month transitory component of annuaiized money stock growth rates was very large; the standard deviation of monthly growth rates due to transitory fluctuations was estimated at 2 l/2 ~Jercentage points! Adjusting for this mndom component would lead one to be less critical of the staff’s it should be noted that the forecasts forecasting accuracy.42 In addition, and error measures are at ar.. annual rate; annualizing monthly errors can make a reasonable forecasting error seem deceptivel:f large. Table 10 An Analysis of Fed Staff Short-Run (One Month) Money Stock Forecasting Firtors 1971-1973

j

%z Final Freliminary

ME -1.36 -0.67

j

MAE

L!SE

3.09 3.@!

j 3.91 4.29

Thail r7-i 0.49 0.53

R2 0.36 0.37

4.6e 1.0

0.44+ 0.94

0.10 0.24

-Note:

For definitions of the errormeasures, sea notes to Table 3.

Rationales aside, the staff and the FQMC were painfully aware: of the size of the errors. The staff was continually strivir.g to imp.rove the projections through detailed analysis of past errors, the use of more sophisticated empirical techniclues, and the respecification of the underlying mod& used to generate the forecasts. In the meantime, the FOMC was told on many occasions that the forecasts were subject to conslderable error: As the Bluebook notes, and as idscent experienc? 8Jlt to specify .,I has indicated, it at will be assoc advance the grow ated with any given set of money market co act will be on 0 e tes encompasses. : 11

credit market conditions. (FOMC, December 1970, p. 3 1 y Alan Holmes) The bluebook is quite specific-as it no doubt should be-in establishing a relationship between aggregate growth rates and money market conditions. But as we all know, these specifications often go astray. (FOMC, February 19?1, p. 55, Alan Holmes) Yn general, it was clear that transactions demands for money balances varied with the state of the economy, but as yet little was known about the precise nature of the relationship. (FGMC, February 1971, p. 29, J. Charles Partee) The Committee may properly be skeptical of the staff’s ability to predict these relationships with any precision. And I can assure you that the staff itself has a healt’ly skepticism. But we don’t discount ourselves completely. (FOMC, December 1971, p. 46, Stephen Axilrod) The FOMC was often less tolerant and more skeptical than the t :aff. As a result, FOMC members frequently suggested that the forecasts should be discounted in the policymaking process: Mr. Robertson remarked that it might be best for the Committee to set aside the staff’s estimates--he would call them guesses-of the growth rates in the aggregates that were likely to be associated with particular Federal funds rates. The Committee might simply instruct the Manager to maintain an even keel in the money market during the coming period, while taking any feasible actions that would tend to reduce the longer-run growth rates in the a,ggregates. (FOMC, rtlty !“7t,p.81) He [Mr. Hayes] had been struck:, for example, by the f&t that lthe Board’s projections of the May growth rate of MJ had changed in successive weeks from 8 to 10 to 5 percent, while the New York Bank projections had moved from 15 to 11 to 6 percent. Such erratic changes, in his view, did not provide

36

any good b&s for a change: in policy with respect to money market conditiaas. (FOMC, May 15’72, 1’. 49)43 George Mitchell eloquently summarized the prevailing mood at the mont’hly meetings with perhaps the most imaginative comment during this four-year period: Mr. Mitchell .:ommented that the situation in which the Committee founti itself reminded him of Paul Dukas’ orchestral composition, “The Sorter’s Apprentice.” The Committeesorcerer had directed the staffwapprentice to develop a model to use in guiding policy formation. The staff had done so to the best of its ability, but nevertheless it made many’ mistakes; in trying to accommodate the Committee, the staff went further than its techniques would permit. In consequence many misunderstandings and uncertainties arose and were compounded into a confusion which was more than the “apprentice” or even the “sorcerer” cC+u!ddispel. (FOMC, August 1972, pp. 35-36) Obviously, the short-run r;and!>m vanation in the money stock, ‘mentioned above, made the staff-apprentice’s job difficult. However, a portion of the forecasting error may reflect weaknesses in the underlying structured relationships and inaccurate assumptions concerning the “exogenous” vari;ables (e.g., income). We pursue these other sources of error by first examining the staff’s money demand function, :and then reporting some simple regrezssion estimates that attempt to assess the consequences of inaccurate underlying assumptions. The Staff’s Implicit Money Demand Function As discussed briefiy in Section 11, the money demand function was the cornerstone of the staff’s “demand approach” to money stock de’lermination. lden tifying the approximate sgecification of the function is, therefore:, useful and, perhaps, not as difficult as one might suspect, since several current and fcrmer :;taff members have provided considerable infDrma’tion over the years on the type’; of functions used ( avis and Schadrack, 197 Pierce, 19;‘4; Pierce and Thomson, 1973, 1974; Thomson, Pierce, and Parry? 1975). .In genei-& ithe functi,,rts were of the form:

37

(2, money demand; some proxy for transactions demands, e.g., personal income or retail sales; a short-term rate of interest, such as the Federal funds rate, commercial paper rate, or Treasury bill rate; distributed lag coefficients.

function

The implied short-run interest &sticiiy of the staff’s money demand (PO) can be identified directly. Recallthat the Bluebook usually

presents t:he FOMC with three money stock forecasts and the Federal funds rate consistent with these forecasts (alternatives A, B, C). Divr3ing the percent change in the money stock across the alternatives by the associated percent change in the Federal funds rate will reveal the staff’s view of the short run (I- to 1 i ,‘2_month) interest (elasticity of money demand. For example, with alternative B serving as the base, the percent change in the funds rate for the movement from alternative 8’ to alternative A is easily calculated. SMlarly, the percent change in the money stock can be calculated by comparing al:ternative 61to alternative A. The short-run interest elasticity of money demand is then defined GAB = 7L?i g.44

With three Bluebook alternatives, it is possible to

0

calculate three elasticities: the implied elasticity for movements between A and B, betwee:n B and C, and between A imd C. Of course, one would not expect to find significant asymmetries. The average values for the interest eiasticity are presented in Table 11 The first row contains the average elasticities for the period January 197 1 tc December 1973.45 The demand for money function embedded in the staff’s r.orecasts appears to be rather interest melastic in the very short run; with the i:litiaI funds rate at, say, 9 percent, a C;Obasis paint rise in the funds rate im,tnedi&e& following the meeting would be expected to lower average money growth by only 0.84 percentage points (measured at an annual rate) over the next 1 to 1 I/2 months. An examination of the elasticity valwes for individual months shows that the staff’s money demand model was reviseid around October 1972. The s::cond row in Table 11 presents the average elasticities for the first part of the period, while the third row presents the average elasticities for the later .period. 111general, the elas!icities in the later period are roughly twice those in the duly period; a 50 basis point increase in the funds rate was projected to reduce I i-l2 rlear-km owth of the money stcck by 0.49 percentqge

38

Table 1 I c~xt-Run(I- to 1 i/2-month) Intexest ticities Emlwdded in ~~f~M~~~eyStock-Interest Rate Fcremsts 19714973

hpli

z--

---

Time Period 71:1*73:12 71:1-72:Y 72:1O-73~12 Notes:

QAB

%c

---

%B

SC

rt,C

4.012 9.0078 4.018

4.015 dOW8 -0.023

6013 WJQ76 4019

nils --

Low

4.05 4.01 1 -0.05

u.002 4.(302 Ml08

= Ave

tic&y ior movement horn alternative B to A.

