" . . . Under the American law, the Fed is independent of the presidnet. It's just like the judicial system. I don't have any influence on it, but that doesn't mean I have to sit mute. My own judgment is that the strictly monetary approach to the Fed's decision [increasing] the discount rate and other banking policies is ill-advised.
"I think the Federal Reserve Bank Board ought to look at other factors and balance them along with the supply of money. Now, in my judgment, too much of their decision is made just by measuring the amount of money available in our system, both M-1 and M-2 supplies of money. I think that the Fed ought to look at the adverse consequences of increased interest rates on the general economy as a major factor in making their own judgments . . .
" . . . I think they put too much of their eggs in the money supply basket and are not adequately assessing . . . other factors . . . " -- President Carter, Oct. 3, 1980.
Why are interest rates rising sharply when recovery from the recession has hardly begun? Has the Board of Governors of the Federal Reserve and the other members of the Federal Open Market Committee who together set monetary policy turned into monetarists who are indifferent to interest rates?
Jimmy Carter, singulary unhappy about the recent jump in rates, first lashed out as Federal Reserve policy two weeks ago during a backyard politicking appearance in Philadelphia. He repeated the criticisms last week in East Tennessee.
Carter and his economic advisers are worried that current Federal Reserve policies could choke off the recovery even though unemployment is still 7 1/2 percent. At the same time, he and his political advisers also fear rising rates could help persuade voters that his opponent Ronald Reagan's charges of mismanagement of the economy are right.
Remarkably, it was the first direct criticism of the Fed this year by the White House despite interest rates that reached unprecedented heights.
According to interviews with a number of key Federal Reserve officials, the Federal Open Market Committee still is paying close attention to interest rates -- far too much attention to satisfy some of the Fed's monetarist critics. The explanation of what is happening in financial markets is far more complex than that. In fact, there are several possible explanations involving some of the most complex issues confronting economic policymakers today.
But if the issues are complex and the language arcane, the results of the policymakers' choices will be concrete, affecting both the level of economic activity and the inflation rate for years to come. Anyone looking for affordable mortgage money last week could testify to that.
A year ago, the Federal Reserve announced the major change in its operating procedures that generated Carter's complaints. It involved focusing more directly on a target for growth of the money supply than on interest rates, something many monetarist economists long had been urging.
In 1975, following the requirements of a congressional resolution that later became law, the board had begun setting targets for growth in the stock of money as part of its continuing effort to influence the level of economic activity and inflation.
But the central bank nevertheless continued to try to hit those targets, primarily by manipulating certain short-term interest rates and generally without all that much success. So, on Oct. 6, 1979, after a lengthy study by its staff, it declared that henceforth it would seek to hit the chosen money supply targets, which emphasize fighting inflation, by controlling the level of bank reserves directly instead of doing so by manipulating interest rates.
The record since then, whether judged on the basis of control of the money supply or performance of the economy, satisfies no one, least of all Federal Reserve policymakers.
Fed Chairman Paul Volcker -- whom Carter praised as "a highlyy qualified, very brilliant man" -- would not comment directly on the president's criticism. As for the ups and downs of the money stock in the last 12 months, he wryly observed, "Well , I think we've learned that you don't control this thing -- I think people have generally learned -- it's not something you control from week to week or month to month. I think we have learned what we always knew, but we learned it in spades this year."
Then he added confidently, "But if you look at the broader term, I don't have any sense that the money supply is out of control." Many financial analysts and economists are not so sure.
After four months of initial -- and what a Fed staff economists calls "fortuitous" -- success by the Fed in meeting its target for money supply growth, things got completely out of hand. In the early spring, interest rates skyrocketed to historic highs amidst chaotic conditions in financial markets. Mortgage interest rates climbed to 16 percent and banks were charging their best business customers 20 percent for short-term loans.
Partly as a result of the spike in rates and a sweeping credit control program imposed by the Fed in March to help prick the speculative bubble that had developed, the economy plunged into recession in the second quarter. Despite the new procedures, the money supply followed the economy in its "free fall." One measure of money, M-1b, plummeted in April at a 14.1 percent annual rate, the fastest drop in several decades.
Interest rates swept downward, too, even faster than they had risen only weeks before, and the unprecedented decline in rates sparked an economic rebound, particularly in housing construction, that came far more quickly than expected.
Now the roller coaster has headed back up once again. In August, M-1B rose at a 21.6 percent annual rate. In the weeks ended Sept. 24 and Oct. 1, M-1B fell by $4.5 billion to $381.7 billion, but for the month of September , it still grew at an annual rate of 15.5 percent.
