An Explanation of Federal ReserveActions

N RECENT YEARS there has been a noticeableshift in professional opinion with respect to the im-pact of Federal Reserve actions on national income.More economists now acknowledge that these actionsplay a key short-run role in the determination oftotal demand. Monetary studies, using United Statesas well as foreign data, have given considerable sup-port to this position.’ Parallel with the increasedrecognition of Federal Reserve actions as an impor-tant determinant of national income has been anescalation of the controversy over the proper interpre-tation of monetary policy. For example, the financialpress has at times expressed concern that restrictivepolicy statements are not always followed by restric-tive actions.

This public controversy about the alleged discrep-ancy between some monetary policy statements andFederal Reserve actions is based upon a fundamentalcontroversy within the economics profession over theproper measure of Federal Reserve actions. Econo-mists of a neo-Keynesian persuasion believe that Fed-eral Reserve actions have their primary effect on theeconomy through changes in interest rates. Accordingto this view, high or rising interest rates indicate re-strictive monetary influences on the economy, whilelow or falling interest rates indicate easy monetaryinfluences. By this measure the Federal Reserve hasalmost always followed appropriate countercyclical

*The authors give special thanks for helpful comments onearlier drafts to Leonall Andersen, Karl Brunner, DavidFand, Harry Johnson, Allan Meltzer, David Rowan andWilliam Yohe. The authors are solely responsible for anyremaining errors.

‘For example, see “Monetary and Fiscal Actions A Test ofTheir Relative Importance in Economic Stabilization” byLeonall C. Andersen and Jerry L. Jordan, available asReprint No. 34 and taken from the November 1968 issueof this Review. Also see Milton Friedman, et al., Varieties ofMonetary Experience (Chicago: University of Chicago Press,1969), and Michael W. Keran, “Monetary Policy and theBusiness Cycle — The Foreign Experience,” this Review,November 1967. In the neo-Keynesian tradition, the MIT-FRB model also shows the strong impact of monetaryactions.

(1933-68)

stabilization policies. Interest rates have generallybeen rising when the Federal Reserve called for tightmoney, and falling when it called for easy money.

Economists who consider that the Federal Reservehas its primary effect on the economy through changesin monetary aggregates, such as the money stock orthe monetary base, consider that an accelerating ag-gregate is a sign of expansionary monetary influenceson the economy and a decelerating aggregate is asign of restrictive monetary influences. On the basisof aggregate measures, Federal Reserve actions havebeen criticized for not always being consistent withstated monetary policy.

The intent of this article is to examine the reasonsFederal Reserve actions, as measured by mone-tary aggregates, have not always been consistent withstated monetary policy. This discrepancy is largelyexplained by the fact that while monetary policy istypically stated in terms of attempting to stabilizeincome, employment, prices and the balance of pay-ments around some desired level or growth rate, Fed-eral Reserve actions are actually responsive to a widerset of objectives, As the “bank of last resort”, theFederal Reserve has a responsibility to insure theinstitutional viability of the nation’s financial system.As the fiscal agent of the Federal Government, theFederal Reserve has a responsibility for insuring areceptive market for Treasury issues of new debt.When these other objectives are added to the stabili-zation objectives, we have a more complete view ofFederal Reserve actions and an explanation for theobserved discrepancies between monetary policystatements which are related to stabilization objec-tives and actual Federal Reserve actions.

In the following sections indexes will be constructedto represent the Federal Reserve’s stabilization andother objectives. Building on these indexes, evidenceis presented showing •that for the past 36 years theFederal Reserve has acted in a consistent mannerwith respect to these objectives.

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FEDERAL RESERVE BANK OF ST. LOUIS JULY, 1969

Measuring Monetary Policy orStabilization Objectives

Monetary policy is defined in this article as theFederal Reserve’s response to stabilization goals, thatis, achieving target levels of income, employment,prices and the balance of payments. Most economistswho have examined the basis of monetary policy haveapproached it by postulating a behavioral link be-twcen these stabilization objectives and some indica-tor of monetary policy, such as free reserves, themoney stock or the Treasury-hill rate. This approachto measuring monetary policy has several importantdrawbacks.’ For the reasons given in footnote 2 andin the Appendix, this study does not attempt to linkstabilization objectives to ultimate target values ofincome, employment and prices. Instead, a proxyvariable will be used as a summary measure of thestabilization policy objectives of the central bank.

