35

B. Alton Gilbert

R. ,4lton Gilbert isa vice president at the Federal Reserie Bank ofSt. Louis. Christopher A. Williams provided research assistance.

lilA Case Study in MonetaryControl: 1980-82

ORSEVERAL YEARS PRIOR to October 1979,the Federal Reserve implemented monetary policydecisions of the Federal Open Market Committee(FOMC) by targeting the federal funds rate. Staffof the Open Market Desk bought or sold govern-ment securities with the objective of keeping thefedera’ funds rate within a range specified bythe P0MG at its latest meeting.

The effects of monetary policy on the economyunder a procedure of targeting the federal fundsrate depend on the willingness of policymakersto move the funds rate target fast enough and farenough when the pace of economic activitychanges. In the 1970s, the tendency of the Fedto limit changes in the federal funds rate as thegrowth of total spending accelerated producedrapid money growth, resulting in acceleratinginflation in the late 1970s.

In response to the accelerating inflation, theFed in October 1979 adopted a procedure oftargeting nonborrowed reserves (NBR), TheFOMC stated that it adopted the NBR operating

procedure to promote better short-run control ofthe monetary aggregates, to better control infla-tion.1 Under the NBR operating procedure, theobjective of the staff of the Open Market Desk wasto keep the average level of NBR between FOMCmeetings at levels consistent with the short~runobjectives of the FOMC for growth of the mone-tary aggregates.

The Fed stopped targeting NBR in the fall of1982; the operating procedure used since then issimilar to targeting the federal funds rate.2

The NBR operating procedure generated a greatdeal of interest and controversy among econo-mists. There is a large literature on the conductof monetary policy under that procedure and,in recent years, economists have continued toanalyze the conduct of monetary policy duringthe three years ending in the fall of 1982.~Criticsof the NBR procedure contend that it caused ahigh degree of interest rate volatility, as illustratedin Figure 1. Some critics argue that the Fedactually did not change its operating procedure

For a description of the decisions by the FOMC at ts meetingin October 1979 see Board of Governors (1979, p. 974).

2 For a general description of the mechanics of various oper-ating procedures, see Gilbert (1985). Thornton (1988) pro-vides evidence that targeting borrowed reserves has beenessentially the same as targeting the federa’ funds rate.The following are selected references to the literature on theNBR operating procedure: Goodfriend (1983); Hetzel (1982,

1986); Hoehn (1983); Lindsey (1982, 1983); Lindsey andothers (1984); McCaIlum (1985); Poole (1982); and Spindtand Tarhari (1987). For recent addiflons, see Avery andKwast (1993)! Goodfriend and SmaU (1993) and Pearce (1993).

U

SEPTEMBER/OCTOBER 19-94

36

Figure 1Weekly Federal Funds Rate: January 3, 1979, to December 28, 1983

1983

Note: Shaded area encompasses the period of nonborrowed reserves targeting

in any fundamental way in October 1979.~Others

blame large errors in hitting money targets onimproper design of the operating procedure,especially in combination with lagged reserveaccounting in effect at the time.5

Whatever the flaws in the NBR targetingprocedure as a method of monetary control, theFederal Reserve did achieve its objective of sharplyreducing the rate of inflation during the periodin which it used that procedure (Figure 2). Thatsuccess in reducing the rate of inflation, however,came at the price of a very sharp recession(Figure 3).

This article extends the literature on NBRtargeting in two ways. First, it presents informa-tion relevant for interpreting policy actions thatwas confidential until several years after the end

of the period of NBR targeting: Federal Reservestaffprojections of total reserves (TR) over periodsbetween P0MG meetings, and staff estimates ofthe levels of TRover the same periods that wouldhave been consistent with FOMC objectives forgrowth of the monetary aggregates (the TR paths).8

In addition, this article extends the literature byanswering a question not answered by the otherstudies: Did the pattern of policy actions underthe N]E3R operating procedure reflect a consistentuse of the procedure for hitting short-run targetsfor growth of the monetary aggregates, given theinformation available to policymakers on staffprojections of TR and estimates of the TR paths?

This article may have implications for thechoice of operating procedure in the future. Ifthe Federal Resen~echose once again to target a

See Poo~e(1982).See McCallum (1985). Gilbert and Trebing (1982) providea description of tagged and contemporaneous reserveaccounting.

6 The weekly reports of the Manager of the Open MarketAccount, which included the projections and estimates ofTA, became public information five years after the dates ofthe reports. Cook (1989a, 1989b) presents some, but not

all, of the nformation on the NBR operating procedure pre-sented in this arficle. In parficular, Cook presents nformationon the gap between projections of TR and the TA path, buthe does not present the evets of those projections and esti-mates. Feiriman (1988) made extensive use of the datafrom the week’y reports of the Manager of the Open MarketAccount in an unpublished dissertafion.

Percent22.5

20

17.5

15

123

10

7.5

(10/3/79 through 9/29/82).

FEDERAL RESERVE BANK OF ST. LOUIS

3.7

Figure 2Rate of Growth in the GDP Deflator12

11

10

9

8

7

6

5

4

21975

Note: Rates of growth in the GOP deflator are two-quarter growth rates;the shaded area encompasses the period of nonborrowed reservestargeting (1 979:04 through 1982:Q3).

Figure 3Rate of Real GDP Growth

10

8

6

4

2

0

-2

-4

-61975

Note: Rates of real GDP growth are two-quarter growth rates; the shadedarea encompasses the period of nonborrowed reserves targeting (1979:04through 1982:03).

77 79I I

83 1985

SEPTEMBER/OCTOBER 1994

38

narrow monetary aggregate, the Federal Reservemight consider a change in operating procedure,perhaps to an NER operating procedure. Severalprominent monetary economists have expresseddissatisfaction with the lack of success of theFOMC in hitting its targets for money growthunder NBR targeting.7 It is not possible to evaluateNBR targeting as a method of monetary controlfrom the experience of 1979-82, however, withoutknowing whether policy actions were consistentwith use of the procedure for monetary targeting.

