Monetary policy - United States ; Bank reserves

Brian Motley

Joseph Bisignano

English

Research Papers in Economics

FRBSF WEEKLY LETTER
March 8, 1985
Rules vs. Discretion in Controlling Money
Duringthe last decade, and especially since
October 1979, the Federal Reserve System has
expressed its monetary policyobjectives in terms
ofthe growth rates ofmonetary aggregates, often
withthe principal emphasison M 1 (which
consists ofthe public's holdingsofcurrency and
checking accounts). Annual and quarterly targets
for these aggregates are established bythe Fed-
eral Open MarketCommittee(FOMC), and the
System uses its policy instruments -principally
the buying and selling ofgovernment securities
in open market operations-toachieve these
targets. Since 1979, the majorfocus ofmonetary
policy has been to reduce monetary growth
graduallyto a rate consistent with reasonable
price stability overtime.
One issue that has commanded the attention of
the FOMC in this period has been whether it
should establish a quasi-fixed rule for responding
to unexpected increases ordecreases in mone-
tary growth relative to its targets, orfollow a more
flexible approachoftreating such divergences on
acase-by-case basis. In the course ofdescribing
the methods ofshort-run monetary control used
bythe Federal Reserve in recent years, this Letter
discusses some ofthe advantages and disadvan-
tages ofa procedure based on rules versus one
allowinggreater discretion.
Since most money in the U.S. consists ofcheck-
ing accounts, which are the liabilities ofprivate
depository institutions, the Federal Reserve
cannot directly control the quantity ofmoney
outstanding. However, the central bank can
affect the money stock indirectly because depos-
itory institutions are required to hold reserves
equal to specified proportions ofcertain oftheir
deposit liabilities, and the supply of reserves is
underthe Federal Reserve's control. By increas-
ing ordecreasing the supplyof reserves, the
Federal Reserve can change the quantityof
deposit liabilities the private banking system is
ableto create. It thus can increase ordecrease the
total stock of money in the hands ofthe public.
Sourcesofbank reserves
Bank reserves take the form ofreserve accounts
held by depository institutions at Federal Reserve
Banks and ofcash held in theirvaults. They have
two components: nonborrowed reserves and
borrowed reserves. The supply of nonborrowed
reserves is directly influenced bythe Federal
Reserve: when the Trading Desk at the New York
Federal Reserve Bank buys orsells government
securities in the open market, nonborrowed
reserves rise orfall.
Borrowed reserves, on the other hand, come into
existence when private banks and other deposi-
tory institutions borrow from the Federal Reserve
Banks, or "cometo the discountwindow" as it is
usually called.Although the Federal Reserve sets
the interest rate ("discount" rate) on this borrow-
ing, the quantityofborrowing - at least in the
short run - is determined mainly by thedeci-
sions of individual banks. If, for example, market
interest rates rise and make discountwindow
borrowing relatively less expensive as a source of
bank funds, borrowed reserves tend to rise. A
portion ofthe total stock of reserves is thus
determined bythe decisions of private depository
institutions rather than exclusively by the mone-
tary authority.
In theory, itwould be possible for the Trading
Desk to control the total stock ofbank reserves
by using open market operations to offset all
changes in borrowed reserves with equal and
opposite changes in nonborrowed reserves. In
fact, however, the System has neverfollowed
such a total reserves controlprocedure, although
itfrequently has been urged to do so by its critics.
Before February 1984, each bank's required
reserves in a given week depended on its deposit
Iiabilities two weeks earlier, which meantthat
total required reserves were predetermined in
any particularweek. Since the Federal Reserve
had nooption butto supply at least that quantity
ofreserves, a total reserves control procedure
was notfeasible. Reserve requirements on trans-
action deposits are now contemporaneous, but it
is still argued thatthe banking system cannot
quickly alter its total deposits, and hence its
required reserves. In practice then, attempts to
control total reserves mightcause short-term
interest rates to become unduly volatile. PartiallyFRBSF
in response to this concern, such a procedure has
not been implemented even though theshiftto
contemporaneous reserve requirements was
urged by many Federal Reserve critics to make a
total reserves control procedure feasible.
Instead, short-run monetary control since
October 1979 has focused on the proportion of
total reserves in borrowed versus nonborrowed
forrn.A rise in this proportiontends to reduce
money growth. Both the Federal Reserve and
individual commercial banks view access to the
