Regional President Speech

A PRIMER FOR INTERPRETING MONETARY POLICY By Frank E. Morris, President Federal Reserve Bank of Boston An Address Before the Annual Meeting of the Financial Analysts Federation Washington, D. C., May 7, 1973 The events of 1966 and 1969 have persuaded a great many people in the financial community, if they were not persuaded before, that monetary policy can have a substantial impact on the course of economic activity and on the securities markets. This has lead to a greatly intensified interest in the Street in the interpretation of monetary phenomena and monetary policy. In fact, one of the major activities on the Street is money supply watching. I know portfolio managers in Boston who a year or two ago did not know the difference between Ml and M2 but who today breathlessly await the latest release of the St. Louis Fed. By and large, however, the quality of the interpretations of monetary policy published in the Street is not very high. It seems to me that there are two principal causes for this. One basic cause is the ingrained propensity of the market to read too much into very short-term changes in monetary indicators. This stems from the fact that much of Wall Street is oriented toward trading and underwriting business where a man must have a short-term view. If a trader or underwriter should make the mistake of looking too far ahead he is likely to find himself frozen out of the trading and underwriting business into the involuntary status of an investor. The financial press similarly tends to over-emphasize short-term changes in monetary indicators for the very good reason that it makes much better copy. The rate of change in the money supply over the past nine to twelve months is not very newsworthy, since it doesn't change all that much from week to week. What is newsworthy is what has happened to the money supply last week. One cannot fault the press for printing what is newsworthy and ignoring what is not, but it does contribute to erratic behavior in the interpretation of the course of monetary policy. This propensity toward the short view, combined with the very large random element in the weekly and monthly money supply figures, can create a lot of unnecessary nervousness, not to say panic. Last December, for example, the financial community was quite upset over the fact that Ml increased at a seasonally adjusted annual rate of 13 1/2%. It was widely expressed that the money supply was out of control and that this would inevitably lead to a financial crunch later on. Then in January, when the money supply contracted at an annual rate of 1/2 of 1%, there was concern in the Street that the crunch was here. We do not know all of the reasons for the behavior of Ml in December and January but we do know of one, which is illustrative of the sources of random movement in the money supply series. The Federal Government made its first revenue sharing payments to state and local governments in December. Many of these governments had made no plans for the immediate investment of this money. As a consequence, it was reflected in a sharp rise in the demand deposit balances of state and local governments. For reasons which I have never thought very persuasive, demand deposits of state and local governments are included in the money supply while demand deposits of the Federal Government are not. As a consequence, this shift of deposit balances from the account of the Federal Government to the account of state and local governments produced an increase in Ml, raising the average level of Ml for December. As state and local governments finally got around to investing these funds, demand balances declined contributing to the failure of Ml to grow in January. If we look at the two months combined we get an average growth rate of Ml for December and January of 6 1/2%. One may not agree that this is the proper long-term rate of growth for Ml, but the statistics for this two-month period neither suggest that the money supply is out of control nor that a credit crunch is upon us. If the weekly or monthly changes in the money supply have little or no economic significance, the question arises over what span of time should a money supply watcher watch money. Last September the Federal Reserve Bank of Boston sponsored a conference on "Controlling Monetary Aggregates". Two papers were commissioned for this conference on the question of the proper time frame for assessing the significance of monetary growth rates. Specifically I asked the authors of these two papers, one of whom was Leonall Andersen of the St. Louis Federal Reserve Bank and the other Jim Pierce and Tom Thomson of the Federal Reserve Board staff, to answer the following question: if the money supply rose at a 6% rate during the year, does it make any difference whether it rose at a constant 6% rate or whether it rose at an uneven rate during the year; say, 10% in the first half and 2% in the second half. Both papers came up with the same finding: that it doesn't make any significant difference whether a 6% growth rate for a calendar year is attained in smooth fashion or whether its growth is irregular. They did find, however, that if we extended the irregular monetary growth pattern to three calendar quarters, that is if we assume a 2% growth rate for three quarters followed by a 10% growth rate for three quarters, we begin to find measurable differences. This suggests to me that a six-months span of time is too short for measuring the economic impact of the rate of growth in the money supply but that a nine-month span might be about right. For your information, over the course of the nine months ending in March, Ml grew at an annual rate of 6.3%, and M2 at an annual rate of 8.9%. So much for the time frame problem. A second reason that the financial community has had some serious problems inter preting monetary policy is that the formulation of monetary policy has been going through a period of change in the past few years. As a consequence, many of the rules of thumb which might have been reasonable guides for interpreting monetary policy in years past may no longer have much, if any, validity. The objective of our panel today is not to tell you what monetary policy is or what it is going to be, but to discuss how monetary policy is currently being formulated and executed so that you, as molders of opinion on economic affairs, may have a better basis for interpreting policy in the future. I am going to lead off by discussing the changes in the framework for policy making over the course of the past five years. I will be followed by Steve Axilrod, Associate Director of Research at the Federal Reserve Board, who will discuss some of the issues of concern to those who formulate the options for the monetary policy makers. The policy options for the FOMC are set forth in a most sophisticated document called the Blue Book. As the principal author of the Blue Book, Steve might be called the Henry Kissinger of domestic monetary affairs. The final speaker will be Alan Holmes who, as Manager of the System Open Market Account, executes with great skill and finesse the policy determined by the FOMC. We intend to keep our formal presentations short enough so that we