Chapter 18. Conduct of Monetary Policy Goals of monetary policy Using targets A History of monetary policy Policy Rules Goals of monetary policy Using targets A History of monetary policy Policy Rules

I. Goals desirable goals for the economy Fed uses monetary policy to achieve these goals directly control tools, to influence goals desirable goals for the economy Fed uses monetary policy to achieve these goals directly control tools, to influence goals

High employment i.e., low unemployment federal government has a commitment to full employment goal: natural rate of unemployment about 4-5% today: 5.1% (3/05) 7.7% in Oswego Co. i.e., low unemployment federal government has a commitment to full employment goal: natural rate of unemployment about 4-5% today: 5.1% (3/05) 7.7% in Oswego Co.

Economic Growth annual % change in real GDP U.S. long run average -- 3% 2004 GDP growth 4.4% annual % change in real GDP U.S. long run average -- 3% 2004 GDP growth 4.4%

Price stability i.e., low inflation annual % change in CPI primary goal of Fed since 1980s how high is too high? over 4% goal: 2% or less 2004 i.e., low inflation annual % change in CPI primary goal of Fed since 1980s how high is too high? over 4% goal: 2% or less 2004

tradeofftradeoff between price stability & economic growth controlling inflation can mean slowing down economic growth between price stability & economic growth controlling inflation can mean slowing down economic growth

Financial Market Stability stability of financial institutions stability of interest rates stability of exchange rates Fed stabilized markets October 1987 Summer 1998 September 2001 stability of financial institutions stability of interest rates stability of exchange rates Fed stabilized markets October 1987 Summer 1998 September 2001

II. Using targets Fed directly controls tools (like OMO), not goals it can take a year for tools to impact the goals how to gauge progress in between? Fed directly controls tools (like OMO), not goals it can take a year for tools to impact the goals how to gauge progress in between?

TargetsTargets related to tools and goals used by Fed to judge if they are on track related to tools and goals used by Fed to judge if they are on track goal intermediate target operating target tool (OMO)

operating targets respond immediately to changes in the tools examples bank reserves FF rate Tbill rate respond immediately to changes in the tools examples bank reserves FF rate Tbill rate

intermediate targets affected by operating target closely associated with goals examples M1, M2 or M3 prime rate Tnote or Tbond yields affected by operating target closely associated with goals examples M1, M2 or M3 prime rate Tnote or Tbond yields

exampleexample Fed wants 5% nominal GDP growth intermediate target 4% M2 growth operating target 3% MB growth conduct open market purchases to increase MB by 3% Fed wants 5% nominal GDP growth intermediate target 4% M2 growth operating target 3% MB growth conduct open market purchases to increase MB by 3%

effective targets frequently and accurately measured controllable by the Fed predictably related to goals frequently and accurately measured controllable by the Fed predictably related to goals

2 types of targets monetary targets reserves, MB M1, M2, or M3 interest rate targets FF rate other short or medium-term rates monetary targets reserves, MB M1, M2, or M3 interest rate targets FF rate other short or medium-term rates

target tradeoff Fed can target money supply OR interest rates NOT BOTH! why? Fed can target money supply OR interest rates NOT BOTH! why?

suppose Fed targets M* for MS: M iMS M* MD’’ i’’

but as MD fluctuates, i will change: M iMS M* MD’’ i’’ MD’’’ i’’’ MD’ i’

so if target M*, lose control of i M iMS M* MD’’ i’’ MD’’’ i’’’ MD’ i’

suppose Fed targets i* M i MD’’ i* MS M’’

but as MD fluctuates, Fed must shift MS to maintain i* M iMS M’’ MD’’ i* MD’’’MD’ M’ MS’ M’’’ MS’’’

Fed targets i*, lose control of M M iMS M’’ MD’’ i* MD’’’MD’ M’ MS’ M’’’ MS’’’

TargetsTargets If Fed targets MS, loses control of interest rates If Fed targets interest rates, loses control of MS If Fed targets MS, loses control of interest rates If Fed targets interest rates, loses control of MS

III. A History of Fed Policy Early years ( ) The Great Depression WWII 1950s, 60s 1970s present Early years ( ) The Great Depression WWII 1950s, 60s 1970s present

The Early Years main tool: discount loans real bill doctrine use discount loans for production loans result: inflation main tool: discount loans real bill doctrine use discount loans for production loans result: inflation

cut back on discount loans recession/deflation discovered OMO in 1920s make up for lost revenue from discount loans by holding Treasuries cut back on discount loans recession/deflation discovered OMO in 1920s make up for lost revenue from discount loans by holding Treasuries