The proxy used is free reserves. Movements in freereserves are highly correlated with changes in thepolicy directives of the Federal Open Market Com-mittee (FOMC), which is the key monetary policy-making body of the Federal Reserve. The accom-panying chart illustrates this close association betweenthe level of free reserves and a quantification ofFOMC directives. This quantification of the FOMCdirectives was constructed from a procedure devel-oped by Professors Karl Brunner and Allan Meltzer.’They examined the policy directives from March 1946to December 1962 and assigned a value between +1and —1 to each directive, according to whether it

called for ease or tightness relative to current condi-

2First, the policy objectives may not be independent ofone another. Attempts to achieve one target (eliminating infla-tion) may cause a movement away from another desiredtarget (reducing unemployment). Because it may be im-possible to satisfy, simultaneously, two policy targets withone policy tool, the policymaker may choose to achieveone target one time and the other another time. Given thestatistical tools at hand, it may not be possible for theeconomist to discriminate between these varying responses.Second, the preferences of the policymaker with respect toachieving desired levels of alternative target variables maybe interdependent. For example, the disutility of the policy-maker associated with missing a price stability target maynot be independent of how far other stabilization targetsare missed. Finally, there are serious statistical difficultiesin constructing a systematic statement of the Federal Re-serve’s response to discrepancies between observed and de-sired levels of target variables when the observed values ofthe target variables show little variation during a significantpart of the period. These issues are discussed more fully inthe Appendix.

~ Brunner and Allan Meltzer, “An Alternative Approachto the Monetary Mechanism,” Rouse of Representatives,Committee on Banking and Currency, Subcommittee onDomestic Finance, U.S. Government Printing Office, August17, 1964. The scale and thus the absolute valises assigned toeach directive is arbitrary. Only the sign is important. Thesame absolute values of the accumulated directives at differ-ent points in time are not necessarily comparable.

tions. If the Federal Reserve had been following arestrictive policy but did not wish to be any morerestrictive, the FOMC directive would call for nochange and the number assigned to that directivewould be zero. A move toward restraint was assigneda negative value and a move toward ease, a positivevalue. To measure the progressive easing or tighten-ing reflected in FOMC directives over time, the as-signed values were accumulated. It is these accumu-lated values which are plotted in the accompanyingchart,4

The quantified FOMC directives are plotted onlyfrom 1953 to 1962, because directives prior to 1953were largely concerned with stabilizing the marketprice of Government securities and thus were mel-evant to our present purpose of measuring stabiliza-tion objectives. Directives, after 1962, were not quan-

4There are two interpretations which can be put on theaccumulation procedure. First, it could imply that when thedirective called for tighter money market conditions thanthose previously prevailing, monetary policy is tighter. Second,it could imply that policy is not tighter, but that previoustightening in money market conditions had not achieved thedesired objectives, and that greater tightening in moneymarket conditions is necessary to achieve the desiredtightening in policy. In the first case, desired policy is alwaysrealized, and therefore, the cumulative directive measures achange in desired policy. In the second case, desired policydiffers from the observed index, and the progressivetightening in the directive represents an attempt to eliminatethe discrepancy, so the accumulative directive is alwaysmoving in the right direction. Either interpretation of thedirective is consistent with the accumulation procedure. Theshorter the time period, the more likely that the secondinterpretation is correct, and the longer the time period,the more likely the first interpretation is correct. The nse ofquarterly observations in this study supports the firstinterpretation.