discountwindow as a privilege. There is a general
reluctance to borrowfrom the Fed, butthis
attitude depends on the spread between the
federal funds rate and the discount rate. The
greaterthe spread, the greater the wiIIingness to
borrowfrom the discount window. As a result, if
the Trading Desk were to reduce the supply of
nonborrowed reserves, market interest rates
would tend to rise and only then would banks
become willing to borrow more from the discount
window. Hence, such a Desk action increases
the proportion oftotal reserves that is borrowed,
pushes up interest rates, and causes money
growth to slow as the holding ofmoney becomes
less attractive to the public relative to the holding
of interest-bearing assets.
The reserves control experiment
In the period between October 1979and October
1982, the Federal Reserve followed what came to
be known as a nonborrowedreserves control
procedure. Given the desired short-run path for
money, and hence for required reserves, the Desk
(after each FOMC meeting) set a path for non-
borrowed reserves. Despite the influenceofun-
controllable and unpredictable factors such as
changes in Federal Reserve float and in the
Treasury balance, the Desk is able to hit such a
nonborrowed reserves objective with consider-
able accuracy.
Ifthe demand for money grew more rapidIy than
planned, the path for nonborrowed reserves was
normally not raised. This rule meant that the
resulting need for additional reserves had to be
met at the discountwindow. Hence, faster money
growth caused interest rates and the proportion
of borrowed reserves in total reserves to increase.
These higher rates in turn tended to curb money
growth and bring it back toward path. The main
advantage ofthis "rule-based" procedure there-
fore was that it had a built-in "automatic stabil-
izer" which tended to moderate departures of
moneyfrom the short-run path over time.
As a side-effect ofthe nonborrowed reserves
rule, interest rates tended to become more vari-
able than they had been priorto October 1979.
This would not have been a disadvantage ifmost
changes in the quantity ofmoney demanded
reflected changes in the level ofeconomic activity
which the Federal Reserve wished to "lean
against." However, critics ofthe procedure
argued that, to the extent that changes in money
demand represented temporary or random fluc-
tuations that the central bank should have been
content to accommodate because they did not
significantly affectthe growth of nominal GNP,
the interest rate fluctuations unsettled the money
marketswithoutserving any useful moneycontrol
purpose.
Since late 1982, the FOMC has come to the view
that many changes in money represent increases
or decreases in the demand for money thatdo not
appreciably influence real output and prices.
Hence, a control procedure that automatically
offsets all short-run money demand fluctuations
is not necessary. A more discretionary system
would enable the central bank to decide, on a
case-by-case basis, which variations in money
demand should be accommodated and which
should be offset.
The result ofthis re-appraisal is the present
borrowed reserves control procedure which
focuses on the level ofdiscountwindow borrow-
ing rather than on nonborrowed reserves. Under
this procedure, an initial path for nonborrowed
reserves is derived by subtracting from required
reserves (in turn derived from the short-run
money path) the objective for discount window
borrowing, and adding an assumed level of
excess reserves. The Trading Desk may alter this
initial path for nonborrowed reserves between
FOMC meetings as needed to achieve the bor-
rowing objective. Importantly, underthe current
control procedures and in contrast to the proce~
dure used before the fall of 1982, there is nofully
automatic mechanism by which the level of
borrowed reserves changes in response to devia-
tions ofobserved moneyfrom its short-ru n path.
However, the FOMC's directive to the Trading
Desk usually does indicate the economic condi~
tions under which the borrowing objective would
be altered.Although both procedures described operate by
varyingthe ratio ofborrowed to nonborrowed
reserves, there is aconsiderable difference
between pre- and post-fall 1982 control proce-
dures. Underthe current procedure, as long as
the borrowingobjective is unchanged, the Federal
Reserve passively supplies as many nonborrowed
reserves as the banking system demands with
little Fed-induced change in interest rates. In
. general, onlywhen the borrowing objective is
altered are the degree of Federal Reserve pressure
on banks' reserve positions-and hence on
short-term interest rates -changed. Underthe
earlier procedure, by contrast, nonborrowed
reserves were the active policy variable that
automatically transmitted short-run variations in
reserve market conditions and money demand to
changes in borrowed reserves and interest rates.
Evaluating thecurrentprocedures