TARGETING NONBORROWEDRESERVES

This section describes the nature of the NBRoperating procedure. Most members of the FOMCat the special meeting on October 6, 1979, agreedthat the degree of monetary control under theprocedure of targeting the federal funds rate hadbecome unsatisfactory. They decided to adoptinstead a procedure that linked the supply ofNBR to their objectives for money growth, whilepermitting larger fluctuations in the federal fundsrate than under the previous procedure of federalfunds rate targeting,8

Ghanges in the Nature of I’OMC’Deciswns

Under the federal funds rate targeting proce-dure, the FOMC stated its objectives for growthof each monetary aggregate between meetings asa range of growth rates from a month before themeeting to a month after the meeting. Beginningwith its meeting on October 6, 1979, the FOMCbegan specifying its objectives for growth of themonetary aggregates as specific growth rates overperiods between meetings. Under the federalfunds rate targeting procedure, in contrast, theFOMC stated its objectives for money growth asranges of growth rates of the monetary aggregates.

Although the FOMC continued to specifyranges for the federal funds rate under the NBRoperating procedure, the ranges were widenedsubstantiafly. For most periods, the range was400 basis points, compared with ranges of 50 to100 basis points under the federal funds rateoperating procedure. The role that the widerranges for the funds rate played in the operating

procedure is unclear. On several occasions, theFOMC widened the range on the federal fundsrate when the rate threatened to move outsidethe range. On other occasions, the federal fundsrate was allowed to move outside its range forshort periods of time.°

At each meeting, the FOMC also made anassumption about the average level of borrowedreserves over the period until the next meeting.The staff used this “borrowings assumption” inderiving the target level for NBR.

Staff Projectimis of TR and Estimatesof the TR Path

After each FOMC meeting, the staff wouldestimate the average level of TR that would beconsistent with the FOMC’s objectives for growthof monetary aggregates until the next meeting.This was called the “TR path.” The target forthe average level of NBR between FOMC meetings,called the “NBR path,” was simply the TR pathminus the borrowings assumption of the FOMC.The objective of the Open Market Desk was tokeep the average 1eve~of NBR between FOMCmeetings equal to the NBR path.1°

Staff estimates of the TR path were based onFOMC objectives for Ml and M2 and estimatesof the following: (1) currency in the hands ofthe public; (2) average reserve requirements ondeposit liabilities in Ml and M2; (3) requiredreserves on bank liabilities not included in Mlor M2; and (4) excess reserves, The staffgenerallyrevised their esUmate of the TR path each week,based on new information about the factors thataffected the relationship between reserves andthe monetary aggregates.

Each time the staff estimated the TR path,they also projected the average level of TR overthe same period. Projections of TR were basedon estimates of the actual levels of the monetaryaggregates between FOMC meetings and the fourestimates specified above that were made inestimating the TR path. Each change in the gapbetween the staff projection of TR and their esti-mate of the TR path during an intermeeting period,therefore, reflected a change in the staff projec-tions of the monetary aggregates. Appendix 1illustrates the process of projecting TR and esti-

See Friedman (1984), McCaIIum (1985), Pierce (1984) andPoole (1982),See Board of Governors (1979, p. 974).See Gilbert and Trebing (1981) and Thornton (1982. 1983).

ID The staff of the Open Market Desk converted the NBA pathfor each ntermeeting period nto weekly and daily objectivesfor NBA. See Levin and Meek (1981), Meek (1982) andStevens (1981).

FEDERAL RESERVE BANK OF ST. LOUIS

39

Figure 4Supply and Demand for Reserves

Interest rates

mating the TR path for the first intermeetingperiod in Table 1.”

Since projections of TR and estimates of theTR path reflected information about the samefour variables specified above, projections of‘FR often were revised in the same direction asthe estimates of the TR path. In the three weeksending February 27, 1980, for instance, the projec-tions of TR and the TR path were both reduced,but by different amounts (Table 1). Changes inprojections of TR a~dTR paths over the 37 periodsin Table 1 had the same signs in all but eight ofthe periods. These comparisons indicate thatchanges in projections of TR over intermeetingperiods tended to reflect the same factors thatcaused the staff to revise its estimates of the TRpath: changes in factors that affect the relationshipbetween reserves and the monetary aggregates.

Graphical Representation of NBRThrge ting

Implementation of monetary policy underthis operating procedure is illustrated in Figure4, using the concepts of supply and demand forreserves and equilibrium in the market for reservesdescribed in Appendix 2.12 Levels of TR andNBR on the horizontal axis refer to average levelsfor the weeks between FOMC meetings. On thevertical axis, r~is the level of the discount rateand r~is the level of the federal firnds rate. TheTR path is illustrated as 11*. The NBR path is N,based on a borrowings assumption of W minusN. The objective of the Open Market Desk wasto keep the average level of NBR over intermeetingperiods close to the NBR path.

TR wouki he at the path level R* if the demand

Although the Federal Reserve began using the NBR operat-ing procedure n October 1979. the reports of the Managerof the Open Market Accouni did not inc{ude projections ofTR and TR paths on a con&stent basis unfit February 1980.Cook (1989b) discusses some of the thfficulties in derivingconsistent informafion from the weekly Reports of OpenMarket Operations on the conduct of monetary policy in thefirst few weeks under the NBA operafing procedure.

12 Lindsey (1982. 1983) describes how the procedure of target-ing NBR worked in pracfice by examThing the timing ofmoney growth r&ative to FOMO objectives, borrowedreserves, the federal funds rate and the discount rate. Meek(1982) descñbes n detail the operations of the Open MarketDesk under NBR targeting.

S

2

N R*R1Reserves

.SEPTEM BERIOCTO BERi 994

40

Figure 5Tightening of Monetary PolicyInterest rates

—-

Figure 6Federal Funds Rate Targeting

Interest rates

S2 S1

2

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I I

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F42 N, R* R1Reserves

4

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FEDERAL RESERVE BANK OF ST. LOWS

41

curve for reserves was D1, From that initialposition. consider the effects of an increase inthe demand for reserves, illustrated by a shift inthe demand curve to ‘~2’which reflected anincrease in the demand for money.t3 TR wouldrise to B1, which is above the TR path. Since thestaff of the Open Market Desk would keep NBRat the level N, the rise in TR to R1 would involvean increase in borrowed reserves. The federalfunds rate would rise from r~tor~,inducing thehigher level of borrowings. Without any addi-tional policy actions, the money stock wouldtend to exceed the FOMC’s objectives becauseTR would be above the path level.

During some intermeeting periods, the FederalReserve took no policy actions in response tochanges in the demand for reserves. In the caseillustrated in Figure 4, FOMC members consid-ered the rise in the federal funds rate from r~to

an adequate response to the shift in demandfor reserves, even if growth of the monetaryaggregates exceeded objectives established atthe last FOMC meeting.