= Ave

intwst elasticity for movement from alternative B to C.

= Awage inten%t&Hi&y for movement fram alternative A to 6.

VA, ffW and Low are the h&bentand lowest {in absolute vnlue) elasticities found.

earlier period versus 1.23 pcsrcentage points HI +Fe later period. Aside trom the fact that the staff was frequently under pressme to produce projc.:tions wh~h showed that a small rise in interest rates would significantly reduce money stock growth over the near term (thus implying the existence of a more elastic demand function),46 it is rot clear what accounted for the changes noted above. Ctne possibility is that the Board staff’s monthly model (Thomson, Pierce, a. !d Parry, 1975) was reestimated around this time.47 The remaining parameters of the staff”s money demand functio;], which the staff believed captured tlhe lagged adjustment of money demand to past movements in interest rates and income, can be estimated with the a;d of restricted least squares. The dependent variable is the staff’s near-term (alternative B) money stock forecast in billions of dollars.4g The independent \,ariaSles include distributed lags on the Fetieral funds rate and personal income. All data were estimated in logartihmic form and “preliminary” income data were used since the staff forecasts were based on the data available at the time. The coefficient PO-the contemporaneous response of money demand to the into rest rate-was constrained to be -0.013, the estimate indicated for the entire I97 -73 sample period in Table 11, M

= 0.48 + 0.75 PI( 13.17) (32.33)

R2 = 0.99

;;pFF’PDL’= 0.97

0.013 RFF.

(3)

S.E. = 0.006

All %tariablesare measured in logs:

“‘j a 9-inonth, he lag covered

0-l to r-7.

RFF (PDL)

is a g-month, second degree polynomial distributed lag on the iog of the Federal funds rate. The lag covered t-1 to r-9.

The equation explains 99 percent of the variance in the staff‘s forecasts and indicates that the (nominal) income elasticity underlying the staff’s forecast is 0.75 and the total interest elasticity is -OS043 (0.03 + 0.013). Neither estimate appears to be out of line with the estimates by Feige and Pearce (1977) from a host of money demand studies. It should hti nrted, however, that the staff’s month?y model implies a much quicker eZ$,.;,mea.t of money demand--that is, the lags are shorter-than do most other quarterly and annual studiesP9 A variety of view of the money derive their financial objections raised by fundamental:

objeciions can be, and have I ,en, raised about the staff’s supply process and the models and procedures used to forecasts.50 Leaving aside various econometric issues, the Karl Brunner (and Allan Meltzer) are among the most

The difference between the [Fed’s money-market theory and the Brunner-Meltzer credit market theory] is conditioned by a fundamental issue in contemporary monetary analysis, viz. the relevant range of substitution relations centered on money. The moneymarket model expresses the Keynesian view that these relations are constrained to money and some financial assets of the same risk class. The credit-market theory on the other hand is based on the denial of such restrictions and follows from an explicit rsseition that money substitutes over the whole spectrum of assets. It follows that in a “Keynesian world” the public’s money denlaud and asset supply to banks are identical, whereas they are separate and independent behavior patterrs in 2 non-Keynesian world. It also follows that the mogey-market theory assigns to the public’s money demand a central position in the process. In this view the properties of money demand dominated the outcome. (Brunner, 1973, p. 105) Given the staff’s view of money stock determination and the way policy ~3s imp!emented, der?and is all that mattered. Thus the “supply” funcii01153piorteerrd by eltzer were thought to be superfluous. 51,52

40

Within the staff’s (and the FO C’s) demand approach, an important potential sou::ce of money forecast errors was an inaccurate nonfinancial forecast. Recall that the income projection was a preder,ernined variable used to proxy the transactions demand for money in the development of the financial forecasts. As a result, errors in projecting income should explain a portion of the money forecast errors. Much to our surprise, we could not uncol,rer any empirical evic’ence suggesting that the large errors in forecasting money growth were a funct.on of the errors in forecasting income. This result raises serious questions abl ut the cons3’ency of the forecasts contained in the \Grecnbook and Bluebook.53 More generally. our findings illustrate some of the problemsdiscussed in detail b:y Friedman (1975, 1977b) and Kareken and Miller (I 976)~that ca.n arise within the Fed’s “two-stage” approach to policymaking. V. Policymaking by the FOMC The previous scctrons focused on policy advice; the concern wa:: with the staff input at the month.ly FOMC meetings. The present section will investigate the policymaking ptocesSs at the Federal Reserve, concentrating for the most part on the behavior ‘of the Federal Open Market Committee. The specific issues examined are the nature of the goals and methods underlying FOMC discus:l;ions, the extent to which staff projections influence FOMC targets and actions, and the possible determinants of FOMC actions in addition to staff projections. On Goals and Modeh James Tobin has summarized vrhat most economists (the only?) logical approach t:, pohcymaking:

would view as a

There is really no subsritu!e for making policy backwards, from the desired feasible paths or’ the objective variables that reaily matter to the mixture of policy .nstrurnents that can bring them abo:lt.... The procedure requires a model-there is no gerting away from that. Models are highly imperfect, but they are indispensable. The model used for policy-making need not be any of the well-known forecasting models. It should represent the policy-makers’ beliefs abcut it should be explicit. the way the worl is not using licy-maker or advi e would be 1 ir, kidding both vised to make exphc:t both his objectives for

the economy and the model that expresses his view of the links of the economic variables of ulZimate social concern to his policy instruments. (1977, p. 763) In essence, Tobin is telling us that policymakers should fiist formulate ultima :e goals, then employ their model to determine the fendble paths to attainment of those goals. A curious aspect of policymaking at the Federal Reserve, however, was that the FOMC appeared to have neither ultimate goals nor a consensus view (model?) of the effects of monetary p01icy.~~ II; was painfully evident in reading the Memorandum of Discussion that the FOMC, as a group, did not have an explicit model. For example, in April 1970, Sherman Maisel said, “It would be difficult for members of the FOMC to agree on a specific’theory of monetary policy, on the relevant [target] variables, or on the relationship between possible [target] variables and desired results” (FOMC, April 1970, 3. 73). As another example, when discussing whether tc issue a more explicit policy directive, George Mitchell commented, “The basic problem-that such records [an explicit directive] would not articulate the committee’s theory about the manner in which monetary policy worked--was a consequence of the fact thiit the committee as a whole did not have such a theory, although individual members might” (FOMC, December 1973, p. 15). S,imilar arguments can be made concerning the FOMC’s stabilirltion goals. While individual members probably had desired income, employment, and price objectives in mind, the I’OMC, as a group, did not have a set of ultimrte obi:&ives gui!ing the formulation of monetary policy. Had the Federal Reserve been operating in a more subdued era and not faced the simultaneous problems of inflation artd unemploymellt, the lack of explicit goals might have been less critical. How’zver, ir, the early 197Os, conflicting demands were being plazed on til? FGci, and it was not always clear, cvcn to themselves, in which direction they were moving. The Norember 1970 meeting is an interesting (and not unique) case in point: the Committee lwas of TWOminds, which seemed to be miles apart in Zheir policy views. On the one hand, several Committee members felt monetary res!r?lnt should br ‘exercised in order to slow inflation. Vice Chairman Alfred Halyes argued that “his major concern, however, related to the outlook for prices,, which seemed to him to be more gloomy than projected.... He ought there was a good de:A.lof inflationary tinder lying around waiting to be rekindled” (FOMC, November 1970, p. 42). In opposition, Sherman Maisel was the most adamant in favoring pclicies that would reduce the unemployment rate, apparently willing to forl.:s&e the battle agairnst inflation: “it [the FOMC] should recognize that, given Irhe de:Tee of unused capacity which even those alsei’sp goals implied, what occurred in the price field would be independent