Interest rates also have spurted. The prime rate is back from a low of 11 percent to 14 percent at Citibank, the nation's largest, and mortgage rates are back to 14 percent or more. Rates have followed the money stock upward as financial market participants speculated that either the Fed had abandoned its monetary targets, which could mean more inflation ahead, or that it had not dropped the targets and would have to provide fewer reserves to the banks, which would require higher interest rates.
The point is that the market for money works much like other markets. There is a supply side, which is the money stock, and the demand side. And like other markets, supply and demand are brought into balance through prices, which in this case are in the form of interest rates. When economic conditions change, either the supply side will reflect the new circumstances or else prices will be altered and the impact then felt on the demand side.
If the Fed is concentrating on holding interest rates within a narrow range, then the demand for money will usually be little changed. In that case, the money stock is apt to fluctuate. If the Fed, on the other hand, is concentrating on keeping the money stock growing on a stable path, then prices -- interest rates -- will have to absorb any shock, thereby changing the demand side.
Against this background, the Federal Reserve Bank of Boston held a conference last week at the Bald Peak Colony Club, a resort on the shore of Lake Winnepesaukie in New Hampshire, to examine the entire set of issues encompassing control of the monetary aggregates, including the Fed's recent record.
Perhaps the most telling point made by many of the economists, bankers and Fed officials present, albeit with some dissenters, was that control of the monetary aggregates will likely be every bit as difficult in coming months as it has been during the past year. Among the participants were 6 of the 12 Federal Reserve District Bank presidents. As members of the FOMC -- 5 of the 12 vote on a rotating basis -- along with the 7 Fed governors, they had no illusions about how easy it will be to keep things on track. At the same time, they are convinced the procedural changes will help.
"With all the leads and lags with which monetary policy works, it's too early to judge this experiment," Roger Guffey, president of the Kansas City Federal Reserve Bank, said "But it clearly has worked better than the previous procedure would have."
His Dallas counterpart, Ernest T. Baughman, declared, "Bad as the situation looks, it would have been worse under the old policy."
Lawrence K. Roos, president of the St. Louis bank, home of monetarist thought within the Federal Reserve system, is unhappy the Fed has not moved much further toward a pure monetarist approach to controlling the money stock. "Everybody from Volcker on down wants to hit the targets, but I'm not sure they understand the procedures we need to follow to hit them," Roos said.
Hitting the targets, which generally call for a gradual slowing of the growth of money to fight inflation over several years, will be difficult no matter what aproach is used. "In a world of certainty, the Federal Reserve could always follow reserve paths that are consistent with the desired growth of the monetary aggregates," the conference was told by James L. Pierce, an economist from the University of California at Berkeley who for several years was associate economist for the FOMC. Unfortunately, he added, "The world in which the Fed operates is highly uncertain . . . the true structure of the relationships between reserves and money is not known. All this uncertainty implies that the Fed cannot hit its monetary targets exactly and that surprises do occur."
The uncertainties range from a decision about what financial assets should be considered money to the nature of the link between changes in the stock of money, however defined, and changes in inflation and real economic activity.
After all, the Fed, as several conference participants stressed, does not seek to control the monetary aggregates for their own sake. Their goal is to achieve a particular outcome in the real world.
Until a few years ago, the question of what constitutes money was much more straightforward. Individuals and businesses used cash and their checking accounts at commercial banks for transactions balances, with deposits in commercial bank savings accounts -- which businesses were not allowed to make -- only a narrow step removed for individuals. Now the lines have become exceedingly blurred.
Businesses today can have savings accounts at commercial banks, and both they and individuals can set up in advance autmatic transfers from savings to checking accounts to cover overdrafts, or order such transfers by telephone. In New York, New Jersey and the New England states, both commercial banks and thrift institutions such as savings and loan associations offer negotiable-order-of-withdrawal, or NOW, accounts, which essentially are interest-bearing checking accounts. Credit unions offer share-draft accounts, which are similar, throughout the nation. And many individuals and businesses have invested in money market mutual funds, most of which also allow certain check-writing.
Beyond all those developments, many institutions have moved aggressively to obtain funds to lend in the form of regular deposits, including large certificates of deposit, but also in what are called "managed liabilities." These include such esoterica as overnight borrowings in the Eurodollar market and "RPs."
