THREE REMAINING ISSUES
THREE REMAINING ISSUES
U.S. monetary policymaking is, of course, not simply back where it
was thirty-odd years ago. Both the economy and the financial system are
different today. Policymakers have learned more about what the central
bank can and cannot do. So have economic researchers, and so has the
general public. As a result, many aspects of the prior experience that most
observers would identify as mistakes are unlikely to be repeated.
But challenges remain. Looking forward, in the specific context of the
role of interest rates in monetary policymaking, three sets of questions
seem most apt.
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Distinguishing Three Roles: interest rates
DISTINGUISHING THREE ROLES FOR INTEREST RATES
The place to begin in understanding not merely the role of interest
rates in monetary policymaking but how monetary policy works more
generally is to realize that the central bank is a monopolist. In highly
developed financial systems like that of the United States, many market
participants can and regularly do buy or sell securities in amounts far
larger than the Federal Reserve’s normal operations. But they usually do
not move markets, much less exert a powerful influence over output,
employment, and inflation. By contrast, moving financial markets to an
extent sufficient to affect nonfinancial economic activity is precisely what
central banks seek to do.
The standard explanation for central banks’ ability to affect large
markets through small operations is that transactions by the central bank
are fundamentally different from transactions by private market participants.
When the central bank buys securities, it makes payment by
increasing the reserve account of the seller’s bank, thereby increasing the
total volume of reserves that the banking system collectively holds. When
the central bank sells securities, it receives payment by reducing the
reserve account of the buyer’s bank, thereby reducing the total volume of
reserves. No other market participant can either increase or reduce the
total volume of reserves. The central bank is a monopoly supplier (and
withdrawer) of reserves.
This monopoly position matters because under any of a variety of
conceptions of the monetary policy process, banks and other financial
institutions must hold reserves with the central bank in order to carry out
the economic functions that households and firms look to them to
perform. The traditional “money view” of monetary policy begins with
households’ and firms’ demand for bank-issued money, against which
banks must, by law, hold reserves (usually specified as some set fraction
of each bank’s outstanding deposits). When the monopolist central bank
reduces the supply of reserves, banks therefore must reduce the amount
of money that they supply to households and firms. As households and
firms compete with one another to hold the now shrunken supply of
money, their individual efforts to sell securities for money cannot
produce any more money but do, collectively, drive the price of securities
down—that is, they drive interest rates up.
Alternatively, in some countries today—for example, in the United
THE ROLE OF INTEREST RATES IN FEDERAL RESERVE POLICYMAKING 45
Kingdom and Canada, and increasingly so among small banks in the
United States since required reserve ratios were reduced in 1990 and
1991—banks’ motivation for holding reserve balances with the central
bank actually has little or nothing to do with reserve requirements. These
reserves are, instead, a necessary means of settling interbank transactions
through the central bank’s clearing mechanism. On any given day, a bank
may have more checks presented for payment than checks deposited. If
its reserve balance is insufficient to cover the difference, its account at the
central bank will be overdrawn at the end of the day, in which case most
central banks will assess a penalty. If the central bank does not allow
“daylight overdrafts,” the bank must similarly maintain an adequate
reserve balance to cover such contingencies even on an intraday basis.
Although the banks’ reason for holding reserves is different, as long as the
need for settlement balances is related to banks’ volume of deposits the
implication of central bank operations is the same as under the “money
view.”
The “credit view” of monetary policy focuses on a different aspect of
the relationship between the financial and nonfinancial worlds, but for
this purpose it too leads to the same conclusion. Households and firms
look to banks to extend loans (credit). Banks can do so only to the extent
that they simultaneously create money—in other words, the respective
totals on the two sides of any bank’s balance sheet must always remain
equal. But if banks must create money in order to advance credit, and
creating more money means requiring more reserves, the central bank’s
role as monopoly supplier of reserves is again crucial. When the central
bank reduces the supply of reserves, banks have to cut back on their
lending, and the loan market will clear at a higher interest rate.
Under any of these different views of why monetary policy matters,
therefore, by exercising its monopoly power over the supply of its own
liabilities the central bank can influence the market-determined array of
interest rates (and prices) on all financial assets. Alternatively, instead of
supplying a set quantity of its liabilities, the central bank can directly
determine the interest rate on any one class of debt instrument by simply
buying or selling whatever amount of securities—and therefore supplying
whatever amount of bank reserves—is consistent with market equilibrium
at the chosen level for the designated interest rate. In this case the
market equilibrium still determines all other interest rates, and the prices
of all other financial assets, but the central bank in effect fixes one interest
rate.
