Bridge over ocean
1 July 1981 Financial Analysts Journal Volume 37, Issue 4

Techniques of Monetary Policy

  1. Henry C. Wallich

In 1970, the Federal Reserve instituted a money supply target, setting the federal funds rate at a level that elicited the desired growth. In 1979, the Fed switched to a reserves-based procedure for achieving this target. The new procedure has given rise to some understandable misconceptions.

“Tightness should be measured by interest rates.” While, under the old procedure, the funds rate was the proper clue to what the Federal Reserve was doing, under the new procedure it is merely a byproduct. The proper test of the Fed’s intent is whether the money supply strengthens more than very temporarily without the Fed acting to offset it by lessening reserve growth.

“Reserves are an indicator of monetary policy.” Reserves reflect, not only attempted changes in the monetary aggregates, but also shifts of funds between banks, between reserve categories and between reservable liabilities.

“Nonborrowed reserves do not control the money supply.” Because borrowed reserves support expansion just as well as nonborrowed reserves, the Fed looks primarily at total reserves. On the other hand, it is aware that an increase in the proportion of total reserves derived from borrowing has effects on interest rates other than the funds rate that are conducive to restraint.

“The funds rate at the time the Fed enters the market is a tip-off to where it wants the funds rate.” This was undoubtedly true under the old procedure, since the Fed rarely entered unless the funds rate was moving in one direction or the other. Under the new procedure, however, the funds rate level at which the Fed enters is largely fortuitous.

“The Federal Reserve’s role, when on a money supply target, is largely passive.” The short-run target the FOMC sets monthly for overlapping three-month periods is subject to variation even if the long-term target (one year, possibly more) is not. Then, too, even if the monetary target were firmly adhered to under fluctuating economic conditions, interest rates would fluctuate widely. In that sense, a money supply target implies a highly activist monetary policy.

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