Experience eventually convinced some FederalReserve officials that rapid policy responses werenecessary to close the gap between actual moneygrowth and FOMC objectives once money growthstarted to deviate substantially from FOMC objec-tives.14 During some periods between FOMCmeetings, the Federal Reserve adjusted the levelof the NBR path or the discount rate to reducethe deviations of the money stock from desiredlevels. The Federal Reserve took such policyactions when the deviations appeared to reflectmore than transitory movements in the moneydemand schedule, perhaps due to changes inaggregate spending.15

In the situation illustrated in Figure 5, thestaff projects TR to be R1, which is above the TRpath (R*). The policy action illustrated in Figure 5is a reduction in the NBR path from N1 to N2,which involves an increase in the borrowingsassumption from R~minus N1 to R* minus N2.Due to the inelastic demand for reserves overintermeeting periods, the average level of TRwould decline to B2, still above the TR path, but

the reduction in NBR would produce a sharpincrease in the federal funds rate, The Fed couldhave the same effect on the funds rate and TR bykeeping NBR at N1 and raising the discount rateto r~. In taking policy actions that reduced butdid not eliminate the gap between projections ofTR and path levels, Fed officials emphasized theassumption that sharp increases in interest rateswould, over time, reduce the quantity of moneydemanded. This article does not model theassumed feedback mechanism based on moneydemand as a function of lagged interest rates.1°

One of the issues policymakers confrontedin determining whether to adjust the NBR pathor the discount rate when TR was projected todeviate from path levels involved their confi-dence in the projections of TR and estimates ofthe TR path. Studies conducted during the periodof NBR targeting indicated large errors in theseprojections and estimates.” These errors wouldtend to be smaller later in intermeeting periods,when actual observations were available for partof the periods. Observations in Table 1 are con-sistent with the view that the projections andestimates of TR were subject to large errors, andthat the errors affected the timing of policyactions. Table 1 indicates that often there werelarge revisions to the projections of TR and toTR paths over intermeeting periods. Also, onthose occasions when policymakers took actionsbetween FOMC meetings, they generally actedat least two weeks after an FOMC meeting, whenthey might assume that the projections and esti-mates were more accurate.

Gni.pbical Representation of Thrgehngthe Federal .Funds Rate

One way to highlight the nature of NBR tar-geting is to contrast the open market operationsfor a given situation under NBR targeting andunder the procedure of targeting the federal fundsrate. Suppose the demand for reserves increases,reflecting an increase iii the demand for money.Under the NBR targeting procedure, the staff ofthe Open Market Desk would continue to targetthe same average level of NER over the interme-diate period (as in Figure 4). If the policymakers

13 If the shift in demand for reserves resulted from an increasein average reserve requirements on deposit liabilities orexcess reserves, the TR path would shift to the right. Therise n the demand for reserves would not affect the federa’funds rate.

‘~ See Axilrod (1981, pp. A23 - A24).15 See Lindsey (1983, p.5).

~6 For references to this feedback mechanism from changes ninterest rates to changes in the quantity of money demand-ed, see Axijrocl (1981, p. A23) and Lindsey (1983).

17 See Levin and Meek (1981) and Pierce (1981).

SEPTEMBER/OCTOBER 1994

42

wished to limit the deviation of money growthfrom FOMC objectives, they would reduce thetarget level of NBR (as in Figure 5). Under thefederal funds rate targeting procedure, in contrast,the Fed would respond to an increase in thedemand for reserves by increasing the level ofNBR enough to keep the federal funds rate un-changed, as illustrated in Figure 6. This contrastprovides a standard for judging whether Fedactions in the three years ending in the fall of 1982were consistent with use of the NBR operatingprocedure for targeting the monetary aggregates.

INTERPRETING FEDERAL RESERVEACTIONS

The framework of supply and demand forreserves is used to interpret monetary policyactions under the NBR operating procedure,as recorded in Table 1.’°

Policy Actions in SelectedIntenneeting Periods

This section illustrates use of the NBR operatingprocedure for implementing monetary policyduring the first two intermeeting periods coveredin Table 1. These periods illustrate very differentpatterns in use of the procedure. During the firstperiod, after the FOMC meeting on February 4-5,1980, the Fed reduced the NBR path and raisedthe discount rate when projections of TR beganto rise relative to the TRpath. This period illus-trates aggressive use of the procedure for monetarytargeting. During the second period, after theFOMC meeting on March 18, estimates of TRdeclined sharply relative to the TR path, but theFed made no adjustments in the NBR path ordiscount rate in response.

The period from the FOMC meeting onFebruary 4-5, 1980, until the next P0MG meetingwas divided into two periods of three weeks eachfor purposes of projecting the average level of TRand estimating the TR path.1°As of February 7,the staff projected an average level of TR for the

three weeks ending February 27 that was only

$38 million below the initial estimate of the TRpath. By February 15, however, the projectionsand estimates of TR had changed substantially,with TR projected to be $313 million above thepath level. As of February 15, the Fed reducedthe target for NBR by $67 million relative to thenew estimate of the TR path. The reduction inthe NBR path was a restrictive policy action.The staff of the Open Market Desk responded toa reduction in the NBR path by adjusting its plansfor open market operations to hit a lower averageof NBR over the intermeeting period. The Fedalso raised the discount rate from 12 percent to13 percent, effective February 16, another restric-tive policy action.

Even though the Fed took these restrictivepolicy actions over the three weeks endingFebruary 27, the average level of TR was $272million above the final estimate of the TR path.These observations raise an issue about how tointerpret monetary policy actions under the NBRoperating procedure. One view of the conductof monetary policy during the three weeks endingFebruary 27 would be that policy actions wereinconsistent with hitting FOMC targets for mon~etary aggregates because TR was above the TRpath. Interpretation of these actions, however,must account for the way that the Fed operatedunder lagged reserve requirements, which werein effect during the period of NBR targeting.Required reserves for each week were determinedby deposit liabilities two weeks earlier. The Fedoperated under the constraint of supplying eachweek enough reserves to meet required reserves,either through open market operations or throughthe discount window. For the three weeks endingFebruary 27, required reserves were based ondeposits over the three weeks ending February 13.By the time the Fed took policy actions onFebruary 15, therefore, required reserves for thethree weeks ending February 27 were predeter-mined.