42

of that action or other actions which the Federal Reserve would take....Whether or not deflationary pressure suc;:eeded in slowing price rises would not depend on the system’ s action but wouId depend on tlile price policy actions of business, !3bor, and government C, November 1970, pp. 4546, italics added). When faced with such conflicts, the FOMC’s energies were usually devoted to modifying the directive wording and adjusting alternatives in order to win unanimous or near unanimous approval.55 As an example, despite a near even @it of policy views at the above meeting, a directive was passed by an 1 l-l $ote. While a directive was approved, it was not clear if monetary policy wasiattempting to slow inflation or to stimulate the real sector of the econ0my.W InI short,

without the guidance or discipline offered by an analytic model andf,BDrmal targets for nonfir,Encial variables, the formulation of rnoaetary policy{often seemed to be a seat-of-the-pants operation. Moreover, it would $

appear tha$ new members of the Committee were rather quickly assimilated iiito the world f;f ad hoc theorizing and policymaking. Jeffrey Bucher joined the Board in riid-1972, and in November 1973, he noted that “with each pa!;sing month he .$ppreciated more how inexact a science was monetary policy and how niclch re:lia&e the policymaker had to place on his own judgments about circumstances ami situations” (FOMC, November 1973, p. 97). Tie ad hoc approach of the FOMC certainly did not produce superior poiicy. Imi.ead, it encouraged an ambiguous approach to policymaking vr,hich some have i:levated to a prerequisite for “successful” policymaking:

P I

A possible side advantage of this, strategy is that it can be followed even though it might be impossible 1 to get agreement among the members of the FOMC either as to ultimate goals, or to the form or level of an intermediate monetary variable, or as to how to define what strategy is being follow +d. (Maisel, 1969, p. 154, italics added) t 1

9 N\ 3st

academic economis-is would not L.gree; as noted by Benjamin Fric:dman,] ’ “An obscurantist framework designed to facilitate unspo agrtrementj among the policymakers about how policy operates can only be i self-defeating. Above all the po~~c~~~~kers tiust first determine what they arp doing and jvhy, before they set a&dr doing it” (19TT*‘a,p. 1OO).“7

Ai though

the FOMC never formally

a 02; d a set of targets for real

GNP growth., inflation, or unemployment, they did choose a set of shorter-term imonetary targets each month. In assessing the role of the staff and the per:formance of policymakers, it is :instructive to examine the extent to which the istaff’s Bluet;:>u;k alternatives influenced the FOMC’s short-run targets. In this regard, severa,: years,ago, two prominent members of the staff, Stephen Axilrod and Darwin Beck?8 argued) “Pro:iected [money stock-interest rate 1 relationships should not be thought of as determinants of p&y” (19?3, p. 83). We readily admit that the projection of a variable and a target value of a variable are conceptually distinct in theory; the issue is whether or not they were or should be distinct in practice. A comparison of the Bluebook alternatives presented to the Committee and the short-run targets selected by the FOMC seems to reveal that targets and projections were, in fact, often distinct in practice. In only 6 of the 37 meetins:: from Sanuary 197 1 to December 1973 did the FOMC select one of the stafi’s alternatives. In the vast majority of cases, the FOMC adjusted the staff’s menu of money stock-interest rate projections before selecting a short-run target.5g A closer examination of projections and targets will reveal the predominant na.ture of the FOMC’s adjustments. In 20 of 37 meetings, the FOMC lowered the staff’s projected Federal funds rate for a given money stock, lowered the targeted money stock growth rate for a given Federal funds rate, or lowered both the staff funds rate 2nd money stock projection. The rationale for the FOMC’s behavior, revealed by a careful reading of the Menalorandum o,f LXscuss,ion and an examination of subsequent actions, seems clear: the modifications usually helped to secure a clear consensus. The FOMC could go on record as desiring lower monetary growth and lower interest rates. What is not clear is the FOMC’s rationalization for implicitly or explicitly ignoring :he constraints on monetary control embedded in the staff’s projec71011s.More specifically, the staff”s projections usually implied that larger interest raate fluctuations than the FOMC was willing to tolerate were required to control monetary growth.60 While the topic is discussed more fully below, most would share Karl Brunner’s reaction to the distinction between targets and projections within the F’OMC’s procedures: “the reader of the Axilrod-Beck paper wonders about the appropriate interpretation of the procedure. Should he infer from the free wheeling intrusion of the FOMC’s judgment that the underlying analysis !subrrlitted to the FOMC is 5 i dubious quality and marginal relevance? Or should be infer that the FOMC cannot recognize relevant analysis with potentiall:, usef~l applications” (1973, p. 1O8)?

The Role 1,/fProjections, Current Conditions, and Monet uy Targets h i%phinin~Committee Actions WI: assume that the sitgle variable which. best captures the Fed’s con4 actions over this period is the Federal funds rate.61 For better or SCioUSpOh$Y worse, the, Fed viewed the funds rate as the anchor on the term structure of 1 interest rabes; movements in the funds rate in this view caused movements in other rates/ affected the demands and supplies for various financial instruments (including /money) and,. therefore, credit flows, and ultimately affected economic act{4ty.62 More than an!* other issue, the “appropriate setting” of the Federal furIds rate dominated discussions ‘it FOMC meetings. In\ order to ascertain the determinants of the funds rate settings, we follow thepleads suggested by the “reaction-function” literature (see, for ex1 ample, I&4 .osa Eind Stern, 1977; Kaminow, 1978). We estimated a large number of equatioqsI using the change in the funds rate selected b:l the FOMC as the dependent !rariable63 and a variety of independent variables including deviations of moneta;yI growth from selected targets, the staff’s nonfinancial forecasts, ,md the ini:oming data on the current state of the economy. The results are presented ii[ Table 12. The Respo@e Tki: deviations )f a!; the resu’ts 8

to Monetary Deviations Bluebook and the Memorandum of Discussion suggestl:d that the money stock from the short-run ta1,qet.s were often viewed of random varia!ions in money demand which could be ignored.