The Great Depression Fed failed to act as lender of last resort and prevent bank failures why? initial failures were small banks Fed failed to recognize domino effect on larger banks & economy Fed failed to act as lender of last resort and prevent bank failures why? initial failures were small banks Fed failed to recognize domino effect on larger banks & economy

mid 1930s recovering from GD but Fed increases reserve requirement -- recession mid 1930s recovering from GD but Fed increases reserve requirement -- recession

during WWII Fed targeted Tbill rate kept rate low to help finance war large MS growth -- but price controls kept inflation low post WWII inflation Fed abandoned Tbill rate target during WWII Fed targeted Tbill rate kept rate low to help finance war large MS growth -- but price controls kept inflation low post WWII inflation Fed abandoned Tbill rate target

1950s s targeting “money market conditions” short term interest rates free reserves = excess reserves - discount loans result: procyclical monetary policy MS rose during expansions, fell during recessions. targeting “money market conditions” short term interest rates free reserves = excess reserves - discount loans result: procyclical monetary policy MS rose during expansions, fell during recessions.

Why?Why? chain reaction: economic expansion income rises MD rises interest rate rise ER decline DL rise FR decline increase MS Fed increases MB

procyclical money growth is not a good thing rapid MS growth in expansion leads to inflation slow MS growth in recession makes it worse procyclical money growth is not a good thing rapid MS growth in expansion leads to inflation slow MS growth in recession makes it worse

MS should be countercyclical “lean against the wind” keep inflation under control help prevent or end recessions MS should be countercyclical “lean against the wind” keep inflation under control help prevent or end recessions

1970s1970s Fed announces target of money aggregates (M1, M2) but FOMC targets both aggregates & FF rate -- cannot do both Fed really targeting FF rate, & MS growth still procyclical Fed announces target of money aggregates (M1, M2) but FOMC targets both aggregates & FF rate -- cannot do both Fed really targeting FF rate, & MS growth still procyclical

Fed criticized in 1970s for failure to control inflation energy crisis of did not help Fed criticized in 1970s for failure to control inflation energy crisis of did not help

inflation over 10% by 1979 Paul Volcker target nonborrowed reserves reserves - discount loans slow MS growth to bring down inflation large interest rate fluctuations inflation over 10% by 1979 Paul Volcker target nonborrowed reserves reserves - discount loans slow MS growth to bring down inflation large interest rate fluctuations

recession “Volcker recession” inflation below 4% by 1982 signaled change at Fed price stability # 1 goal fight inflation inflation before it gets to be a problem recession “Volcker recession” inflation below 4% by 1982 signaled change at Fed price stability # 1 goal fight inflation inflation before it gets to be a problem

targeting “borrowed reserves” or interest rates procyclical policy stopped setting targets for M1, M2 Alan Greenspan 1987 intervened 1987 crash slow to act for recession targeting “borrowed reserves” or interest rates procyclical policy stopped setting targets for M1, M2 Alan Greenspan 1987 intervened 1987 crash slow to act for recession

exchange rate markets $ too high Fed, with other central banks intervened to bring $ down exchange rate markets $ too high Fed, with other central banks intervened to bring $ down

present 1990s longest expansion in U.S. history announced FF rate target “soft landing” prevent rising inflation by increasing FF rate 1990s longest expansion in U.S. history announced FF rate target “soft landing” prevent rising inflation by increasing FF rate

1994 exchange rates this time Fed intervened for a $ that was too low 1998 Russian debt/ Asia crisis lower FF rate to keep U.S. economy expanding 1994 exchange rates this time Fed intervened for a $ that was too low 1998 Russian debt/ Asia crisis lower FF rate to keep U.S. economy expanding

Fed hiked FF rate to prevent inflation Fed reversed FF rate hikes as economy slowed 2002-present FF rate targets have slowly risen but not LT rates Fed hiked FF rate to prevent inflation Fed reversed FF rate hikes as economy slowed 2002-present FF rate targets have slowly risen but not LT rates

IV. Policy Rules how to choose a target for monetary policy? how to respond to changing economic conditions? how to choose a target for monetary policy? how to respond to changing economic conditions?

The Taylor Rule John Taylor equation FF rate target based on -- current inflation -- inflation target -- gap between actual GDP & full employment GDP John Taylor equation FF rate target based on -- current inflation -- inflation target -- gap between actual GDP & full employment GDP

Taylor rule Fed responds to both price stability business cycle Fed responds to both price stability business cycle FF rate = inflation + LR FF rate +.5(inflation gap) +.5(output gap)

NAIRUNAIRU nonaccelerating inflation rate of unemployment lowest unemployment rate possible without triggering inflation possible goal for Fed nonaccelerating inflation rate of unemployment lowest unemployment rate possible without triggering inflation possible goal for Fed

problem: what is NAIRU? prior to 1995 may would have said 5% but unemployment below 4% in late 1990s without causing inflation problem: what is NAIRU? prior to 1995 may would have said 5% but unemployment below 4% in late 1990s without causing inflation