will have plenty of time for questions from the floor. I attended my first FOMC meeting in September, 1968. In the four and a half years that have intervened, I have witnessed a very substantial change in the framework for formulating monetary policy. This has been an evolutionary process which has largely destroyed the usefulness of some formerly useful monetary indicators, such as free reserves. The account I will give you of this change is a personal one - - lacking any official standing. I am sure that some of my colleagues on the FOMC might look upon some aspects of these changes rather differently than I do. First, it seems to me that we are giving more weight to the lags in monetary policy than we did four or five years ago. We still believe in "leaning against the wind", but we are giving a little less emphasis to the wind that is currently blowing and more emphasis to the winds which we expect to be blowing two to four quarters ahead. This is only a change of emphasis but one which, I believe, is criticaaly important. It is reflected in the fact that we have asked our Research staffs to give us economic projections extending farther out into the future than they customarily gave us a few years back. Further- more, recognizing the risks in operating at least partially on the basis of projections, we have asked for these projections to be revised monthly to reflect the latest economic data. In 1972, for the first time, the FOMC established growth rate objectives for the monetary aggregates two quarters or so ahead. When I first joined the Committee we tended to look upon monetary growth rates retrospectively. Th~ Co~mittee_looked at pa~t growth rates in the money supply as a guide in helping to determine the future interest rate policy. If money was growing too fast, interest rates should be pushed up, but no objectives for future monetary growth rates were established. The longer term objectives for the aggregates are subject to review at each FOMC meeting. Currently, at every meeting we establish operating target levels for the aggregates for a two-month time span, the month in which the meeting is held and the month ahead. The two-month target chosen is that felt to be compatible with our longer-term objectives and which will minimize unnecessary fluctuations in short-term money rates. If, for example, the current longer-term objective for Ml is 6%, it might be best to accomplish this with a 2% growth rate for the first two months, a 10% growth rate for the middle two, and a 6% growth rate for the last two months. To attempt to produce a constant 6% growth rate month to month in this example would have required short-term rates to decline sharply in the first two months, rise sharply in the second two and decline again the last two. Since sharply in the second two and decline again the last two. Since there are no compensating economic gains to be expected from a constant 6% growth policy, the instability which such a policy would generate in the short-term money markets would seem to have no redeeming social value. Nevertheless, market observers watching very short-term changes in monetary growth might easily be mislead by the 2% growth rate in the first two months, followed by the 10% growth rate in the second two - - since neither number was reflective of the underlying longer-term course of policy. The past few years have seen a revolutionary change in the formulation of the options for the monetary policy makers. Each option presented to us in the Blue Book presents a specific pattern of reserve growth. On the basis of our current economic forecast, the staff estimates the most probable consequences of that pattern of reserve growth for the growth of Ml, M2 and the bank credit proxy - - together with the probable consequences for short-term money rates. The great virtue of this formulation is that it compels the policy makers to face up explicitly to the trade-off between interest rates and monetary growth rates. If a policy maker advocates a certain course on interest rates, he must be willing either to accept the monetary growth rates which the staff projects would accompany that interest rate policy or he must argue that the staff projections are wrong. This sort of severe trade-off discipline on the policy maker did not exist four or five years ago. Another major change is that the directive of the Committee to the Manager of the System Open Market Account is now highly quantified. The FOMC establishes quantitative targets for the two-month span for RPDs, Ml and M2 - - and asks the Manager to hit these targets within a given Federal funds constraint. These targets are expressed as ranges rather than points. Four or five years ago the directive was stated in such general language that it was quite possible for Committee members to leave the meeting with somewhat differing conceptions as to what our policy for the next four weeks was to be. This is no longer possible. A Committee member may have doubts as to the wisdom of the course selected - - but everyone knows precisely what we are attempting to accomplish over the two month span. One potential problem for this policy making structure is that the specifications for the option chosen by the Committee may not be compatible. It may be that to meet the reserve target the Federal funds constraint may need to be changed. On more than one occasion during the past year the Federal funds constraint has, in fact, been altered during the interval between meetings. Finally, over the course of the past four and one-half years we have come to place more emphasis on monetary growth - - but our concern for interest rates has not diminished in the process. We continue to give a great deal of weight, properly so in my judgment, to interest rates and the independent influence which interest rates have on economic activity and security values. The major change in policy making, in my judgment, is that we are no longer setting interest rate policy with a look back at what has happened to the money supply in the past. Instead, we are choosing a reserve growth path which we expect to produce that combination of future interest rates and future monetary growth which the Committee feels is best suited to the future economy as we read it. To sum up, we have in place a much more complex and sophisticated framework for the formulation of monetary policy than we had a few years ago. I believe it is a framework which will produce better monetary policy. However, its greater complexity means that it is going to be more difficult for the Street to figure out what monetary policy is and where it is headed. The day when you could read monetary policy successfully by reference to a simple indicator is gone. On this sobering note, I would like to turn over the podium to my distinguished colleague, Steve Axilrod.

Frank E. Morris (1973, May 6). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19730507_frank_e_morris

@misc{wtfs_regional_speeche_19730507_frank_e_morris,
  author = {Frank E. Morris},
  title = {Regional President Speech},
  year = {1973},
  month = {May},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19730507_frank_e_morris},
  note = {Retrieved via When the Fed Speaks corpus}
}