Accordingl!), the specific independent variablle used in equation (1) is the deviation of tIQ: m0nr.y stock 5cm its longer-run target over the previous three m Dr,ths.64 . At first glance, the results seem reasonable. Equation (1) suggests that whe:n mane.!I stock gr0wt.k. exceeded its long-run target, the FOMC raised the Federal fun i Is rate. The upward pressure on interest rates was expected to slow the! growth (if money demand and therefore th!e money stock. A I :ss encouraging aspect of the results is that the magnitude of the .I coefficient (rn tile money stock deviation seems very small; a one percentage n of the money stock from its long-run t,arget (at an annual rate), 3 months, will elicit only an 8 basis p.oint adju;Iment in the rate. The dynamic adjustment over time is, of ccurse, much ds rate continlles to adjust by 8 basis points month after month etween af:tual and targeted money growth is clo~ed.~~ Howev% est inelasticity and lagged adjustment of money demand, the to the long-run target path promised to be an extremely slow ol\:over, it seems li cry that the restrained (and serially correlated)

45

Table 12 Determinantsof the Federal Funds Rate Target Selectadby the FOMC 1971-1973

1

0.12 (1.76)

0.084 (4.73,)

2

-1.4 (-1.64)

0.089 (4.59)

3

0.93 (-2.77)

0.073 (4.52)

4

-1.14 (-2.7)

0.075 (4.54)

0:14 (1.96)

0.030 (0.72)

0.19 (1.56)

0.058 (0.72)

O&CD

1.25

0.37

0.49

1.46

0.38

0.12 (3.61)

0.09;’ (2.061

0.58

1.54

0.32

0.12 (3.21)

O.OS!i (0.78)

0.60

1.61

0.33

Notes: The dependent variable in all equations I the change in the FOMC’:r selected Federal funds rate

target. AUother data are apressed in percentagepoints (at an annul! irate). 5EV3

= Average deviation over the previous three months of the prelimbwry money stock from its Gong-run target.

hGNPE3 = Averagestaff

red

GNP Porecastover the next three quartets.

lh%T3

= Averagestaff inflation forecast over the next three uuarteni.

RGNP

= An avenge of the staff’s current quarterreal GNP forest

and the previous quarter’s

preliminaryreal GNP. INF

= An awrap of the staff’s current quarter inflation rate k:ecast and the previous quarter’s preliminary inflation rate. The in&&m rob is measured by the percentage cbangair the implicis price de&&or.

containing the unemployment rate, rather than real ChP, produced snrdlar results; the coefficient on unemployment aas negative and statistically significannat the 1%level.

Eql;atio~~

response of: the funds rate affected expectations, thereby engendering adjustmen’ts in thl,i public’s borrowing behavior whicl: exacerbated procyclical movements i.1 mol/iey growth.66 tendency to under-react to money stock deviations did not go unrecognizec/ by the FOMC; several quotes in the Memorandum of Discussion pl that at least some members of the FOMC were aware of the y indic$te problem and/ its consequences. F’or example, at the June 1971 meeting, Darryl Francis :;aid, \ The\

c i i

In the weeks following every Committee meeting $nce Ianuary the money stock had risen more rapidly t titan called for by the policy directive.... At each sub$querlt meeting rather than reaffirming the desired g!*owtn rate, the Committee had raised the target t rite of monetary growth that was acceptable. The akternative growth rates of money discussed in the biuebook...were all far in excess of anything that had b”:en discussed or even contemplated during prior IT,eetjngs. (FOMC, June 29, 1971, p. 66) i

At the ver.y n{,!xt meeting, July 1971, Francis was more precise in ide.ntifying the source of tire F ederal Reserve’s money stock control problems: ,I !

]In -ecent months, Mr. Francis continued, concern hail been expressed by members of the Committee th;!t monetary expansion might have been too rapid, de! spite intentions to the contrary. That had led some \ to’conclude that the Calmmittee was not able to con1 trcjl money growth adequately. I-Ie attributed the apiharent lack of success, in controlling money to the ini/ thod used. Emphasis had been on ir quencing mc{ney market conditions as a means of achieving a tle:jired rate of monetary expansion. Those market co:\ditions had ‘been permitted to tighten somewhat in T :nt months; at each occasion, however, there had ber~n 3 fear that a rise in interest rates mighh choke off! the G-agile recovery, a ously . It was his Co:i3mittee’s

massive

injection

of

credit since Januiiiry. The growth of those funds had also encouraged inflationary expectati.ons which, in turn, pushed equilibrium interest rates even higher. With current underlying economic conditions and rising, inflationary expectations, the result had been highrr rates of money growth than the Cojmmittee had specified. Mr. Francis sai.d he would suggest that the Committee stop the Icourse toward greater inflation and higher interest rates now by directly placing stress on achieving moderate growth in the monetary aggregates rather than by making adjustments in money market cond:tions. (FOMC, July 199 1, pp. 95-96) Sased on the evidence in the preceding section and the above discusit seems reasonable to’ conclude that in, the early 199Os, the Federal sion, Reserve was preoccupied with moderating fluctuations in the Federal funds rate. 4 reading of the Memorandum of Discus&m will reveal at least three significant factors (in addition to those discussed in ltombra and Struble, lP79) that led to this concern. First, the staff’s forecasts of money stock growth often proved to be inaczurate, and consequently were discounted to some degree by the FOMC in poli::y discussions. Without an accurate money stock-interest rate projection, to constrain behavior, ?he FOMC was able to vote for “moderate money st’ock growth” without voting for a higher or more volatile Federal funds rate. Moreover, the staff (perhaps themselves constrained) sometimes) encouraged the selection of what they viewed as inconsistent short-run targets., For zxamlple, at thr: October I!??2 meeting, the FOMC srdasadvised: [The target Felderal funds rate] range is determined on technical grounas and is, o; course, subject to all the usual forecasling errors. ;Jut in adjudicating among relationships that mvohe monetary aggregates and interert rates, thl;: Committee has ‘more options than the staff. Thus, 01:)policy grounds, the Co:mmittee may wish at timeq t;r constrain the funds rate to a narrower range thar technically seems feasi.ble for a given aggregr ;e objective. (FOMC, October 1992, p. 18, StP@en Axilrod) A second significant

factor contributing

to

the F MC’s desire to

av& iflterest rat \ fhEtUatiOnS concerns the political pressures for stabje rates generated by &hei wage and pike control program, With all wages an.d prices subject to some d \ gree of control, but interest rates free to fluctuate, the potential for confrol\tation with the Administration, Congress, and labor existed if interest rates .wer$ to show significant upward mov*:ments. In the fall of 197 1, when Arthur Burr# expressed the view that “so long as interest rates in general remained below tj:[e levels that prevailed before th:: President’s address he did not think much pl:f :ssure would build for including i hem in the freeze” (FOMC, August 1971, p. li,3), he ?.stablished an implicit constraint that remained with the Fed througholb t 1972 and into 1973.67 The restrictions placed on Federa. Reserve policymak.\ng later became evident; in July 1973, John Sheehan commented that “w:.,t$ the benefit of hindsight, he thought that more restraint might have been aE)plied earlier, but as he had suggested on a nilmber of occasions such a polic,!.ycould well have precipitated 3 legislative freeze on intereslt rates” (FOMC, July1 1973, p. 94). A final f,;{,ctor influencing the FOMC’s concern with interest r ICC fluctuations revolvl]j around the fact that many of the more experienced ilommittee members sq/tmed to have considerable difficulty adapting to the new operating methods./: Having worked for several years by focusing on money market conditions [.nd issuing vague instructions to the account manager, the) showed a reluctanclfi to adopt precise Ml targets and often reverted to their old !I vague procedures. I*llsrexample, at the January I972 meeting, “Mitchell said he could recall the tirde when Committee members felt they could describe their policy preferences f].mply- by choosing from a;nong the terms ‘tighter’, ‘easier’, ‘unchanged’. an thdt basis, he would place himself in the ‘easier’-or perhaps ‘somewhat easier’ -c:;\tegory today” (FOMC, Jatluary 11, 1972, p. 78). Similarly, at the April 1972 qi:eting, Dewey Daane said that “he would favor an effort to snug up a bit on sh&-term interest rataes, while keeping an eye cocked on longterm interest rates. Iie would not try to translate that policy prescription into :I i choice between [altl*rnatives A, B, C] ” (FOMC, April 1973, p. 44). The influ1 ence. of such membtirs would surely prohibit the FOMC from B serious pursuit of monetary aggregz/:e targets and slowed the Committee’s adz,;tation to the new set of operatat!ng \lrocedures. 68 !