This article evaluates whether policy actions

IS Information on the conduct of monetary poilcy ri Cook(1 989a, 1 989b) is similar to that in columns six through nineof Table 1. One difference nvo~vesthe dating of the differ-ence between projections of TR and the TR path (columnsix) and policy actions (cokjrnns seven and eight). Thedates in Table 1 are those in the weekly Report of OpenMarket Operations from the Federal Reserve Bank of NewYork. Cook dates the gap between the projecflons of TRand the TA path and dates policy actions as of weeks en&ing on Wednesdays, thus reflecting the changes thatoccurred during each seven-day period. For this reason, thedates in Table 1 and in Cook (1989a, 1989b) do not match.

When periods between FOMC meetings were longer thanfive weeks, the staff divided the intermeetirig periods intotwo subperiods for purposes of setting TA paths and project~ing the average levels of TR. The staff divided these inter-meeting periods into subperiods to avoid setting weeklyobjectives for NBR just after an FOMC meeting based onestimates of variables for six or seven weeks into the future.The staff considered their estimates that far frito the future tobe so unreliable that revisions in their estimates over inter-meeting periods could generate unnecessary noise in week~iy objectives for NBR.

FEDERAL RESERVE BANK OF ST. LOLMS

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were consistent with use of the NBR procedurefor monetary control by examining the directionand magnitude of policy actions in relation to thegaps between the projections of TR and estimatesof the TR path at the time of the policy actions.From this perspective, policy actions during thethree weeks ending February 27, 1980, wereconsistent with use of the NBR operating proce-dure for monetary control.2°

As of February 29, the staff projected thatTR would be $626 million above path level inthe second intermeeting period (the three weeksending March 19). That day, the Fed reduced itstarget for NBR by $300 million relative to the TRpath to limit the size of this deviation of TR fromthe path. As a result of that reduction in the NBRpath, banks were forced to obtain more of thereserves from the discount window to meet theirrequired reserves. The federal funds rate rose by155 basis points in the week of this policy action.

Projections later in the period indicated thatthe gap between TR and the path level was con-tinuing to grow. On March 14, the Fed imposeda surcharge of 3 percent on discount windowborrowings by banks with deposits of $500 millionor more that borrowed frequently, as part ofPresident Carter’s program of credit controls andmonetary restraint.2’ During this first intermeetingperiod examined in Table 1, the Fed took fourpolicy actions that were appropriate for monetarycontrol with TR projected to exceed the pathlevel: two reductions in the NBR path and twoincreases in the discount rate.

The FOMC met again on March 18, four daysafter President Carter announced a program ofcredit controls and monetary restraint. In supportof the President’s program, the FOMC tightened

monetary policy by increasing the borrowingsassumption substantially (Table 4). With givenobjectives for growth of the monetary aggregates,a larger borrowings assumption implies a lowerNBR path and, therefore, a more restrictive mon-etary policy.

As of the beginning of the period after theMarch FOMC meeting (that is, the five weeksending April 23, 1980), TR was projected to beapproximately equal to the TR path. Later in thatperiod, the projection of TR was reduced and theTR path increased, producing a widening gapbetween projected TRand the path level. The Fed,however, took no policy actions to limit the sizeof that gap. The actual level of TR ended up$435 million below the final estimate of theTR path.

General Patterns in Policy Actions

Examination of policy actions in Table 1 forthe entire period from February 1980 throughOctober 1982 indicates several patterns:22

Variable Pattern in the Use of Policy Tools —

For given staff projections and estimates of TR,policy actions were highly variable. As noted forperiods examined above, widening gaps betweenprojections of TR and path levels induced promptand substantial adjustments of policy tools insome periods but not in other periods. To iden-tify relevant periods when the Fed did not takepolicy actions, it is necessary to specify a criterionfor identifying relatively large deviations of TRfrom the TR path. This paper uses $200 millionor more as the size of a large deviation, based onthe following reasoning. Over the period of NBRtargeting, TR was approximately $40 billion. Agap of $200 million is one~ha1fof 1 percent of

20 The last observation for TR over each intermeeting periodreflects the nformation available to Fed staff as of the end ofthe period. For instance, the last estimate of TR for thethree weeks ending February 27, 1980, was the staff esti-mate as of February 27. The data for TR over iritermeetingperiods reflect the information available to policymakers atthe time, riot subsequent revisions to TA.

21 For more details on the discount rate surcharge, see Boardof Governors (1980, pp. 315-18). For a descñptiori of thecredit control program, see Gilbert and Trebing (1981).

22 This article does not include among the policy actions someadjustments to the supp~yof NBR which might properly beclassified as policy actions. Levin and Meek (1981) mentionthat on some occasions the staff of the Open Market Deskbased open ma~I<etoperations on movements in the federalfunds rate, rather than their numbers on factors aft ecUngNBR. As they describe those actions, the obect~vewas touse the federal funds rate as an indicator of errors in theirnumbers on factors affecting NBR. They do not indicate thatthese open market operations based on movements in the

federal funds rate interfered with hftting targets tor NBA overintermeeting periods.

Other adjustments to the supply of NBR raise more ques~tions about adjustments to the supply of NOR that should belabeled as policy actions. At times, the staff adjusted thesupply of NBR to prevent arge movements in borrowingsand in the federal funds rate just prior to FOMC meefings.Weekly Reports on Open Market Operations mention that attimes the staff did not make the full adjustments to the TRpath that were ndicated by theft information on factorsaffecting the r&ationship between reserves and the mone-tary aggregates, and the reports refer to occasions when thestaff deliberately allowed NBA to deviate from its path level,to avoid forcing large changes in borrowed reserves justbefore FOMC meetings. Table 1 Umits its ist of poflcyactions to those identified clear’y as policy actions n theReport on Open Market Operations.

SEPTEMBER/OCTOBER 1994

Zn

$40 billion. An error of approximately one-halfof 1 percent in hitting a target for an aggregateover a month, compounded over a year, wouldbe an error of 6 percent, which could be inter-preted as a substantial error. TR deviated fromthe TR path by at least $200 million, and the Fedtook no policy actions in response, in each of theperiods after the FOMC meetings on March 18,1980, and December 18-19, 1980.