As William Poole’s seminal paper (1970) neatly showed, if all other
influences bearing on output and inflation (or whatever else constitutes
the ultimate objective of monetary policy) were completely known in
advance, it would make no difference whether the central bank conducted
policy by fixing the supply of reserves or by setting an interest
rate. These alternative operating strategies would be fully equivalent.
46 Benjamin M. Friedman
Because many forces bearing on the central bank’s objectives are unpredictable,
however, the choice of “instrument” by which to implement
policy matters for the effectiveness of policy. As Poole and a series of
subsequent researchers showed, in general the more uncertainty surrounds
the behavior of households and firms in the markets for goods
and services—for example, the strength of consumer spending, or of
business investment—the more advantage there is to fixing the quantity of
reserves. By contrast, the more uncertainty surrounds behavior in the
financial markets—households’ and firms’ demands to hold deposits
versus other assets, their desire to borrow, the willingness of banks to
lend, and so on—the more advantageous it is for the central bank to set
the price of reserves: in other words, an interest rate.
Hence the first potential role of interest rates in the monetary policy
process—importantly, for one interest rate only—is as the instrument
variable that the central bank sets in order to implement its chosen policy.
Even if the central bank uses an interest rate instrument, however, there
remains the question of how it decides what level is appropriate. The
most straightforward approach would be to infer directly, from historical
or other relationships, the interest rate level that corresponds to whatever
level of nonfinancial economic activity, and hence whatever pace of price
inflation, the central bank seeks to achieve.
Here again, the fact that many influences bearing on output and
inflation are uncertain and, moreover, that the effect of interest rates on
both output and inflation plays out only over an extended period of time,
is crucial. To the extent that it is possible to observe along the way the
fluctuation of other variables that might convey useful information about
imminent but as yet unseen movements of output and inflation, adjusting
the central bank’s chosen interest rate level in light of those observations
is clearly helpful. In the limit, if some one observable variable were to
bear a sufficiently close relationship to subsequent movements of output
and inflation, a plausible way to conduct monetary policy would be to
determine what path for that variable most closely corresponds to the
central bank’s ultimate objectives and then adjust the interest rate
instrument in whatever way is necessary to keep that variable as close as
possible to this implied path— in other words, to treat that variable as an
“intermediate target” of monetary policy.
What observable variable might exhibit such highly desirable properties?
Probably none. But following the work of Milton Friedman and
Anna Schwartz (1963) and their many followers, the candidate that has
attracted by far the most attention during the last half-century of
monetary policymaking, not just in the United States but in many
countries with highly disparate economic structures and financial systems,
is one or another measure of deposit money. A second potential role
for interest rates in the monetary policy process, therefore, is again as an
instrument variable, but as the instrument that the central bank varies
THE ROLE OF INTEREST RATES IN FEDERAL RESERVE POLICYMAKING 47
with an eye not toward steering output and inflation directly, but rather
toward targeting the money stock.
Finally, regardless of how the central bank perceives its interest rate
instrument—indeed, regardless of whether the central bank uses an
interest rate instrument at all (as opposed to fixing the quantity of
reserves)—the central bank is able to fix at most one interest rate. Is there
a role for the others? More specifically, and in practical terms, most
central banks use an extremely short-term interest rate as their monetary
policy instrument variable. In the United States, the Federal Reserve has
for many years used the overnight federal funds rate. Is there a role in the
monetary policy process for long-term interest rates? Or for equity prices?
Once again, uncertainty and lags are the heart of the matter. If the
fluctuations of long-term interest rates or equity prices contain information
about future movements of output and inflation—and, crucially, if
this information is incremental, in the sense of going beyond what is
knowable from simply observing the past movements of output and
inflation themselves, or the movement of the central bank’s own instrument
—then in general it is helpful to adjust the instrument in light of this
observed information. Treating long-term interest rates or equity prices
as an “information variable” in this way is conceptually equivalent to
treating money growth, for example, as an information variable. But since
no one expects the central bank to be able to keep either long-term
interest rates or equity prices closely along a designated trajectory, so that
the question of treating these variables as intermediate targets does not
arise, the idea is perhaps even more straightforward.
How can the central bank decide whether any or all of these three
roles for interest rates—as an instrument variable directly linked to the
ultimate policy objectives, as an instrument variable used in pursuit of an
intermediate target, or as one or more information variables—constitutes
a good way to conduct monetary policy? The answer in each case is
empirical. Moreover, because objective circumstances change over time,
so does the state of the relevant empirical evidence. It is not surprising,
therefore, that actual central bank practice changes over time as well.
48 Benjamin M. Friedman
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