Federal Reserve operating targets, past and present - A Review of Federal Reserve Policy

Business Economics, July, 1991 by James L. Pierce

The Federal Reserve's choice of operating target has important consequences for its ability to control inflation and to counter episodes of financial instability. Historically, its practice of stabilizing the federal funds rate produced procyclical growth in money and inflation. After a relatively brief shift to a reserve target in 1979-82, the Fed returned to stabilizing the federal funds rate, a practice that reduces its credibility as an inflation fighter. The Federal Reserve would achieve credibility, and ironically more flexibility to stabilize financial conditions, if it made effective use of bank reserves as its operating target.

IN CONDUCTING MONETARY POLICY, the Federal Reserve must estimate the effects of its open-market operations on inflation and economic activity. All the intermediate steps running from open-market operations to bank reserves and the federal funds rate to money and credit to prices and output are not important in their own right, they are just part of the process producing policy's impact on ultimate objectives. But the linkages between policy action and ultimate effects are complex and uncertain, so that the Fed tries to make the problem more manageable by breaking the policy process into steps.

It starts by using open-market operations in an effort to achieve "operating targets," which are the values of bank reserves and the federal funds rate that it believes are consistent with achieving the values of "intermediate targets" (e.g., growth in the monetary aggregates), which in turn are deemed consistent with achieving the desired ultimate effects on inflation and economic activity. The operating targets are sufficiently "close" to actual open-market operations as to be hit with considerable accuracy. Intermediate targets are "further removed" from open-market operations but closer" to the ultimate objectives. These intermediate targets cannot be hit as accurately as operating targets, but the Fed adjusts its operating targets in attempts to achieve goals for the intermediate targets. The policy loop is completed by adjusting the intermediate targets, and the operating targets with them, in response to information that the ultimate objectives are not being achieved.

The choice of operating target(s) affects the Federal Reserve's ability to achieve its intermediate and ultimate objectives. Desired values of intermediate targets can be hit on average either by using the federal funds rate or a reserve aggregate as the operating target. Which of these two is more effective depends upon the sources of shocks causing errors in hitting the intermediate targets.(1) Furthermore, some reserve measures are more productive than others. For example, total reserves and the monetary base are more closely related to the monetary aggregates than are nonbol-rowed reserves, but they are more difficult to hit as operating targets.

The choice of operating target also affects the public's perception of what policy is and the Federal Reserve's ability to communicate when it has and when it has not changed policy. Suppose the Fed has chosen total bank reserves as its operating target and that it seeks to maintain a constant growth in these reserves. Further suppose that there is an unexpected increase in loan demand. Banks will attempt to increase their lending, reserve demand will rise, and the federal funds rate and other short-term market interest rates will increase. The Federal Reserve has not changed policy, in the sense that it has not deviated from its operating target, yet interest rates have risen. But the public is likely to interpret the increase in interest rates as a tightening of monetary policy.

Now suppose that the Fed had adopted the federal funds rate as its operating target, electing to hold it constant. In this situation, an increase in loan demand will again increase the demand for reserves, but in order to keep the federal funds rate from rising the Fed will have to accommodate the increase in reserve demand by providing more reserves through open-market operations. In this case, an unchanged policy produces an increase in money and credit with no change in short-term interest rates. The public is likely to interpret the increase in money and credit as an easing of monetary policy.

When there is an unexpected increase in loan demand, an unchanged interest rate policy results in a greater stimulative effect on output and inflation than an unchanged policy in terms of total reserves. But it can be shown that the use of a reserve measure as the operating target results in more stimulus than a federal funds rate target when there is an unexpected reduction in money demand or increase in money supply for given values of real output and inflation. By combining reserves and the federal funds rates as operating targets, the Fed could protect against both types of shock. But what would an unchanged policy mean in this case? It would really involve an unchanged "rule" governing how reserves are allowed to respond to interest movements. This is all well and good but such a rule would be very difficult for the public to interpret.