Directions of Policy Actions Were Appropriatefor Monetary Control — Prior to the fall of 1932,the direction of each policy action between FOMCmeetings was appropriate for monetary control.When TR was projected to be above the path level,policy actions included reductions in the targetfor NBR relative to the TR path or increases in thediscount rate. The Fed took the opposite typesof policy actions when TR was projected to bebelow the path level.23

The only exception to this pattern occurredon February 25, 1981. The Fed reduced the NBRpath by $166 million when the staff projected TRto be $351 million below the TR path. At thattime, the growth of M2 and M3 exceeded FOMCobjectives, whereas Ml was growing more slowlythan the target set by the FOMC at its meeting onFebruary 2-3, 1981. TR was below the TR pathbecause required reserves predominately reflectedthe required reserves on deposits in Ml. InFebruary 1981, the FOMC decided to put moreweight on its objectives for M2 and M3 than onMl. Therefore, the FOMC decided to reduce thesupply of NBR to limit the growth of M2 and MiThis reduction in the NBR path on February 25,1981, was consistent with use of the NBR proce-dare for monetary targeting, even though TR wasprojected to be below the path at the time of thepolicy action.

The change in the NBR target on September 24,1982, in contrast, illustrates a policy action thatwas inconsistent with use of the NBR operatingprocedure for monetary control. It is generally

recognized that by the fall of 1982, the Fed hadabandoned use of the NBR operating procedurein favor of smoothing short-term interest rates.24

For operational purposes, however, the staffcontinued to calculate the numbers that had beenimportant for conducting policy under the NBRprocedure. After the FOMC meeting on August24, 1982, projections of TR were increased gradu-ally relative to estimates of the TR path, and bySeptember 24, the gap had reached $495 million.A policy action appropriate for monetary targetingwould have been a reduction in NBR. Instead,the Fed increased the target for NBR, to limit therise in short-term interest rates in response to therise in demand for reserves. This action, the kindof policy action illustrated in Figure 6, providesone way to date the end of the NBR operatingprocedure.

Size of the Policy Actions — Table 2 lists thechanges in the NBR path between FOMC meetingsthat the Fed classified as policy actions. Thesechanges in the NBR path generally were abouthalf or less of the gap between TR projected bythe staff and the TRpath at the time of the policyactions. These observations indicate that evenat those times when the Fed adjusted the NBRpath as a policy action, the Fed was willing totolerate large deviations of TR from the path overintermeeting periods. The emphasis in the policywas bringing the levels of the monetary aggregatescloser to FOMC objectives over time. The policydid not call for actions to force immediate shiftsof the levels of the aggregates back to the levelsspecified in FOMC directives.

Policy Acions Did Not Cause Al! of the SharpFluctuations in Interest Rates — The federalfunds rate was more variable during the periodof NBR targeting than in surrounding periods(Figure 1). These large fluctuations generated alot of complaints from market participants andfrom economists critical of the procedure. Inevaluating NBR targeting as a method of imple-menting monetary policy, it would be useful to

23 Some changes in the gap between the NBR path and theTR path were abeed technical adjustments” to the supplyof NBR, not poilcy actions. The purpose of these technicaladjustments was to offset the effects on interest rates ofchanges ri the relationship between borrowings arid thespread between the federaf funds rate and the discount ratefor TR. At times, the staff concluded that there were pers~s-tent changes in the quantity of reserves borrowed by banksfor given spreads between the federal funds rate and thediscount rate. In terms of Figures 1 and 4, there appearedto be shifts in the slope of the supply curve of reserves. Atthose times, the staff adjusted the supp’y of NBR to offsetpossible effects on interest rates of such changes in the

behavior of banks. Tab~e1 does not nclude these adjust-ments to the supply of NBA because the purpose of this arti-cle s to examine patterns of policy actions under the NBRoperating procedure. Reports by the Manager of the OpenMarket Account distinguish between technical adjustmentsand changes n the supp’y of NBA labeled policy actions.

24 See Thornton (1983, 1988).

FEDERAL RESERVE BANK OF St LOWS

Cl

Table 2

Size of Chanrs tn the NonborrowedReserves Path

Change ntiS NBRpath as a percentageeflhemo*current

Changem statfprojeøtonottheçNfl path tbtg~pbetween

flate (mftrronto*4ouw~) ThstidtheiR path

1980

15 2<4%212 4G05 ÷100WE ES

Pm 6tIff 00I Sb Si

49S

2250

Se 2S4 S

1S8Z

4$

tN$ft~ *duced* times*eGTh ws~e~4jGCtS bebans patb

know whether the relatively large fluctuationsin interest rates under NBR targeting reflectedfrequent, aggressive policy actions to hit short-runmoney targets. Perhaps fluctuations in the federalfunds rate under a NT3R targeting procedure wouldbe substantially smaller than the experience of1980-82 if the Fed used the procedure less aggressively in attempting to hit short-run money targets.In contrast, mai~yof the relatively large weeklychanges in the federal funds rate may have

occurred simply because the Fed placed lessweight on limiting interest rate fluctuationsunder the NI3R operating procedure than otheroperating procedures.

It is possible to determine whether the rela-tively large weekly fluctuations in the federalfunds rate reflected the effects of policy actions byexamining their timing and the timing of policyactions.25 Table 3 examines the pattern of policyactions during the weeks in which the federalfunds rate changed by 100 basis points or more.Changes in weekly average levels of the federalfunds rate of 100 basis points or more were rela-tively common during the three years endingin September 1982. For example, Table 3 list29 weeldy occurrences. During the three yearsending in September 1979, in contrast, there wereno weeks when the federal funds rate changedby as much as 100 basis points. During the threeyears ending in September 1985, the three yearsfollowing the period of NBR targeting, the federalfunds rate changed by 100 basis points or morein only five weeks.

Seven of the relatively large changes in thefederal funds rate in Table 3 occurred in the weeksjust after FOMC meetings. For instance, the fed~oral funds rate rose 154 basis points in the weekending March 26, 1980, the first week after theFOMC meeting on March 18. The decisionsof the FOMC at its meeting on March 18, 1980,can be characterized as a tightening of monetarypolicy. Table 4 illustrates the shift in monetarypolicy at the FOMC meeting on March 18 in termsof an increase in the borrowings assumptionrelative to the level set at the prior meeting:from a level of $1.25 billion set at the meetingon February 4-5 to a level of $2.75 billion seton March 18. The rise in the federal funds ratein the week ending March 26 is consistent witha tightening of monetary policy at the FOMGmeeting on March 18.

