Policy of Targeting Market Aggregates
October 1979 – October 1982
New Policy of Targeting Monetary Aggregates
The Federal Open Market Committee (FOMC) made a shift in the approach to monetary policies and started targeting the quantities of money in non-borrowed reserves (Econ, 2003).
It was expected that the new approach would increase the volatility in the rate of federal funds.
The chart shows the rise in inflation that reached peak levels in the late 70’s, causing the Federal Reserve to come up with new policies to solve the issue.
Late 70’s were characterized by the deregulation of the interest rate as well as the innovations that had an impact on the ability of the Federal Reserve to change policies through monetary aggregates’ targeting (Econ, 2003).
A significant development was the increased popularity of the money market mutual funds used as a vehicle for alternative savings or.
Households made a shift in the balance between deregulated accounts, mutual market funds, and deposit accounts that led to growth rates levels of different monetary aggregates changing based on the accounts included in them.
The chart shows that the average federal funds varied between 1979 and 1982.
Early 80’s – wide growth fluctuations (M1) not related to the country’s economic environment.
Lack of coordination between fiscal and monetary policies of the 80’s – Failure in targeting market aggregates:
Fiscal and monetary authorities had different views of their policies and pursued different objectives. E.g., they had different perceptions of what was the best for the society and the economy.
Authorities had different opinions about the effects of the implemented policies on the economy. E.g. they adhered to different economic theories.
Fiscal and monetary authorities conducted different forecasts about the possible economic environment in the absence of interventions. Different forecasts resulted from the difference in economic theories or from different forecasts of exogenous variables (Hole, 1982).
Late 1982
Move Away From Targeting M1
The Federal Reserve responded to the decreased inflation and market innovation through by the return to targeting price instead of quantity.
FOMC began to conduct operations on the open market that were believed to impact a degree of ease or tightness within the reserve market conditions (Econ, 2003).
The Federal Reserve focused on M2 (broader monetary aggregate)
for a short period of time FOMC policies decided not to focus on monetary aggregates to guide its decisions:
“At one time, M2 was useful both to guide Federal Reserve and to communicate the trust of monetary policy to others […] But that long-run relationship also seems to have broken down with the persistent rise in M2 velocity” (Alan Greenspan, Chairman of the Federal Reserve 1987-2006) (as cited in Qureshi, 2016, p. 17)
Monetary Acceleration in the late 80’s
No quantifiable model for deriving the finds rate from the money supply target (Hetzel, 1984).
Monetary control depended on a feedback mechanism, in which the funds rate was led to into the appropriate direction as long as the money supply was not the target.
Great importance was given to the temporal nonlinearities in the function of the borrowed reserves.
The start of monetary acceleration was characterized by the negligible banks’ usage of the discount window.
Monetary acceleration had self-reinforcing dynamics that were underappreciated at that time.
The late 1980’s were associated with the uncertainty present on the bond market within the course of the long-term rates, which led buyers to only be interested in non-monetary liabilities of banks, because:
Bonds sellers and buyers started to opt for short-term markets;
Sellers raised the demand for bank credit (Hetzel, 1984).
Inflation and Stock Market Crash
October 1987 – July 1990
The Federal reserved responded to the stock market crash of October 1987 (Black Monday) by:
Accommodating the increased demand for currency through purchases on the open market;
Dropping federal funds rate target from 7.5% to 6.75%;
Making sure that the monetary policy was stimulative enough for averting a crisis.
Outcomes
Inflation rose in ’88, ’89, and ‘90 despite the economy being put through recession in the early 80s to ensure price stability;
CPI inflation rose from 3.8% to 5.3% in 1986 and 1990 respectively;
Employment cost inflation increased from 3% to 5% in 1986 and 1989 respectively;
The unemployment rate decreased from 7% to 5.3% in 1986 and 1989 (unemployment rate had not fallen below 5.5% since 1973) (Goodfriend, 2002).
October 1987 – July 1990
Reasons
Pressure on the economy had started building before October 1987;
The 30-year bond rate was showing rising expectations of inflation that increase by more than 2 % (from 7.5% to 9.6%) (Ireland, 1996);
The reaction of the federal reserve was not as effective as it could have been;
The inability to respond correctly influenced the doubts of inflation lingering.
Conclusions
There was a range of sufficient reasons for the Federal Reserve to implement preemptive policies targeted to eliminate inflation;
The October stock market crash intervened before implemented policies could have an impact on the economy;
Monetary policies restraints could have been implemented a few years earlier to prevent the mentioned events from occurring.
Spring of 1988
The Federal Reserve started raising funds rate to meet 10%, which led to the
Increase in the real short rates to more than 5%;
Real GDP fell from 4% in 1988 to 2.5% in 1989, which led to the decrease in funds rate to approximately 7% in 1990.
August 1990 – January 1994
U.S. economy dealing with the severe blow caused by the 1990 Gulf War (lasted 100 hours);
Outcomes
Aug. 1990 oil prices rose to 35$ per barrel;
Recession from July 1990 to March 1991.
Monetary policies
Could not avert the impact caused by the Gulf War;
The Federal Reserve’s credibility was compromised in 1990;
The Fed. Res. Decreased the federal funds rate from 8% to 6% in Spring 1991, 4% by the end of 1991, 3% in October 1992, lasting until February 1994 (Goodfriend, 2002).
References
Econ, D. (2003). How did the Fed change its approach to monetary policy in the late 1970s and early 1980s?Web.
Goodfriend, M. (2002). The phases of U.S. monetary policy: 1987 to 2001. Economic Quarterly, 88(4), 1-17.
Hole, J. (1982). Monetary policy issues in the 1980s. Web.
Qureshi, I. (2016).The role of money in Federal Reserve Policy. Web.