Page 8

FEDERAL RESERVE BANK OF ST. LOUIS

tified by Karl Brunner and Allan Meltzer in their 1964article.~Virtually every change in the FOMC direc-tives after 1952 was related to an expressed concernfor inflation, unemployment or the balance of pay-ments. For this reason the directives are considereda good indicator of the stabilization objectives of theFederal Reserve.0 The patterns of movement in thefree reserve and FOMC directive series are quiteclose. Every turning point in free reserves and eventhe magnitudes of most changes are fairly accuratelyreflected in the quantification of the directives. Thecorrelation coefficient between free reserves and theaccumulation of the Brunner-Meltzer quantificationof the directive for the period 1953-62 is 0.87. Theauthors used the Brunner-Meltzer procedure to quan-tify the directives in the period 1963 to 1968, and therelationship with free reserves was unchanged (cor-relation coefficient of 0.86).

The use of free reserves as a proxy measureof stabilization objectives of the Federal Reserve hasalso been followcd by other economists who haveattempted to analyze Federal Reserve behavior. Mostof these economists assumed that the full concern ofthe Federal Reserve was directed toward stabilizingthe growth of income, employment, prices and attain-ing equilibrium in the balance of payments. Withonly stabilization objectives in mind, their results ledthem to conclude that free reserves are “the mostreliable indicator of monetary policy.”7 Finally, theFederal Reserve itself seems to place strong relianceon free reserves as a measure of monetary policy:

“A down’tvard trend in net free reserves overa period of several months preceding a particularaction confirms that Federal Reserve policy hasbeen tending to become somewhat less stimula-

‘~Meltzerhas very recently extended the quantification throughMarch 1969. Flowever, it was not available in time to beused in this paper.

6Even-keel is mentioned many times in the FOMC directives,but only as a reason for delaying a change in policy, never asa reason for taking action.

JULY, 1969

tive with regard to the growth of credit andmoney than it had been earlier ... In general,the net reserve position of member banks is animportant gauge of pressure on hank reserves.When net free reserves rise, the result is in-creased marginal availability of reserves whichthe banking system can readily use to expandcredit

Free reserves are used in this article only as a proxyfor the stabilization objectives of the FOMC. Their useshould not be taken to imply that we consider freereserves to have any causal impact on bank behavior,The evidence marshaled against free reserves as animportant causal link in the monetary process is im-pressive.a In this article we assume that the ultimatestabilization goals with respect to income, employ-ment, prices and the balance of payments, whenfiltered through the preference function of the FOMC,are approximated by the level of free reserves.

Measuring Other Federal ReserveObjectives

An assumption of this paper is that stabilization ofincome, employment and prices is an important, butnot the only objective of the Federal Reserve. Twoother objectives embedded in the Federal Reservehistory and practices are: (1) assisting the UnitedStates Treasury Department “to make a market” dur-ing periods of debt financing, a practice which isgenerally referred to as “even-keel”; and (2) perform-ing the role of bank of last resort by protecting finan-cial institutions and financial markets from collapse orserious “disorderly conditions.”

The even-keel objective may be a carryover of theFederal Reserve’s single-minded policy during andjust after World War II of pegging the market priceof Government securities, This policy was pursuedwith the expectation that unless the capital value ofthe public’s and banks’ recently increased holdingsof Government debt was maintained at, or close to,its face value, a large share of it would be redeemedor sold in the open market, snaking debt managementdifficult. Until this policy was officially abandonedafter the March 1951 Accord with the Treasury, Fed-eral Reserve actions were strictly subordinated to theneeds of debt management. The Accord was designed

‘~7’heFederal Reserve System: Purposes and Functions, 5thEdition, Board of Governors of the Federal Reserve System,Washington, DC., 1963, pp. 222-23.

0See A. James Meigs, Free Reserves and the Money Supply(Chicago: University of Chicago Press, 1962).