The federal funds rate fell by 244 basis pointsin the week ending April 30, 1980, which was thefirst week after the FOMC meeting on April 22.At its meeting on April 22, the FOMC decided toreverse the tightening of monetary policy at itsprior meeting. Table 4 illustrates the easing ofmonetary policy at the meeting of April 22 with

25 Cook (1 989a, 1 989b) conducted a similar analysis of thetiming of policy actions and changes n the federa’ funds rateduring the period of NBR targeting. Cook invesfigated thedegree to which changes in the feder& funds rate over peri-ods between FOMC meetings could be exp’ained in terms ofpolicy actions. Cook concluded that roughiy two-thirds of

the changes in the federal funds rate were due to judgmen-tal actions of the Federal Reserve. This article, in contrast,examines the tim~ngof relativ&y large weekly changes n thefederal funds rate and poUcy actions.

SEPTEMBER/OCTOBER 1994

52

N N

~Tibie ~

Funds R$eOMn9SJnThG~

~z t=tr ~= lEE2OndsScbfteflPsb~S week

N N

N N N

N H ~ X

N N N N N

N\~f~ \\ 44~ ~ N ~C N

N

> N N /N \ ~

N N N

N + N N ~ N N

\~ \\ N N N N N N

~ to~ N N N NN NN

N\ t N~ ~ N \~N~NN /~

\NN e~\ N NN \ ~ z ‘~~i~/NN Ut N N

~\\ N N /

/ ~N K

t iga N N N ~E~H~\ N ~N

N~ \\ N

7i5~ /

1982 1~1JZ 102

\2~241114 N~\

N

\\ 112

-Is?+1

N -117

FEDERAL RESERVE BANK OF ST. LOthS

5.3

tions at the FOMC meetings, and relatively large

Tble4InLtlaLAáumptI*ns forBorrowed

\\y roM& 1~8O42~~Atftatasau iptoiStot

Dat iteetMg

~ t%G~

75GAp\MO~ /

N

~ \\ \N

N

N N N~°

iS~\~~\\~ ~N ~ N

NN \

4~* ~S/ /\~ ~%h~N\\~N~~tVJ4 9~\ ~W ~.

NNN\N~s)~ 2~ N N

~

Decemberz ~\\\

\NNN

~

S

Mars N t 150

* I BOG~

Octqbe&250

~DSembe2O-21

the decline in the initial borrowings assumptionto $1.375 billion.

Comparison of Tables 3 and 4 illustrate thisconsistent pattern: On those occasions whenthe federal funds rate changed by over 100 basispoints in the first week after an FOMC meeting,increases in the federal funds rate coincidedwith increases in the initial borrowings assump~

decreases in the federal funds rates were associ-ated with reductions in the initial borrowingsassumptions. This pattern prevailed until the fallof 1982, when the Fed had largely abandoned useof NEW targeting. Thus, some of the relativelylarge changes in the federal funds rate reflectedpolicy actions initiated at the time of FOMCmeetings.

Of the 29 weeks in Table 3 in which the federalfunds rate changed by 100 basis points or more,15 were not the first week after an FOMC meetingor weeks of changes in the NJ3R path or the dis-count rate. Many of the relatively large weeklychanges in the federal funds rate, therefore,reflected the relatively low weight the Fed attachedto limiting fluctuations in the federal funds rateunder the NBR operating procedure. Also, theeconomy was very volatile during the periodof NBR targeting. Influences other than the con-duct of monetary policy may have contributedsubstantially to the variability of interest ratesover this period.

CONCLUSIONS

The conduct of monetary policy in the UnitedStates from October 1979 through the fall of 1982has important implications for the design of pro-cedures for targeting monetary aggregates today.This is the only period in which daily open marketoperations were tied directly to objectives of theFOMC for growth of the monetary aggregates. Itis our closest approximation to short-run monetarycontrol in the United States. Some critics of theconduct of monetary policy in this period haveconcluded that errors in hitting the money targetsof the FOMC reflected problems inherent in thedesign of the procedure.

This article presents information on theconduct of monetary policy in this period ofnonborrowed reserves (NBR) targeting not avaihable in other published studies. This informationincludes Fed staff projections of the actual levelsof total reserves (TR) over periods between FOMCmeetings and staff estimates of the average levelsof TR between meetings that would have beenconsistent with FOMC objectives for moneygrowth (the TR paths). Using this information,we can examine the timing and size of policyactions in relation to the information availableto Fed policymakers at the time.

Examination of policy actions during theperiod of NBR targeting yields the following

SEPTEMBER/OCTOBER 1994

observations. First, the pattern of policy actionsdoes not reflect consistent use of the procedureover time for monetary targeting. During someintermeeting periods in which the staff projectedthat TR would deviate substantially from the TRpath, the Fed took no policy actions, whereasin other periods the Fed took aggressive actionsconsistent with monetary targeting. Second,when the Fed did take policy actions, they werein the directions appropriate for monetary controLgiven the staff projections and estimates availableat the time. This observation contradicts asser-tions that there was no change in the operatingprocedure in October 1979. Third, the magnitudeof policy actions often was small in relation tothe gap between the projection of TR and the path.These three observations have implications forinterpreting the three years ending iii the fall of1982 as au experiment in monetary targeting. Thecommitment of policymakers to hitting short-runmoney targets varied over those three years. Anyconclusions derived from data for those threeyears concerning NBR targeting as a method ofmonetary control should account for variationover time in the commitment of policymakers totake actions appropriate for monetary control.

The fourth observation concerns the degree ofinterest rate variability under a procedure of NERtargeting. While several of the relatively largeweekly changes in the federal ftmds rate coincidedwith the timing of policy actions, the Fed took nopolicy actions at the time of some relatively largefluctuations in the federal funds rate. hiterest ratefluctuations during the period of NBR targetingreflect use of an operating procedure which leftthe federa’ funds rate largely unconstrained withinwide bands. It is difficult to extrapolate from thisexperience to the degree of weekly interest ratevariability that would exist under use of an NURprocedure now. This experience, however, isconsistent with the view that targeting NBR forpurposes of short-run monetary control wouldtend to increase weekly interest rate variability.

REFERENCESAvery, Robert B.. and Myron L. Kwast. “Money and Interest

Rates Under a Reserves Operating Target,” FederalReserve Bank of C’eveland Economic Review (secondquarter 1993), pp. 24-34.

