Intermediate Targets and Indicators for Monetary Policy: A Critical Survey.

Hegji, Charles E.

This volume contains a series of studies by members of the staff of the Federal Reserve Bank of New York. Its purpose is to evaluate the usefulness of alternative monetary policy operating procedures, particularly in the light of the breakdown of the relationship between M1 and income that occurred during the 1980s, and the Fed's subsequent abandonment of the use of M1 as a policy target. The volume is encyclopedic in its coverage and clearly the best study I have read to date concerning Federal Reserve operating procedures. It is a little esoteric at times, but for the most part it is accessible to non-policy-making economists. It is certainly a must reading for Federal Reserve watchers.

The volume consists of an introduction by Richard Davis, and eleven studies concerning the desirability of using alternative macroeconomic variables as monetary policy operating guides. Given this introduction, the volume is set up so that each essay can be read by itself without loss of continuity.

Davis does a good job of introducing the non-initiated to the jargon of the targets and indicators of monetary policy. He clearly explains the differences between instruments, under direct control of the Federal Reserve, intermediate targets or operating guides to policy, and information variables, that is, policy indicators. Policy indicators are further divided into those that provide information to the Federal Reserve during the conduct of monetary policy, and indicators that the public can watch to determine the current stance of monetary policy.

I found particularly useful the explanation Davis provides for the use of an intermediate target, based on recent theoretical developments. The policy literature has clearly established the inefficiency of using intermediate targets as policy guides, given money and other financial variables can be used as information variables. However, money may still be useful as a policy target to provide a nominal anchor to policy and prevent time-inconsistent inflationary policies. Moreover, the use of money as an intermediate target potentially enhances Federal Reserve credibility.

The first four essays consist of a series of studies on the usefulness of monetary aggregates as intermediate targets or information variables. The monetary base, broad and narrow monetary aggregates, liquidity, and credit are the subject of study. The studies include theoretical discussion, review of past literature, updating empirical work to include all of the 1980s as the sample period, and overall evaluation of the aggregate considered. A common theme is seen throughout these essays. Either because of the breakdown of the relationship between the monetary aggregate and real income, or because of the breakdown in the ability of the Federal Reserve to control the particular aggregate, none of the candidates proves a useful intermediate target. The reason for this breakdown is the changing structure of the financial system emerging during the 1980s.

There are alternative ways of looking at how these structural changes affected the viability of particular monetary aggregates as intermediate targets. The best explanation for the breakdown in the MI-GNP link during the 1980s is provided by John Winneger. He suggests that when interest rates decreased during the 1980s, time deposit rates decreased more quickly than NOW account rates. This reduced the gap between the two rates, shifting public holdings into NOWs and driving down M1 velocity. When reinforced by the fact that the majority of M1 holdings switched from corporate to personal holdings during that period, the M1-income link could no longer be relied upon as a relationship on which to base monetary policy.

This breakdown of monetary aggregate-income relationships has led some to advocate the use of nominal GNP directly as a policy guide. This is the subject of a review essay by Spence Hilton and Viveck Moorthy. The argument is that nominal GNP could provide a nominal policy anchor to a Federal Reserve concerned with controlling inflation. I personally never bought this argument, since nominal income is too close to the Federal Reserve's final targets to be a credible intermediate target. The authors of this essay agree, and argue that close enough control of nominal GNP to use it as an intermediate target is beyond the Federal Reserve's ability. They also demonstrate that if the Federal Reserve could peg nominal GNP, inflation control would be achieved only at the expense of adverse variation in real output.

The use of interest rates as intermediate targets is the subject of the next essay. The authors' empirical findings suggest that the link between interest rates and income is relatively uncertain, particularly because of the effect of inflationary expectations on real interest rates. Due to this uncertainty, interest rates fail as intermediate targets. However, use of interest rates as policy instruments is still an option to the Federal Reserve.

The last three variables, commodity prices, the yield curve, and foreign exchange rates, are considered as information variables rather than as intermediate targets. Each has its limitations, though, in this role. The link between commodity prices and the aggregate price level is too weak to use commodity prices as a long-run predictor of inflation. However, commodity prices might provide useful information for predicting turning points in the inflation rate. Exchange rates are seen to be poor indicators of inflation, but can be used as information variables of foreign exchange market conditions that might impair monetary policy. Along these lines, the yield curve fares best. Estrella and Hardouvelis argue that since the Federal Reserve has control over the Federal funds rate, and therefore other short-term interest rates, movements in the yield curve can be used to give information about shifts in real income that may affect long-term interest rates.

Due to the problems involved with each of the variables considered in the volume, by this time one wonders what the Federal Reserve can do to implement policy. The last two essays tie the other studies together and help provide an answer to this problem. A useful rationalization for the use of an intermediate target even if not closely linked to the final target, as during the 1980s, is provided by Steven Englander. Timely information concerning the extent to which the Federal Reserve achieves its intermediate targets keeps the Fed credible and prevents it from introducing an inflationary bias into the economy. This is a nice extension of the essay by Richard Davis.

The last essay, however, provides the most telling explanation of current Federal Reserve behavior, in light of the above difficulties. In her review of Federal Reserve operating procedures, Ann-Marie Meulendyke suggests that the difficulties of the 1980s and the relative failure of all monetary aggregates as operating guides has led the current Federal Reserve policy stance. Now the Federal Reserve "looks at everything," including monetary aggregates, interest rates, prices, and income. This current mix of intermediate and final target monitoring may be the best it can do given the currently evolving financial structure. It's nice to hear someone from the Federal Reserve saying it.