The considerable reversal in M1 growth between
the first and second halves of 1984 raises the
question ofwhether the current control proce-
dures are adequate. M1grew at an 8-percent
annual rate in the first six months of 1984 but
only at a 4-percent rate between June and
December. Critics have argued that, although
short-term rates rose in the earlier period and
declined sharply after September, these changes
would have taken place sooner under a nonbor-
rowed reserves procedure and that, as a result,
monetarygrowth wouId have been smoother
overthe year as a whole.
This criticism ofthe current procedure is the
latest example ofa more general and longstand-
ing criticism that the central bank attempts to
smooth market interest rates and so causes mone-
tary growth to be determined bydemand. The
Federal Reserve often is charged by its critics
with inadvertently accommodating the public's
demand for money rather than independently
controlling its supply, and thus with producing
pro"cyclical rather than contra-cyclical money
growth. To avoid this tendency, critics argue that
control procedures should incorporate some
automaticity in the response ofborrowed re-
serves, and hence interest rates, to deviations of
moneyfrom target. The nonborrowed reserves
control procedure incorporated such an automatic
response since moneydeviations necessitated
changes in the level ofdiscountwindowborrowing.
The importantpolicy debate is over the extent to
which interest rates should move automatically
in response to deviations ofM1 from some
pre-determined target. The choice is between
greater short-term discretion over interest rates
and possibly tighter short-run control over money
growth. As already mentioned, the principal
feature ofthe nonborrowed reserves approach;
which distinguished it from both earlier and later
control procedures, is that interest rates tended to
respond somewhat automatically to deviations of
money from its target path.
All monetarycontrol procedures operate ulti-
mately by causing variations in interest rates that
affect the public's willingness to hold and deposi-
tory institutions' incentives to supply money. On
a theoretical level, a strong argument may be
made on monetary control grounds for a nonbor-
rowed reserves regime because under such a
procedure, interest rates respond quicklyto devi-
ations ofmoneyfrom path since no explicit
policy decision is required. In 1984, however, the
FOMC was willingto permitthe wide swings in
interest rates required to hold M1 within its
long-run target range, so the argument for a
rule-based procedure may be less applicable in
that recent experience. Nonetheless, the debate
over short-run monetary control always will
involve the extentto which interest rates should
be permitted to move in orderto reduce devia-
tions ofmoney from target, and the issue of "rules
versus discretion" will remain a hotone.
Brian Motley and Joseph Bisignano
Opinionsexpressed in this newsletterdo not necessarily reflect theviewsofthemanagementof the Federal Reserve BankofSan
Francisco,orofthe Board ofGovernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor.•..FreecopiesofFederal Reservepublications
can beobtained from the Public Information Department, Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.UO:Pu!4S0m 4o~n u060JO 0POI\0U
040PI !!OrTIOH O!UJ0J!l0) ouozPl:J o~soll:J
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
02/13/85
Change
from
02/06/85
Changefrom
02/22/84
Dollar Percent7
Loans, Leases and Investmentsl 2 188,177 636 12,697 7.3
Loans and Leases1 6 170,084 744 14,815 9.5
Commercial and Industrial 52,449 384 5,961 12.8
Real estate 62,211 48 2,622 4.4
Loans to Individuals 32,542 48 5,637 20.9
Leases 5,269 - 21 266 5.3
U.S. Treasury and Agency Securities2 11,010 - 106 - 1,245 - 10.2
OtherSecurities2 7,083 - 2 - 868 - 10.9
Total Deposits 194,596 1,727 10,575 5.7
Demand Deposits 45,998 1,764 3,582 8.4
Demand Deposits Adjusted3 28,226 -2,019 733 2.6
OtherTransaction Balances4 12,923 46 992 8.3
Total Non-Transaction Balances6 135,675 - 84 6,005 4.6
Money Market Deposit
Accounts-Total 43,714 86 3,436 8.5
Time Deposits in Amounts of
$100,000 or more 38,966 - 92 783 2.0
Other Liabilities for Borrowed MoneyS 19,955 - 416 - 1,038 - 4.9
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency(-)
Borrowings
Net free reserves (+)/Net borrowed(- )
Period ended
02/11/85
31
21
10
Period ended
01/28/85
123
57
66
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes tradingaccountsecurities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephonetransfers
s Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs andothersources
6 Includes items notshown separately
7 Annualized percentchange

Rules vs. discretion in controlling money

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Rules vs. discretion in controlling money

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