Federal Reserve System Implementation of Monetary Policy: Analytical Foundations of the New Approach

Abstract

On October 6, 1979, the Federal Reserve announced a change in its open-market operating procedures that moved the focus of short-run guides for open-market operations away from the federal funds rate and toward reserve aggregates. Under the old procedures, the Trading Desk maintained close week-to-week control over the federal funds rate within a range specified by the Federal Open Market Committee (FOMC). Alteration of the funds rate between FOMC meetings was subject to guidelines conditional on behavior of the money supply relative to specified tolerance ranges. Under the new procedures the Trading Desk targets on a family of reserve aggregates-principally nonborrowed and total reserves. The reserve operating guides under the new procedures are derived from targets for growth of the monetary aggregates and are expressed as averages of weekly levels over the short-run operating period, normally the intermeeting period. As a corollary, less attention is paid to the federal funds rate, and it is permitted to vary over a much wider range during the short-run operating period as compared with the old procedures. It should be understood that the October shift to a reserve operating guide for openmarket operations did not also encompass a change in either the proximate or ultimate objectives of monetary policy; they continued to be, respectively, the money supply and goals for economic growth, employment, and prices. Rather, the shift involved a change in the technique of achieving the proximate money supply objectives. Two reasons can be advanced for the shift. First, the old technique of operating on the federal funds rate seemed to be a less reliable means, in practice, of attaining the proximate policy objectives. Second, in view of the worsening inflationary psychology at the time, a shift to a different technique of operations would help to dramatize the Federal Reserve's continuing commitment to slowing money growth to curb inflation, and thereby would work to reduce inflationary psychology. This paper first summarizes the analytical framework underlying the choice between a reserve aggregate and a federal funds rate operating target, as well as some previous research bearing on the issue. Next, the technical aspects of implementing the new procedures are explained and contrasted to the theoretical paradigm underlying previous empirical results. Finally, experience with the new procedures since last October is reviewed and some conclusions are drawn.

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