fo~~~wi~g the staff’r lead., often spoke :iated with monetary policy. l’his view wou!,j lead one to rimarily by foresasts tions would be guide of economic act&i ty,!(1-rather than il~~o~~~~~g data descri Con ,!$e &.her hand, the average errors e%bedded in the S$aff”P the economy.@ t C,

49

forecasts might lead the FOMC to discount the forecasts and base their actions on incoming data and possibly a simple extrapolation of the economic conditions indicated by that data. The results presented in Table 12 (equations 2-4) suggest that current eccnomic conditions dominated the FOMC’s setting of the Federal funds rate target. For example, equation (3), with current real GNP and inflation, has a higher R2 and a-statistics than equation (2). In addition, when forecasts and current conditions are used together in equation (4), the staff’s forecasts are rot statistically significant, and current real GNP and the money stock deviation provide the bulk of explanatory power. 70 A reading of the &Zc!morandum of DiscussrYoonwould lead one to a similar conclusion. Policy dBmssions usually focused on the recent behavior of the money stock, the current state of the economy, and the staff’s and Committee’s outlook. There seemed to be a tendency, however, for the FOMC to concentrate on the current state of the economy.. Although frequent references were made to forecasts and future prospects, most comments tended to focw on the current situation or near-term (1 qu:rter ahead) outlook. Indeed, Gelorge Mitchell even offered a rationale for not reacting to the longer-run outlook: “it exposed policymakers to such critici:;m as ‘why did you start to restrain when unemployment ‘was so high”.... Thus, it was easier to move toward restrain” after there was concrete evidens,ce of the need for restraint” r?OMC, Septem’+er 1972, p. 58) Jamles Pierce (then a senior staff advisor at the Fed) nol:eJ a similar tendency: It is very difficult to convince a policymaker to move an instrume~nt in what he views. to be the wrong dire&ion. That is to say, if incoane is expanding very rapidly and .the models are predicting it is going to fall in the future unless he eases up, it is very difficult to get him to ease up because that sort of policy recommendation is contrary to what is going on currently. I must say that until our models do a lot better, his wariness may be justified. Again, the problem is one of how to handle risk: what if the model were wrong? What if the economy were expanding very rapidly, th.c policymaker eases up, but economic expansion becr,!nes more rapid? The cost of the en-or to the policymakcr would be very large. (1974, p. 18)

SOma Com.mitte\ members were quite catncerned about the hplications of ignoring th,e lox&r run an voiced their uneasiness from time to the. For example, John Balleri (the president of the Federal Reserve Rank of San Francisco); a+c l~~s 1-’ second F&HvICmeetilig, c

abow the lags in the effects of etary policy on the real economy. s recollection, those lags had not been e previous meeting, nor thus far In the Committee had long si.nce laid ns relating to lags as unanswerable, r I.972, pp. 94-95) ot widely shared. with the FOMC’s response pattern are obvious. m outlook and current conditions d’ominate policymaking, there will ti/? a tendency for the Federal Reserve to generate procyclical movements in tit .e money stock and contribute to cyclical instability. i: 1 VII,

The preceding operations, assessed the to how plolicy has been

Summary and Conclusions have examined specific aspects of the Fed’s ‘s advice, and filled in many of the details pertaining In general, the making of policy can be viewed (the Federal funds rate or si-me reserve

depends importantly

on

the errors were large period, a:nd were biased estimated while inflation have been partly due to supply-side shocks

two-stage process forecasts and analysis provided by the staff. With that on average the as o hers available. However; horizon, detei.:arated over the 1970-73 that real GNB growth tended to be overhJle he latter problems may underestimated. heir studied and the massive pro ably also acflected the ure to ades aately assess t preach to ~~~eta~y

control, the staff’s forecasts and analysis of the fiit linkage-that is, the linkage between the Federal funds We and the money stock--assigned a paramount role to money demand. Slipp;ages inI-.erent in the “demand approach” and the large random movements in monetary gro~vth over the short run contributed to large money stock projectic.m errors. Tht: size of thcl errors,, the staff’s interpretation of their significance for future policy, and the FOMC’s subsequent discussion of policy alternatives suggest that the staff and FOMC were (purposively?) vague on the analytical significance of the money stock. Throughout this period, it was evident in the Memorrz+z&~ of Pllmmion that the money stock was alternatively viewed as a target, an indicator, or an information variable. Such vacillations only frustrated communication among the parties involved and led to inconsistencies and c&ularities in l?olicy formation. As for actual policymakin,.,0 by the FGMC, it was evident that the Committee never selected ultimate objectives fer policy. The implied disorienta’tion, along with the large nonfinancial proS.=ctiola errors, imparted a short-run bix, to policy discussions and thus a focus on ccrrent, rather than proj:.:cLed, economic conditions in deciding among policy alternatives. The economic and financial ramifications of short-sircuiting the second linkage (intermediate target IO final target) were exacerbated by the breakdown !ii the first linkage resulting In p&artfrom the FOMC’s reluctance to adequately adjust the instrument (the Federal funds rate). Taken together, these aspects of polilWfmak.ing contributed to pros:yclical movements in lthe monley stock and economic instability. The staCT and FOMC were not unaware of some of the problems we discussed, as the following quotatioil suggests: In the judgment of the directive committee, Mr. Maisel observed, there were four major deficiencdes in the procedures under which the Federal Open Market Committee now developed its policy directives. First, the FOMC did not have a clear enough picture of the relationship between changes in operating variableswhether money market condi.tions or reserves-and changes in the intermediate monetary variables. Secondly, there was insufficient understanding of the relationship between changes in the intermediate variables and changes in the economy, including questions of both timing and magnitude. Third, there tended to be insufficient discussion of developments with respect to the de and for money, although that

52

subject has been ]:,:onsidered at length on some occasions-such as la:kc spring and summer when international event:; ”trere influencing money demands. Finally, thte tin1 4 perio’d on which the Committee focused in its pc r$,:y deliberations was often too short. When the Commiftee set its targets for intermediate variables for only j month or two ahead, it was dealing i with a period in fhich current operations could n0.S have much effect and it was not taking into accoun:: the lorlger-run im cations of its decisions. ie problems of arriving at a proper :l remarked, there also were some operating problem under current procedures. It was the Open Ma’ket Committee’s practice to try to 1 achieve i,ts objef;tiies for the intermediate monetary c variables by ‘callingffor gradual changes in the Federal funds rate from mt%:ting to meeting. But that particu\ lar control mecharhism was a poor one; like a badly designed thermosta%’ it tended to result in repeated $’ undershooting or 13vershooting. Moreover, because market participant1 were aware that the System f operated by changilqg the funds rate gradually, day-tot day changes in thatjrat: affected expectations in ways which often were cc!mte:rpro&ictive from the System’s point of view. (FC$AC, February 14, 1972, pp. 4-6) a Such critiques might sol\nd very familiar. In a series of seminal studies bqhich inalyzed various facets of j’ederal Reserve policy, Friedman and Schwartz (1963) Brunner and Meltzer ($ 96#4a), and Weintraub (1974) reached very similar conclusions. What is onI: to infer from this body of research across 0 different time periods, utilizing vfrious techniques and sources? First, it suggest: that one should res.ist the temy#:ation to blame Arthur I3urns for all of the shortcomings of monetary polic)?b in she early 1970s; such problems character. ized policy long before he tookioffice. Second, it suggests that the previous critiquesof monetary policy had iess effect on the SubStanCe, as ypPOE’:d to the form, of policymaking than is oY\en thou t. to be the case. Third, it suggests either that th: staff believes mu& of this monetary research is somehow faulty and thrls car&s Out .nnd utilizes i:.he results of its own research in a Way that “captures” the policymakep, or *'iat,~oiicymakess in general de.nand, and the h