Last year the Fed modified its definitions of various measures of the money stock to take account of these changes. But the central bank, in setting its targets for M-1A, M-1B, M-2 and M-3, has to try to guess how much money may shift from one "M" to another as the public decides, for instance, to shift assets from a checking account to a money market mutual fund.As of Jan. 1, NOW accounts will be legal in the remaining 42 states, which Fed economists expect will cause M-1B to grow more rapidly but without being certain about precisely from where the funds will come.
Other major changes in the nation's financial structure are imminent, too. As a result of the Depository Institutions Deregulation and Monetary Control Act passed this year, virtually all financial institutions will have to maintain reserves with the Fed after a lengthy phase-in period.
Now only banks that belong to the Federal Reserve system -- all nationally chartered banks must be members and some state-chartered banks choose to be -- must do so.
As these changes progress, the relationship between the level of reserves and the growth of money stock surely will be altered, and probably in unpredictable ways.
Even the level of reserves to some degree is beyond the Fed's control because of two other factors. First, the level of required reserves is based upon the level of deposits at banks two weeks previously. Probably by next fall the Fed no longer will allow banks this accounting luxury. Second, banks may unexectedly increase the level of reserves borrowed from the Fed itself at the so-called discount window.
But even if the Fed does control reserves closely, and even if it were able to forecast correctly the link between reserves and money on the supply side of the equation, an essential and often highly volatile ingredient would remain: the public's demand for money. The money stock dropped so sharply in April, for example, most conference participants agreed, because of a sudden downward shift in the public's desire to hold transactions balances. Whether that happened as a result of the sky-high interest rates -- which made holding non-interest-bearing balances quite costly, because of credit controls, because of the sharp fall in economic activity, or some combination of these -- it seems clear such a shift occurred. a
A few more extreme monetarist economists, such as the University of Rochester's Karl Brunner, argue that the Fed should have ignored this shift in public demand and concentrated on providing reserves to the banking system along a chosen path.
Brunner would prefer the Fed abandon attempts to control any of the various "Ms" and concentrate on the monetary base, which includes only currency and bank reserves.If you did that, he said, "None of the 'Ms' would get out of line."
In the past year, the Fed, which formerly kept the federal funds within a very narrow band usually only about one-half a percentage point wide as part of the process of controlling the money stock, has let the rate swing within about a six-percentage-point band. But at times in the spring and summer, there were sufficient reserves available to banks that the rate fell to the lower edge of the band. During at least two periods, the level of rates rather than the level of reserves and the money stock became major factors in Fed money market actions, according to Peter D. sternlight, mangager for domestic operations of the system's open market desk in New York.
During those times, continuing to pump in reserves by buying government securities from the banks and giving them cash could have pushed the federal funds rate very low indeed. Stephen H. Axilrod, staff director for monetary and fiscal policy at the Fed and economist for the FOMC, said Brunner's approach might have meant a federal funds rate "close to zero," a "scary" prospect."
Both Axilrod and Sternlight, as well as numerous other Federal Reserve officials, unanimously said monetary policy is not being managed on anything like a purely monetarist basis. Among all 19 members f the FOMC, probably only St. Louis' Roos is truly a monetarist.
The essential difference this year has been that, with the new approach, the FOMC has felt free, both politically and economically, to allow interest rates to vary over a much wider range. In the past, the money stock often rose more rapidly than planned because the committee was unwilling to change the federal funds rate until the evidence it should be done was very clear.
And like any committee on which a consensus must be found before action is taken, the changes -- which usually were considered by both the FOMC and financial markets to be changes in policy -- often were not large enough.
By picking growth targets for the monetary aggregates, and letting the staff specify the proper path for growth of reserves, the FOMC has gotten itself out of the box of tightly managing interest rates, with all of the attendant political hassles. Politically it is one thing to let interest rates bounce up and down because of market forces; it is quite another deliberately to move them up directly as the result of a policy decision.
As part of an attempt to force the Fed to go further in a monetarist vein, the House subcommittee on domestic monetary policy, whose chairman is Rep. Parren Mitchell (D-Md.), recently approved a bill that would set a specific target for growth of M-1B and require the Federal Reserve to achieve it. The subcommittee acted relying largely on the advice of its staff director, economist Robert E. Weintraub.
Weintraub, another participant at the Bald Peak conference, agrees that following such a rigid prescription would mean wide interest-rate fluctuations. f"But I don't know if those shocks are any greater than those you get with bad monetary policy," Weintraub maintained.
Even with the huge ups and downs in rates and money stock growth in the last 12 months, there is still a reasonably good chance the Fed will hit most or all of its targets for this year, Weintraub said. "I'm not as critical as others of my faith," he explained. "The Fed may come out of this looking well."