Axilrod, Stephen H. “US. Monetary Poilcy in Recent Years:An Overview,” Federal Reserve Bulletin (January 1985),pp. 14’24.

‘Monetary PoUcy, Money Supply, and the Feder&Reserve’s Operating Procedures, Federal Reserve Bulletin(January 1982), pp. 13-24.

“Overview of Findings and Evaluation’ NewMonetary Control Procedures, Federal Reserve Staff Study,vot. (February 1981).

Board of Governors of the Feder& Reserve System.‘Announcements,” Federal Reserve Bulletin (April 1980),pp. 314-24.______ ‘Record of Policy Actions of the Federal Open MarketCommittee,” Federal Reserve Bulletin (December 1979),pp. 972-8.

Cook, Timothy. ‘Determinants of the Federal Funds Rate:1979-82,” Federal Reserve Bank of Richmond EconomicReview (January/February lgSga), pp. 3-19.

______ “Determinants of the Federal Funds Rate: 1979-1982,”Federal Reserve Bank of Richmond Working Paper 88-7(March 1989b).

Feinnian, Joshua, ‘Art Analysis of the Federal Reserve’sNonborrowed Reserves Operating Procedure.” Ph.D.dissertation, Brown University, May 1988.

Friedman, Milton. “Lessons from the 1979-82 Monetary PolicyExperiment” The American Economic Review (May 1984),pp. 397-400.

Gilbert, R. Alton. “Operating Procedures for ConductingMonetary Policy,” this Review(February 1985), pp. 13-21.

______ and Michael E. Trebing. “The New System ofContemporaneous Reserve Reqthrements” this Review(December 1982), pp. 3-7.

and ______ - “The FOMC fl 1980: A Year of ReserveTargeting,” this Review (August/September 1981), pp. 2-22.

Goodfriend, Marvin. “Discount Window Borrowing, MonetaryPolicy, and the Post-October 6, 1979 Federal ReserveOperating Procedure,” Journal of Monetary Economics(September 1983), pp. 343-56.

______ and David H. Small, eds. Operating Procedures andthe Conduct of Monetary Policy: Conference Proceedings,Finance and Economics Discussion Series, Board ofGovernors of the Federa’ Reserve System (March 1993).

Hetzel, Robert L. Monetary Policy n the Earty 1980s,”Federa’ Reserve Bank of Richmond Economic Review(March/April 1986), pp. 20-32.

______ ‘The October 1979 Regime of Monetary Control andthe Behavior of the Money Supply ri 1980,’ Journal ofMoney, Credit and Banking (May 1982), pp. 234-51.

Hoehn, James G. “Recent Monetary Control Procedures andResponse of Interest Rates to Fluctuations in MoneyGrowth,” Federa’ Reserve Bank of Dallas Economic Review(September 1983), pp. 1-10.

Levin, Fred, and Paul Meek. “Implementing the NewProcedures: The View from the Trading Desk,’ NewMonetary Control Procedures, Federal Reserve Staff Study,vol. I (February 1981).

Luidsey, David E. “Nonborrowed Reserve Targeting andMonetary ControL,” n Laurence H. Meyer, ed., ImprovingMoney Stock Control: Problems, Solutions, andConsequences, Economic Policy Conference Series, co-sponsored by the Center for the Study of American Businessat Washington Universfty and the FederaE Reserve Bank ofSt. Louis, Kluwer-Nijhotf, 1983, pp. 3-41.

______ “Recent Monetary Devefopments and Controversies!”Brookings Papers on Economic Activity (January 1982),pp. 245-68.

FEDERAL RESERVE BANK OF ST. LOUIS

55

______ arid others. “Short-Run Monetary Control: Evidence Poo’e, William. “Federal Reserve Operating Procedures:Under a Non-Borrowed Reserve Operating Procedure,” A Survey and Evaluation of the Historical Record SinceJournal of Monetary Economics (January 1984), pp. 87-111. October 1979,” Journal of Money, Credit and Banking

(November 1982, part 2), pp. 575-96.McCaIIum, Bennett. T. ‘On Consequences and Criticisms ofMonetary Targeting, Journal of Money, Credit and Banking Spindt, Pau’ A., and Vefa Tarhan. ‘The Federa~Reserve’s New(November 1985, part 2), pp. 570-97. Operaung Procedures: A Post Mortem,” Journal of Monetary

Meek, PauL U.S. Monetary Policy and Financial Markets, Economics (January 1987)! pp. 107-23.Federa’ Reserve Bank of New York, 1982. Stevens, E. J. “The New Procedure,” Federat Reserve Bank of

Pearce, Doug’as K. ‘Discount Window Borrowing and Federal Cleveland Economic Review (summer 1981), pp. 1-17.Reserve Operating Regimes,” Economic Inquiry (October1993) pp 56479 Thornton, Daniel L. “The Borrowed-Reserves Operating

- Procedure: Theory and Evidence; this ReviewPierce, David A. Trend and Noise in the Monetary Aggregates,” (January/February 1988), pp. 30-54.

New Monetary Control Procedures, Federal Reserve StaffStudy, vol.11 (February 1981). - The FOMC in 1982: De-eniphasizing Ml,” this

Review (June/July 1983), pp. 26-35.Pierce, James L. “Did Financial Innovation Hurt the Great

Monetarist Experiment?” The American Economic Review ______- “The FOMC in 1981: Monetary Control in a Changing(May 1984), pp. 392-6. Financiat Environment,” this Review (April 1982), pp. 3-22.

SEPTEMBER/OCTOBER 1994

56

Appendix I

Illustration of Staff Projections and Estimatesof Total Reserves

This appendix describes the steps involved instaff estimates of the TR path and projections ofTR for the intermeeting period after the FOMCmeeting on February 4-5, 1980. The staff dividedthe intermeeting period into two subperiods ofthree weeks each, ending on February 27 and

March 18. They made such divisions when theperiods between meetings were longer than fiveweeks to avoid using projections of variablesseveral weeks into the future in determining thesupply of NBR early in an intermeeting period.