Page 9

TSee John Wood, A Model of Federal Reserve Behavior,Staff Economic Study No. 17, Board of Governors of theFederal Reserve System, p. 14. William G. Dewald andHarry C. Johnson, “An Objective Analysis of the Objectivesof American Monetary Policy, 1952-61,” Banking andMonetary Studies, ed. Deane Carson (Homewood, Illinois:Richard D. Irwin, 1963), and James W. Christian, “A Fur-ther Analysis of the Objectives of American Monetary Pol-icy,” The Journal of Finance, volume XXIII, June 1968,have found that the movement in free reserves can be ex-plained as a response aimed at achieving stabilized valuesfor income, employment, prices and the balance of pay-ments. Separately, Dewald “Free Reserves, Total Reservesand Monetary Control,” Journal of Political Economy, April1963, indicates that the monetary policy can be closelyapproximated by the movement in free reserves.

FEDERAL RESERVE BANK OF ST. LOUIS JULY. 1969

to allow the Federal Reserve to pursue stabilizationobjectives with respect to income, employment andprices — objectives which became increasingly impor-tant with the intensification of the Korean War.

The even-keel objective is designed to stabilizeGovernment security prices during the period whenthe Treasury is in the market, An even-keel periodcan last for as long as several weeks for each issue ofsecurities. It is believed that private dealers, who arethe initial purchasers, need to be assured that they willnot face the risk of a capital loss in order to inducethem to “make a market” in Government securities,1°Because these dealers borrow short-tenn funds tofinance their inventories of Government securities,even-keel amounts to providing a “neutral” short-termmoney market during the period of Treasury financing.

The second nonstahilization objective of the Fed-eral Reserve is related to its role as the bank of lastresort and guardian of the U.S. financial system. Thefinancial panic of 1907 was the cause celebre thateventually led to establishment of the Federal ReserveSystem in 1914. The Federal Reserve’s concern withthe viability of the financial system is not simply dueto a desire to protect this one segment of the econ-omy. The history of depressions in the United Stateshas shown that the deepest and most severe have beenassociated with financial panics. A major criticism ofthe Federal Reserve’s behavior in the early Thirties isthat the major depression of that period was exa-cerbated by the financial collapse, which some arguethe Federal Reserve could have prevented.

According to some authorities, the Federal Reserve’sobjective of maintaining the viability and solvencyof financial institutions and markets is more difficultto achieve during periods of extended prosperitywhen interest rates are rising. There are severalsources of financial instability: general financial panic,special problems for savings and loan associations(S&L’s), and the housing industry. Hyman Minskyhas discussed the conditions which could lead to ageneral financial collapse.’1 His model implies a be-havior pattern of the following sort. Prosperity andeconomic boom conditions interact with expectationsin a way which makes it likely that with rising in-

101n addition, the Federal Reserve has taken the position that

Government security dealers, during a Treasury financing,should not receive a capital gain as a result of the FederalReserve’s role in the market.

‘1Hyman Minsky’s position is presented in “Can ‘It’ HappenAgain,” Banking and Monetary Studies, ed. Deane Carson(Richard D. Irwin, 1963).

terest rates, private persons and institutions assumeliquidity-debt ratios which are relatively narrow andtherefore vulnerable to a slowdown in the growth ofeither income or the money stock. According to Min-sky, the Federal Reserve should be cautious of ag-gressively engaging in restrictive monetary actionsduring periods of extended prosperity, because “dis-orderly” markets may develop and possibly snowballinto a full-scale financial panic such as occurred inthe early Thirties.

Conversely, during periods of extended economicslowdown, private persons and institutions assumeliquidity-debt ratios which are relatively large and,therefore, a potential source of future inflation. Duringsuch periods, the Federal Reserve may be cautiousof aggressive easy monetary actions because it wouldadd to inflated liquidity positions and consequentlyfrustrate monetary control in the future.1’

However, the Federal Reserve is not only con-cerned with the possibility of overall financial insta-bility. It has two additional financial concerns relatedto interest rates which are narrower in their focus.First, for certain financial institutions, high and risinginterest rates by themselves can bring about financialinstability. In particular, by borrowing short and lend-ing long, the S&L’s have created portfolios whichhave left them vulnerable to upward secular shiftsin interest rate levels. During periods of rapidly ris-ing interest rates, S&L’s become “locked-in” to theirlong-term, relatively low interest rate assets, whichmeans that their net worth will decline and theirprofit margins will be depressed. Another objectiverelated to interest rates is the Federal Reserve’s de-sire to lower rates to encourage the growth ofinterest-rate-sensitive sectors of the economy, such ashousing construction.

