Less than two weeks ago, Peter Sternlight sat in his eight-floor office patiently explaining to a vistor the basis on which the New York Federal Reserve Bank performs arcane manipulations in its daily striving to keep the nation's monetary policy on course.
But at that time, few people knew that in a few days the Federal Reserve Board would move dramatically from the way it has carried out monetary policy for years.
Sternlight, who run the Federal Reserve's so-called open market account, chatted with his visitor the day the pope arrived in New York. It was a day many New Yorkers snuck away from their desks to catch a glimpse of the pontiff.
Sternlight instead excused himself to prepare for a daily 11 a.m. conference call with Federal Reserve officials in Washington and other parts of the country. During that call, the officials review the banking and credit situation and decide what action, if any, the open market desk should take that day.
Four days later, the pope was in Washington, and New York City was back to what passes for normalcy.
As the pontiff addressed the Organization of American States on Oct. 6, Federal Reserve Board Chairman Paul A. Volcker met with a group of reporters in a hurry-up press conference four blocks away.
What volcker had to say would trigger as much pandemonium in the nation's money markets as Pope John Paul II caused among adoring fans in the nation's streets.
Volcker, who headed the New York Federal Reserve Bank until August, said the Federal Reserve was so troubled by its inability to control inflation and money supply growth that the central bank would take new severe steps to tighten policy and would adopt a brand-new approach to its open market operations.
When financial markets reopened last Tuesday, investors panicked. Interest rates soared, and stock prices plummeted. Normally the Federal Reserve would have stepped in to preserve "orderly markets." Instead, the central bank "sat and watched," according to Sternlight.
That 11 a.m. phone call would never be the same.
Adter years of focusing on interest rates as a guide to its daily decisions to buy or sell government securities, the central bank said it now would focus primarily on bank reserves.
That is not the stuff of high drama. But monetary policy plays a major role in determining how many Americans have a job, how much they must pay for goods and services, and whether they and their employers can get a loan -- and at what price.
The key policy decisions are made monthly in Washington -- or, when events dictate, more frequently by phone -- by the 12-member Federal Open Market Committee. Its members include the 7 Federal Reserve governors and the presidents of 5 of the 12 Federal Reserve banks, The president of the New York Fed -- the most powerful -- is always one of the five.
Day-to-day implementation of that policy is carried out by Sternlight and a small crew of traders in the Fed's trading room a few steps from Sternlight's office.
For decades the open market traders would enter the market -- either by purchasing securities from approved dealers or selling them -- using an interest rate target set by the Open Market Committee and modified as market conditions changed.
Since Oct. 6, the Fed is in uncharted waters. "We are still in a learning process." Sternlight said last week. "It is still very much experimental."
For the Fed has not decided what will replace its interest-rate target or, indeed, if anything will.
There are nearly as many nuances to monetary policy as there are snowflakes.
But basically what the Fed tries to do is achieve a rate of growth in the nation's money supply (checking accounts and currency) that is consistent with keeping inflation under control and keeping the economy producing goods, services and jobs to the best of its ability.
The rate of growth of money is a judgement call by Fed. It has discovered in recent years -- and especially in recent months -- that is has been less and less able to achieve the money growth it wants by using its interest target as a guide.
As money got more expensive, companies kept borrowing and banks kept making loans. Rising interest rates were supposed to prevent that.
The Federal Reserve is able to carry out a monetary policy -- that is, affect the amount of money and credit available -- because is has influence over the nation's banking system.
The Federal Reserve sets the level of interest it charges a bank to borrow from it. The Fed decides how much of a new deposit a bank must put aside as a "reserve" and how much of that deposit it can lend to customers.
And, most importantly, it can use its ability to buy and sell government securities in the open market to decide how many total reserves the banking system has and, therefore, how much loans banks can make and how much money they can create.
At its meetings, the Open Market Committee decides how fast it wants the money supply to grow and what level of bank reserves will result in that rate of growth, and it tells the open market account manager how he should tell when reserves are growing faster or slower than desired.
Suppose it thinks reserves are growing too fast. Sternlight's traders call up the securities dealers the Fed has relationship with (the Fed won't say how many, but it's about 36) and tell them it will sell them securities. The dealers then come back with their proposals -- usually within 15 or 20 minutes. d
When the Fed accepts a dealer's proposal, the dealer has to take money out of his checking account to pay for the securities. That reduces the amount of deposits in the nation's banks, reduces the amount of bank reserves and, in theory, makes it harder for banks to make loans.
To decide whether reserves were growing too fast or too slow, the Federal Reserve used to focus on a key interest rate: the federal funds rate, which is the interest that a bank in need of reserves pay to borrow from a bank that has excess reserves.
Many banks -- especially the big ones make more loans than their reserves would permit. Other have more reserves than they need. If a bank sees it does not have enough reserves to comply with Fed regulations, it often turns to the federal funds market: a loose telephone market of banks and brokers. The market provides reserves (or other fund that the Fed does not require a bank to maintain a reserve against), usually on overnight loan. More than $50 billion usually changes hands each day in this market.
The Fed used to try to figure out what level of federal funds rate would be consistent with a level of bank reserves that would achieve that rate of money growth desired. Now the Federal Reserve will look much less closely at the federal funds rate and more closely at the level of reserves.
As sternlight put it in central bankerese, the Fed's ultimate goal is the same -- achieving a certain rate of money growth -- but the "operational focus" has changed.
Before, if the federal funds rate jumped up higher than the Fed thought it should, the Fed often would enter the market to buy securities (adding money to dealer accounts and, therefore, to banks). The Fed might be in the market two or three times a day, or even more during hectic periods.
If the Fed thought the funds were needed permanently, it would buy the securities for good. If it thought the funds were needed temporarily, it would buy the securities for a period of time, at the end of which the securities dealers agreed to buy them back. Such transactions are called repurchase agreements. (Reverse repurchase agreements, or matched sales, do just the opposite. The Fed drains reserves temporarily and returns them by buying back the securities from the dealers).
The trouble was that the Fed found that the federal funds rate it thought would result in a desired level of bank reserves did not. Instead, in the last six months, reserves grew much faster than the Fed wanted. So did the money supply and inflation.
Now the central bank will be less concerned about day-to-day or hour-to-hour changes in interest rates and instead look at reserves themselves, probably over a period as long as a week, The Fed then will add or subtract reserves based on these more direct calculations.
But the Fed isn't sure which of a number of different ways to calculate reserves is the best guide to policy operations, he added.
Sternlight also warned that the the Fed has not junked the federal funds targe. It merely has de-emphasized it.
"In large measure, we'll add or drain reserves based on our reserve estimates, although we'd expect to get some information about the validity of our projections of market factors. . . from the behavior of the funds market," he told anxious securities dealers the other day.
In other words, the central bank has adopted a new operating strategy -- one, incidentally, that many so-called monetarist economists have urged for years -- but the Fed is finding it hard to figure out just what that strategy is.