Because of the "veritable revolution" taking place in the way in which people now can invest their money, the Federal Reserve System eventually will be forced to rely less on money supply targets as the main basis of policy, Anthony M. Solomon, president of the New York Federal Reserve Bank said yesterday.
As vice chairman of its Federal Open Market Committee, Solomon is the second-highest official in the Reserve System, ranking only behind Chairman Paul A. Volcker. Solomon addressed a joint seesion of the American Economic and American Finance Associations here.
He predicted that at the end of a process of innovation and deregulation, all but the smallest of any kind of money accounts would pay "market-related interest rates" and that most of them would be free of reserve requirements, thus shrinking the totals that are "readily controllable" by the Federal Reserve, except indirectly through interest rates.
Solomon told a reporter his speech was less a policy statement than an academic exercise aimed at stimulating a public debate about "the problems that innovations are creating for the coherence of the money-targeting approach." Under this approach, formalized first in 1975, the Fed plays primary attention, in trying to achieve broad economic goals, to setting and following one-year targets for growth in various measures of the money stock.
The approach reflects the currently predominant view of monetarists that a slowdown in the trend rate of money growth is the most important condition for defeating inflation.
The burden of Solomon's argument was not to take issue with monetarist theory itself, but to suggest that the increasing use of substitutes for bank accounts and other traditional money accounts--such as NOW accounts and money market funds--creates problems for a monetary policy based only on setting money targets.
"Increasingly, we live in world of universally flexible interest rates and highly mobile sources of funds . . . My own instinct is that there is no single approach to monetary policy that is best for all times and places. As conditions change, the approach will have to change, too," Solomon said.
Although major elements of the financial "revolution" have yet to take place, Solomon said that the impact can already be seen in the divergent signals sent by different measures of the money suply this year.
During the first 11 months of 1981, he said, M1B, adjusted for the introduction nationwide of NOW accounts, rose at a 2 1/2 percent annual rate. The comparable measures for the broader M2 and M3 aggregates were 10.1 percent and 11.1 percent, respectively. The result in the narrow definition was less than the low end of the range, while higher than the upper end of the range for the broader defintion.
Thus, taken literally, the narrow measure of money supply (M1B) makes the money policy look quite tight, while broader definitions make policy look loose.
He confessed that the Fed did not anticiptate how wide the divergencies would be, and said this was a complication in setting policy: "Over most of the year, M1B seems to have been giving a misleadingly weak signal. . . . On the other hand, monetary policy cannot reasonably be charged with the easy policy that a literal reading of the broad measures would suggest."
During the transition period that lies ahead, Solomon said the Fed "will have to allow for more uncertainty about the demand for money," perhaps by greater use of mid-year corrections or by wider target ranges.
Solomon said that the major policy question for the Fed involves the central bank's ability to control the various forms of money supply.