staff supplies, an&y& which triies to achieve a. delicate balance among short-run political and social pressures ancllionger-run economic considerations. Does the reluctance of’ the Federal R.eserve to modify the policy proces: (at least until recently) imply a stalemate between policymakers {and their staffs) and academic researcher::,.7 An optimisi wlould say no, so long as researchers pay more attention to the “political economy of the money supply process” and policymakers heed Robert Weintraub’s assessment: “It is not easy to be sanguine about the Fedem Resenre’s focus being changed through internal debate alone.... I say this because the entrenched intellectual traditions of established institutions are seldom if every changed from within (1974, p. 14). Economic instability has remained a disturbing prloblem in the: United States. It is certainly time for all of us to unclog lines of communication. Researchers need to develop a ftitier appreciation of the objective functions and constraints facing polic-{makers and policy advisors, and policymakers could be more rc;ponsive to ?he w3:brkof academic researchers. It is hoped tlhat tYlispaper represents a step ir, that dixxtion.

54

To avoid cOllf&ir)n,iv should be em@ j&ed that the term “staff ”reYersto the staff of the Board of Govemoris in Washington, D,l:, The stdfs at the Reserve Banks had little, if any, direct effect on the analysis presentedjby the Board staff in briefings aa,i ir various documen& Since the Reserve 3ar!kstat& Ireg[uontiydisagreedwith the Board atiff, oue would not want to attribute what WYexamine to tii:br 2.

3.

4.

Several senior staff membersare still prc&ant.For example, J.CharlesPartee, former Managing Stti Direclr;g,.is flow a Beard member md Stephen Axilrod is now Staff Director for Monetary Policy. hr addition, seven of the i(urrent Reserve Bank Presidents served in the early 19706. i On October 6* 1979, the Federal KIllserveannounced a change in its monetary ccntrol procedures from a Federal funds rate olieratingguide to a reserveguide. !t remains to be seen if this representsa significant change in
5.

It should be emphasized that the Boart staff was not a monolithic body. Individual staff members frequently qumtioned varioui1 aspects of the procedures, analysis, and forecasts examined below. As a result, our use oft i ie term ‘“staff“should not be misconstrued.

6.

Readers interested in more details are re ‘vmd to Lombra and Tort0 (197:;) and the literature fcited therein. We shall use the present,@rather than the past, tenbe in the discussion which follows. As noted above, the significance 3Ethe changes in procedures, announced on October I 6,1979, cannot yet be assessed.

7.

The operating handle (eit:ler reserves 01;i the Federal funds rate) and short-run.money stock target are to guide the Managerof the %‘rading Desk irrthe conduct of Opel, market operations. The “handle” terminology wait suggested by .,tithur Bums at the February 1972 meeting: I The word “handles” might be{ used to refer to the operating guides that might he employed 11 working toward the monetary objectives which wtre deemed bt1It calculated to serve the fund* mental objectives. There were twr,[,majorhandles-;lnvnIvingprimary emphasis on reservc!sand on mt{ney market ;uJndioiono+mdthe Committee was seeking to arrive It a judgment about their respective merits. (FOMC.PebNary 197:f, p. 25) 1 In the 1970-73 period we focused on, &is happened three to four times a year. Currently, the FOMCdoes it in Februaryand July n conjunction with the preparation of its report to T of the Humphrey-HawkinsAct. The FOMCwill Congress in accordance whh the provishfns .ieconsiderthe longer-term tugets more fri quently if economic conditions warrant.

a.

9.

k The sthff’s version of the MIT-PENN-SGRC model is a descendent of the FMP (Fedtral :eserve-MIT-PENN) model. SeeDeLeenjvand Gramlich (1969) for a general description of :he FMPmodel. 1

10.

Sincedata on M3 are only available monjhly and with a lag, the staff focuses on Ml and

11.

the FOMCthis way: : ,tiff member, Stephen AxLod The set of projection shown in the 5~~eboQk by different staff members empl#(ying different techniques. One

set is develop4 by applying the Board’s monthly econometric model. I might note in passing that lately some use has also been made of a wrkly model, but the results thus far have proved less relisble than rhose of the monthly model. Another :iet of projw tions is developed by staff members using wlholly judgmental methods. A ;erlior staff member-uwally myself-ca~nsiders these prelimulary f@res .md arrives at tentative decisions regs projections to be shown in theBlu&ook, which are t!hen with the staff group responsible for ihe content of that document. (FOMC, January 1972, p. 4!i) For completeness, it should be noted that other variables, slnch as M2, bank credit, reserves against private deposits, and member bank borrowings, often #appeared&onp with Ml and the funds rate itier each alternative., Since these other entries were conditiunsl on the funds rate and Ml vuwth &lee Ax&d and Beck, 1973, pp. 86.89), nothing is lost by ignoring them here, Iir !:hould rdso be noted that the vari~~usWiiabll?s were expressed ,as ranges. gee Lombra and Tot-to (1975) and our discussion below for elaboration. The “supply approach” encompasses the familiar view thlat the money stock is the product of a multiplier (M) and II reseerveaggregate (e.g., the monetary base or nonborrowed reserves). Within this approach, money stock control would be carried 0lr.t by forecasting the money multiplier and solving for the growth of, my, the base (Bl consister,t with a particular growth rate of the money stock W, M = .:nP,thus B = M/m. As Peter Keir, a senior- staff member, explained to the FOMC, the control of money with a reserve target also worl:e:1 through the demand side in the staff’s view: At any given point, bank demands for reserves d’epend on the volume of dep#Msrtsoutsbmling and the consequent need for re quired reserves. Under pr$::rentoperating procedures, if thr: growth in private depcbsits and ~smciated RPD’s [reserves against private deposits] apperus to be more ropid than de&&d, the Desk holds back on the provision of nonborrowed reserves. ‘I%isforces banks to seek out sources of resI:rves and, on the margin, to turn to Gle System discount window. In the first instance, except for a slight reduction in banks’ excess reserves, the Desk’s aclion does not reduce the flow of RPD’s: it only changes the mix between nonborrouqd and borrowed Ireserves. However, if the constraint on RPD’s persists, increased member hank borrowing L partly offset by smsiler increases-or reductions-in nonSorrowed ni:serves, and as banks seek alternative sources of funds, they bid up money market rate% In time, higher b&zest rates encourage the public to economize on deposits; and ilrowth in the monetary aligre@tes dews down. The sequence of relatiouships in this process is clear. The Desk holds back or1 the proviision of nonborrowed reserves, forcing banks into debt at the d&count window. This raises money market rates Higher interest mtes lead the public to economirre on deposits, and demands for RPD’s ar12then ilowerbd. In the last ianalysis, while the reserve tigirtening process starOs with the Desk holding back on the provision of nonborr>wed reserves, the acturl attainment of 4ower growth in total WD’n and the aggreg&tes rollects a lagged :esponse to :ligher interest m&es. (FOMC, Au@st 1972, p. 31) rfant asswniptions undierlying this proceduee are that the qusrtedy income prothe ~o~tbl~ interpolations of that forecast, are correct, tinat there is no shnificity pwblem over ia one- or hvomontb period, pnd that vet:y recent and prodeliations of rnonetaey growth from the assumed longer-run target c&nbe e atter, another aspc!ct of the ass~rn~~ absence of s~~t~~~~~~~ amounts to t?s~! b&i& &at the outside iag in policy excee& two to three moniths.