To aid in clarifying the timing of relationshipsbetween deposits and reserves, Table Al presentsa calendar of January and February 1980. At itsmeeting on February 4-5, the FOMC specifiedits short-run objectives as growth of Mi-B at a5 percent rate and M2 at a 6.5 percent rate overthe first quarter of 1980. To estimate the TR pathfor the three weeks ending February 27, the staffwould do the following calculations:

1. Project the weekly levels of Ml and M2 growingat the desired rates from mid-December throughthe three weeks ending February 13. Deposits

over the three weeks ending February 13 deter-mine required reserves over the three weeksending February 27. These weekly levelsare projected from the seasonally adjusteddata for December and then converted intononseasonally adjusted levels using the sea-sonal factors for those weeks.

2. Estimate currency in the hands of the public,not seasonally adjusted, for the three weeksending February 13.

3. Subtract the estimate of currency in the handsof the public from the projection of Ml toderive the level of checkable deposits, notseasonally adjusted, if Ml grew at the ratedesired by the FOMC.

4. Multiply the average level of checkable depositsas derived in step 3 by an estimate of the averagereserve requirement on checkable deposits.

5. Subtract the estimate of average currencyholdings as described in step 2 and checkabledeposits as described in step 3 from the pro-jection of M2, as described in step 1.

Multiply by an estimate of the average reserverequirement on deposits in M2 but not in Ml.

6. Sum estimates of required reserves as describedin steps 4 and 5 and an estimate of requiredreserves on deposits not in M2 to derive anestimate of what required reserves would bein the three weeks ending February 27 if Mland M2 grew at the rates specified by theFOMC at its meeting on February 4-5. Addan estimate of the average level of excessreserves for the three weeks ending February27 to get an estimate of the TR path over thethree weeks ending February 27.

The steps involved in projecting TR are similarto the steps in estimating the TR path:

1. Estimate liabilities subject to reserve require-ments for the three weeks ending February 13,not seasonally adjusted. The Federal Reserve

FEDERAL RESERVE BANK OF ST. LOIBS

57

staff generally had data on reservable liabilitieseight days after the end of a reserve mainte-nance week. By February 7, the date of the firstprojection, the staff would have had informationon reservable liabilities for the week endingJanuary 30. They would have to estimate lia-bilities for the weeks ending February 6 and 13.

Appendix 2

2. Estimate average reserve requirements onvarious categories of liabilities.

3. Sum the projections for required reserves forthe three weeks ending February 27, based oncalculations described in steps 1 and 2, andadd an estimate of average excess reserves.

A Tool for Describing the Conduct of Monetary Policy:Supply and Demand for Reserves

This paper describes the conduct of monetarypolicy under the NBR operating procedure usingdiagrams of the supply and demand for bankreserves.1 This appendix describes the determi-nants of the supply and demand curves, and thefollowing section uses this analytical tool todescribe the mechanics of the NBR operatingprocedure.

Reserves available to meet reserve require-ments include currency that banks hold in theirvaults and their reserve balances at FederalReserve Banks. The Federal Reserve suppliesreserves. Banks demand reserves to facilitatetheir customers’ transactions and to meetreserve requirements imposed by the FederalReserve, which are based on the amount andcomposition of their liabilities.

Banks earn no interest on reserves. Thisarticle identifies the opportunity cost to banksof holding reserves as the federal funds rate,which is the interest rate that banks charge eachother for lending reserves.’ A bank changes itsreserves by borrowing or lending at the federalfunds rate.

Demand for reserves by banks is drawn as afunction of the federal funds rate in Figures 4-6.Reserve requirements on deposits included inthe money stock create a close relationship

between the demand for money by the publicand the demand for reserves by banks. Demandfor reserves, therefore, depends on reserverequirements and the demand for money.

Demand for money is assumed to be a functionof total spending in the economy and interestrates. Various influences can cause shifts in thedemand curve for reserves. A change in totalspending in the economy, which influences thedemand for money, would cause the demandcurve for reserves to shift. Shifts in the demandfor reserves could reflect other influences: changesin the random component of money demand; theaverage reserve requirement on deposit liabilitiesincluded in the money stock; reserve require~ments on other liabilities; or the demand forexcess reserves.

Elasticity of the demand for reserves dependson the relevant time period over which averagereserves are measured. The demand curves forreserves in Figures 4-6 are steeply sloped becauseit is for a period between FOMC meetings. Overthese periods, there is little time for a change ininterest rates to change the quantity of moneydemanded, feeding back to a change in thequantity of reserves demanded.

Factors that influence the supply of reservescan be analyzed by considering separately the

For convenience of exposition, the term ‘bank’ refers to alldepository institutions.

2 Federa’ funds brokers facilitate the operation of the federalfunds market. These brokers receive orders from depositoryinstitutions located throughout the nation to lend or borrowreserves, and the brokers match enders and borrowers atmutually agreeable interest rates. Most of the transacfionsthrough the federal funds market involve borrowing and

lending reserves for one day. The transfers of reserves toborrowers are made the same day through wire transfer sys-tems, ncluding the Fed Wfte of the Federal ReserveSystem.

SEPTEMBER/OCTOBER 1994

58

determinants of borrowed reserves and NBR.The Federal Reserve determines the amount ofNBR directly through the open market opera-tions. Banks decide the amount of reserves theyborrow from the Federal Reserve, but their deci-sions are shaped by lending terms set by theFederal Reserve, including the discount rate andlimits on the size and frequency of borrowingsby individual bathcs. Banks try to avoid exceedingthese borrowing limits to ensure that they main-tain access to credit from the Fed to cover theirshort-term liquidity requirements. If a bankborrows now, it will be subjected to greateradministrative pressure to limit its borrowingsin the future, when the attractiveness of borrowingfrom the discount window might be greater.

Goodfriend (1983) derives the relationship between borrow-ngs and the rate spread from a theoretica’ framework that isbased on profit-maximEzing bank behavior.

The supply curve for reserves in Figure 4 isdrawn as a vertical line from the level of NBR(labeled N) up to the level on the vertical axis atwhich the federal funds rate equals the discountrate (~d) If the discount rate is above the federalfunds rate, the amount of reserves borrowed fromFederal Reserve Banks tends to be relatively lowand insensitive to small changes in the federalfunds rate. The supply curve of reserves isupward sloping in the range with the federalfunds rate above the discount rate. Given theterms for lending set by the Federal Reserve, ittakes an increase in the spread between the fed-eral funds rate and the discount rate to inducebanks to increase their borrowings from thediscount wiudow.~

FEDERAL RESERVE BANK OF ST. LOUIS