Federal Reserve monetary policy continues to be the subject of a critical cacophony. Economists and strategists assert that the Fed kept interest rates too high for too long, leading us to the economic downturn of 2001, and then too low for too long during the ensuing slow recovery. As a result, the Fed is now being accused of precipitating an economic downturn since monetary policy will have to get “tighter” if it is to dampen inflationary expectations. Even with the current pause — the Fed ended its long rate-hiking march when it kept its key interest rate at 5.25 percent this week — equity markets don’t believe there will be any permanence to this policy change.
I think it is time for a little clarity on what modern Federal Reserve policy is all about.
The Fed attempts to influence interest rates by targeting the fed funds rate, or the rate at which banks lend reserves to one another to meet required levels of reserves at the Fed. The Fed buys government securities to increase bank reserves, and thereby lowers the funds rate, or sells government securities to decrease bank reserves and raise the rate. Prior to 1981, the fed funds rate was used to affect the growth rate of the money supply. Responses to swings in money-supply growth produced inordinately wide swings in the fed funds rate as well as uncertainty over the economic outlook. The funds rate hit 20 percent when Ronald Reagan assumed the presidency in January of 1981.
A key turning point in monetary policy occurred in 1981 when the Fed, under Paul Volcker, changed Fed policy. On October 28, 1982, the editorial page of the Wall Street Journal featured an article written by Arthur B. Laffer, the well-known supply-side economist, and Charles W. Kadlec. The essence of this article was that the Federal Reserve had embarked upon a new monetary policy based on a “price rule.”
Prior to implementation of this change, the Fed conducted monetary policy on a quantity rule. Under a quantity rule, the Fed attempts to control the growth rate of the money supply by varying the fed funds rate (until the growth in money moves into a target band). Milton Friedman, the father of monetarism, advocated controlling the growth rate in money to constrain inflation, and due to Friedman’s influence, the quantity theory dominated Fed policy. A number of years ago the Federal Reserve Bank of St. Louis actually published growth-rate bands for various measures of money, suggesting where Fed policy might respond to money supply growth that was either too fast or too slow.
Under a price rule, however, the Fed controls the price of money (the fed funds rate) in order to manage inflation and lets the quantity of money fluctuate. In practice, the Fed will supposedly track the price of a basket of commodities as a benchmark for inflation, and when the price of this benchmark moves above a certain level, the Fed will raise the fed funds rate (the price of money) until commodity prices move back within the target range.
In 1989, in an article for Laffer Associates (“The Price Rule Vindicated”), I tracked the implementation of the price rule relative to a proxy for the Fed’s benchmark, the Dow Jones Spot Commodity index, from 1982 through 1989. My conclusion was indeed that the Fed was conducting monetary policy using a price rule: “Market participants are continually looking for new indicators that reduce the uncertainty of the future. Seldom have we had an indicator that gave us such an accurate measure of what direction Fed policy might take.”
The success of the price rule is reflected in the above figure, where the high volatility of interest rates, as measured by fluctuations in the fed funds rate in the early 1980s, gave way to the systematic management of fed funds as the price rule restored credibility and certainty to Fed policy. This certainty, reflected in above-average economic growth and low inflation, also contributed to a record twenty-year bull market in both the bond and stock markets.
Yet even with this success, there remains some controversy over current Fed policy. In their recent NRO article, “What’s Wrong with Fed Policy,” Reuven Brenner and Martin Fridson imply that the Fed is still attempting to control the money supply: “The source of the problem is the Fed’s reliance on mis-measured aggregates to control the supply of dollar liquidity, rather than market prices.” Can the Fed do both — control or attempt to control the supply of money (some measure of the monetary aggregates) and the price of money (the fed funds rate) simultaneously?
The answer is no: You cannot control the price of something and the quantity of something at the same time.
General Motors, for instance, can either set the price of Corvettes and let the market determine the quantity demanded, or the number of Corvettes produced and let the market set the price. In 1976, GM took the unprecedented step of creating a bicentennial edition of the Corvette, producing only one Corvette for each Chevrolet dealer. Soon after the announcement was made, demand for these limited-edition Corvettes exploded. Not having the vehicles in hand, each dealer began selling contracts for these cars. These “futures” contracts sold at huge premiums since there was only a limited number of Corvettes produced. Obviously, GM underestimated demand by limiting supply, and early buyers capitalized on GM’s decision to limit production.
Under the price rule, the Fed sets the price of money — the fed funds rate — and ignores the growth in the quantity of money. How do we know the Fed ignores the money supply? Just look at the data. The following examination of the effective fed funds rate versus the intended (or target) fed funds rate provides ample evidence that the Fed is controlling the fed funds rate.
In contrast to the relationship between the target and actual fed funds rates, volatility in the monetary base — a measure that the Fed supposedly controls — indicates that either the Fed changes it’s mind a lot or that the monetary base is not controlled or controllable by the Fed.
When you examine policy statements made by Fed chairmen, it is obvious that strategy changes are few and far between. Following the economic downturn of 2001, the Fed adopted a policy of lowering interest rates to cushion the economy from the slowdown and avoid the possibility of deflation. In 2004, when the economy reflected the positive economic impact of President Bush’s tax-rate cuts of 2003, monetary strategy changed to raising interest rates. While these changes are clearly reflected in changes in the fed funds target, virtually no one could examine the fluctuations in the growth rates of the monetary base and ascertain the direction of Fed policy. Minutes from Fed board meetings and testimony by Fed chairmen reflect an absence of any effort to use money-supply growth as a policy objective. Rather, Fed chairmen discuss at length efforts to control inflation or deflation by varying the fed funds rate.
Fed policy has given investors confidence that interest rates will remain stable and not fluctuate wildly — as occurred under a quantity rule. This confidence is reflected in long-term interest rates that have remained unusually low by historic standards, even in the face of record budget deficits. If the Fed reverted to attempting to control the money supply rather than controlling interest rates, increased volatility in interest rates could lead to a rise in inflationary expectations and lower economic activity.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc., and principal of Victoria Capital Management, Inc.