16.

ln the simplest case if IWD= ul Y - a2 /and we treat Y

for

thy

(~4;i=

i;tystMrate- (13 “consistent” 1

-

a-L

with

the

Worn4

BBgiven, then we can solve

alternative quantities

of money

demanded

D.

I

17.

Ignoring the deterministic case where ‘he mnney &land

18.

tion are both perfectly stable, tbis approach c~oviously has liffle in common with the i supply approa%h. I See the earlier dtations from Make1(1!/74) above.

function and money supply func-

P9.

Since the Fed staff is, of course mterested in th,! accuracy of its forecasts, formal (internal) analysis of “model,” and %onwnsus’* forecasting errors are periodbaily undertaken.

20.

The Fed’s outlook has not been totalilr ignored by re,searche)s.Pa earlier study by Hinshaw (1968), utilizii the Memomndum of ~3i&ussfon,had estimated the FOMC’srecognition lag; Hinshaw concbnled, ‘The recognitior patterns of the FOMCand the mean patterns of the eight business forecastersanalyzed by lie18are quite similar” (1968, y. 105).

21.

These include DRI, Whartbn, Chasf’ BEA, the American StatiatirxdAssociation, General I’ Electric, and Ray Fair. I McNees wms thhrt“ihe search for ithe best overall forecaster’ is fruitless. Perfonnauces depend entirely on the varizble(s) of rjrterest,on the horizon of the forecast,and sometimes even on whether levels or changes arl considered” (19760, p. 31). Zamowitz has exprersed 1 a similar attitude: “Even more hazar,lous, if not irresponsible, are attempts to grade forecasters on the evidence of how well tl\ey predicted change in a particularshort period, say, a year or a few years. Clearly, on any/individual occasion sOme forecasters will be ahead of others by sheer chance or for some ldiosyncra& reasOns” (1979, p. 2); ...the search for a

22.

consistently

superior

stone” (1979, p. 8).

forecaster is al: wt

E I

as peomising as the search for the phi)osophers’

23.

Thus. the MAE derivd from the Mclijeesdata are the averageof the MAEs over each in& vi&; forecaster, wits the exception !,f Ray Fair. McNees suggested excluding Fs.irbecause F&r’sobjective is different from the o j;lerfoeecssters (McNees, 1973).

24.

For elaboration, see ,~‘arnuwitz(1979,1;,. 6); McNees (1975, p. 9).

25.

ti,e McNees (1973, p’>e7-g; 1975, pp. i:-7). 1 A more detailed examination of the;Fed staff vb&isoach individual forecaster reinforces this generalization; the Fed staff is I@ more accurate than any individual forecasteracross alI variables, nor is ary individual forejaster consistently more accurate than the Fed.

26.

27.

One possibility would be to take the 1 &af’f’sforecasts and policy recomrqendationsand compare the “losses’*to actual policy arul various policy rules using the fmuework developed by Craine,Ilwenner, anti Berry (1978). 1

28.

We have computed .dl the 8t&&iCs~ discussed above for the various components of and ~rnp~ed them to MC the staff forecasts of consu i?o than U~ose from ot 100

2!k

New Economic hIicy on August 15,11971 with Phase I, a 9O-dayfteere on all wages and prkzs. It was folkowed by phase II on November 13.1971 in which wage ixueases were limited to 59 percent arut price increams to 2.5 percent. chase lJ remained in effect until January 12,1973, when a more hberaJPhase ill was introduced. MaYon began to increase under tile new guidelines and ‘Phase 3 112,” a 604~ freeze on rouiiilprices, was announced on June 13,1973. Phase P? ran from August l&l973 to April 30,1974, when the wage and price control propam ‘“expired.”

30.

See, for example, the assessment by 3. Charles Partee CPOMC,August 1972, pp. 1849X

31.

The

32.

On occasion, the expected stance of fiscal policy expkitiy affested the staff% monetary asaumptionl): To inaare that the full benefits of this f&d stimulus would carry tbrovgh, we have assumed a one-~percentrlgepohtlsrgm growth in money supply after the third quarter than in our standard projection. This would hold down the rise in money velocity and avoid a constriction in private fmanciai markets that would partially offset the expansive effects of larger Federai deficit fmancing. (FOMC,June 29,1%1, p. 31, J. CharlesPartee) Such interdependencies between monetary and fiscal policy repremnt an underdeveloped area in macroeconomicpolicy analy&h

33.

I the equation is estimated with the CochraneOrcutt transformation, the results are very simiiu; MrDcu is stiil statisticaily significant, while ~XJ~Wis not.

34.

If the lags are in fact long, this may help to explain why the deviations of money stIock growth from the long-term targets did not explain much of the staffs error fi faIrecsstingGNP3.

35.

In general, as one would expect, the staffs views ‘were very similar to the estimates derived horn the Fed’seconometric model (DeLeeuw and Gamlich, 1969).

36.

For example, in June 1973, J. Cba&6 P&Peesaid, “‘a one percentage point increase in the unemployment rate had been associated .with a 0.7 percentage point decline in the rate of increases in prices...” (FOMC,June 1973, p.42).

37.

We are indebted to Jerry Jordan and John Taylor for helping us to clarify this point.

38.

hesitbant Nixon inCmduced his

failure to adjust forecasts for differing poiicy assumptions, which typically reflects an absence of the relevant data,L one of the more seriou,sproblems aaxaziated with trying to compareforecastspurportedly produced by different models.

gee, for example FOMC (June 1970, p. 13). The r&tionship between unemployment,~wages,

and prices built into the staffs version of the YE% model is discussed in considerable detail by Pierce and PnrJer (1974). ;9.

?e results are robust in the sense that the lags ton the various variables were varied considerably and the relationships held. The lags reported in the table had the most explanatory power. It might be noted that the various explanatory variab~iesare highly co~zelated, and this probably accounts for the lack of statistical significance for some variables when 1 are included in the rame re b rton&c&e is supported by additional evidence;, we have ruin a huge number of regressions in the staff% forec& of, say, in.Nation for a given quarter as the dependent f independent variables. Jn general, deviations of monetary grswth es help to explain part of the revisions in the staff's forecasts. rate deviatc:d front the mid-pobits of the Etuebook ~~e~~~a~es~ we interamong thr. znorney stock alterriat~es.

42.

ft would also Ie~d one to pe/r fess attention to fluctuations in weekly and monthly data.

43.

The staff tracks the monetar iI aggregates between FOMC meetings and reviayr its forecasts

r

weekly as new data are receiv!‘S.

l aa an example, the percentage change in the Federal funds

44.

purposes of calculating arc elasticit&

the form&

used

alculating the percentage change in the money stock is digbtly stock must fiit be converted to levels before the percentage suming a $250 billion money stock, this percentage change is nplied interest elasticity is 9.0414/-6.06 = -0.0868. 45.

The data from 1970 were too/rketcby to use in these calculations.

46.

Simply put, the FBMC often found it difficult to believe that a small change in the Federal fuuds rate, say 10-25 basis f i Grits, would have virtually no effect on monetary growth over I to show some effect is M example of ths constraints on the the coming month. The presl+re forecasts, discussed above.

47.

For p::qoses of comparison, Lheshort-run (l-mouth) interest elasticity implied by Goldfeld’s 1 work 11973) is about -O&05, VThisis close to the elasticity in Table 11 foi the early period, but it P considerably smaller &an the staff’s elasticities for the later period. f

48.

Tbe results are not sensitive tti the alternative we used.

49.

.1 Thz staff’s monttlly model I rplies full adjustment in 3 quarters, while Goldfeld (1973, p. 606), using a quarterly I, estimates full adjustment in 7 to 10 quarters. Stanley Black (1973) has examined ying estimates in some detail.

50.

See, for exdmple, Prunner (11173), other papers in that vohtme, and the comments on Pierce and Thomson (137+) by Melt~~er(1974) and Goldfeld (1973).

51.

Quotes are plaeti around th, f word supply because the func ions developed by Brunner am. Meltzer, and discussed in det/il by Burger (1971), are not independent of money demand in the sense that they depend 01: the composition c:i’the public’s demand for money.

52.

Recent work b:l Zoharmes aid Rasche (1979) suggests that forecasting errors might be u:duced by using I supply appr&ch. \ The conspicuous sbsence of iscussions of velocity in these documents (or FQMC meeti,rgs) may be anotb*;r m.;nifestation of the lack of consistency. 1

53.

54.

55.

i

i

In an important study that chas not received the attention It deserves, Robert Weintraeb (1974) interviewed members of the FOMC regarding their views of the transmission meclra! to monetary control. His report complements our discussion nism and other issues relatin,; and is referred to in the ccncf rding section of this paper. I Achieving a clear consensus v:ss always a prime consideratiol,l. For example, after the Board of Governors narrowly rejecfed a request for a discount rree increase, Arthur Burns sdd, “‘information about this act III should be held in strict confidence by everyone preient today. It would be particular I I unfortunate if the information became pubhc and was irlrerpreted, as it probably wouldfbe, as ‘ds May 1971, p. 52).

:’ 56.

ack on his tenuri: at the Fed, arket Cammittee [evesled as much co&u;ion among ~Q~~cym~~e~sbS emor;g the!;

57.

To avoid misunderstanding,the discussion above should not be interpret& as being especially cr5tica.lof edecticism. With a committee- ma decisians, ecIecticism is inevitable snd p&ably desirable. Given uncertrinty, the social welfare function, aud soms nouzero pmbalbility that vuious competing th&es are %ue,,” it may very well be that policymakers wnold want ta pursue a pOticy that Blended theories so II to r&i&e Me maximum e~or. The readinesl to use more than one theory to guide policy is not the central problem; ecl.ect&$m impli~csa fleshing out of thear,es and implications which in general did not occur. Our thanks to Thomas Mayerfor wging us to clarify our p&ion.

58.

Bath economists are still at the Board. Mr. Axilrud is a&f Director folrMonetery policy, tea and Mr. Beck L;the s&f’%senior expert on monetary

59.

In actuality the staff presented the FOMCwith ranges for the money stocf:‘;rind ?ederal funds rate. The FOMG’sadjustments involved moditliestious of the ranges.

60.

As d&us& above, a not Infrequent occurrence during this period was tbe tendency for the FOMCto reduce the lower end of the range of monew growth fo.ra give:ntimis rate. Ile staff viewed the Bluebook range as a standarderror around a point estimate (the midpoint of the range]. In contrast, the FOMCwas using tbe range (and modificatitmlrof it) to moUify those on the committee who desired foster monetauy growth or, more pnmally, to express its willingness to tolerate leas rather than more monetary growth. In ow judgment, the fact thslt monetary growth was outside the rangesabout half the tIma, and that the funds rate was seldom allowed to vary outside its specfid range, reveals as much about FOMCpreferences es llhe various rangesselected. See also Kane (1974‘5

61.

We would not argue that the funds rate is the best measure of the effect of Fed policy over thir period.

62.

WC {and others) believe the above view is somewhat myopic. Rather than the funds market driving the rest of the ecowmy, one can view the pressures generated in the economy as conver&g on the funds market. In the short run, tiis Fed can p-it these pressuresto affect thr: funds rate or, as was more normally the case, the i%d can supply 0.1absorb rese&s As nelded to in&ate the funds rate fmm these pressures. However, 98 time passes and the pressures accumulate, the fed must give way unless it totally abandons .?s pursuit of economic stabilization.

63.

For example, if the Fed selected a funds rate of 5 percent at its June meeting arid 5 l/2 pe;rcent at Its July meeting, the entry for the dependent variable would be l/2 percent.

64.

We tried the nveraget,.wiation over the previous 1 to 6 months. The three month deviation provided the most explanatory power.

65.

Note that this could also occur by subsequently &justipg the target.

66.

Le Poole (1975) for elsboralion.

67.

From time to time, Burns reminderJthe Committee of the implicit constraint: “If there ww an outkxy about inflation, and if at the same tune interest rates were rising sharply, many people would. Linkthe diffMties facing the country with the interest rate policies of the Federal Reserve” (FOMC,March 1972, p. ‘76,Arthur Burns&Speakingof the Fed’s influence Ofli , “..Y interest rates did not rise appreciably, the environment wo e to a decision to reduce the wage guideline’* (FOMC,September 1972, rns). Such constraints may help to aplain the %nalysid accorded the P~~~~~~~ of monetexy growth during this period. At the April 1972 FOMC meeting. tm money supply growth rate of about 10 percent, Burns said that gt! of the business cysle-give~ tbc fact that there had been littile ac far more than a year of the so-called -he Qd ncrt consider ta t~~at~e: by histori sent palicy could ,evienbe res C, April 1972, p. 54,

68.

69.

70.

Similar piroblsmsmay well inb f,it the Fed in its “new’”reserve-bzredapproach to monetary control. ! ! ,& noted above, incoming data ;nd the forecasts are not independent.

in order to test for the effec I E of the experted change in economic ccnditiona we use I forecasts minus current condit ens aa the independent variable (e.g., lWF3 - Ih’ F). If tt,‘; i FOMC expected inflation or i.!af GNP growth to accelerate (or decelerate), it would b? expected that they would the funds rate setting accwrdingty.f.n theie reaction f ctions, the expected chanp in the inflation rate lacked significant expluitstory I;ower; the expected change iu real GNP ~\rowth was significant but had a negative sign. ‘Ele negative coefficient would indicate

current real GNP growth was rtrong, but expected to decline in the quarters ahead (Le.,

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