In the spirit of quantitative analysis in which thisarticle is written, we attempt to measure the even-keel and financial system objectives of the FederalReserve. Because there is no generally accepted meas-ure of even-keeling, or of the Federal Reserve’s roleas the bank of last resort, a certain amount of ex-perimentation was conducted. Even-keel is mentionedin the FOMC directives whenever the Treasury is

52Federal Reserve Annual Report, 1937, p. 2. In referring tothe increase in reserve requirements in March and May1937, the reason given “ ... was in the nature of aprecautionary measure to prevent an uncontrollable expan-sion of credit in the future.” At that time the Aaa corporatebond yield was 3.3 per cent; the consumer price index was16 per cent lower than in 1929, and the unemployment ratewas 14 per cent.

Page 10

FEDERAL RESERVE BANK OF ST. LOUIS

refinancing old debt or financing new debt. However,a new debt issue is presumed to require greater Fed-eral Reserve action than refinancing old debt. In theformer ease, the net increase in supply of securitiesto the market would be equal to the size of the newdebt issue; in the latter ease, there would be no netincrease in the supply of securities because the Treas-ury would have paid off the holders of old Govern-ment securities. Thus, most important Federal Reserveactions are assumed to be associated with the issueof new debt. This is measured by changes in thenational debt held outside of the trust accounts of theFederal Government (AD) 13

We have selected, as our proxy of the FederalReserve’s concern for the viability of financial insti-tutions, the deviations of the corporate Aaa bondyield from its “normal” level.’4 Interest rates whichare higher than “normal” are taken as a signal to theFederal Reserve that financial institutions are morevulnerable to restrictive monetary actions by the Fed-eral Reserve. In addition, higher than normal rateshave an adverse effect on S&L’s and the housing con-struction industry, which the Federal Reserve findsundesirable. On the other hand, lower interest rateswould be indicative of high liquidity-debt ratios, im-plying a concern on the part of the Federal Reservethat highly liquid, that is, sloppy financial marketswould make control of future inflation difficult.’5

The behavior of the Federal Reserve under thesecircumstances would be to act in a way to increasethe supply of funds when the interest rate was abovenormal and to act in a way to decrease the supplyof funds when the interest rate was below normal.

Measuring Federal Reserve Actions

The criteria used for selecting a particular mone-tary aggregate as the measure of Federal Reserveactions are: (1) that its value be dominated by theactions of the Federal Reserve, and (2) that it havean important and measurable effect on total demand.

With respect to the first criterion, the Federal Re-serve has three traditional tools which it can controlcompletely: open market operations, changes in re-serve requirements, and the discount rate.’° Openmarket operations are measured by changes in Fed-eral Reserve holdings of Government securities,changes in reserve requirements by changes in thedollar amount of required reserves (holding the dol-lar value of deposits and their distribution by classof bank constant), and the discount rate by theamount of borrowing of member banks, It is widelyacknowledged that open market operations andchanges in reserve requirements are the primary mon-etary tools, and that the discount rate is at best onlyof secondary influence,

One way to combine the two primary toolsinto one quantifiable measure of Federal Reserveactions is by adding a “reserve adjustment” tochanges in Federal Reserve holdings of Governmentsecurities.’7 This series (adjusted Federal Reserveholdings of Government securities) meets the firstcriterion, because the value can change only if theFederal Reserve takes some action on the open mar-ket or changes reserve requirements. However, thisseries does not satisfy the second criterion, that ofhaving an important and measurable influence ontotal demand. Previous research published in thisReview and elsewhere has presented theoreticaljustification and empirical evidence which indicatethat the monetary base has an important influenceon total spending. The dominant source componentof the monetary base is Federal Reserve holdingsof Government securities adjusted for changes in re-serve requirements)8 This can be seen in Table 1,which lists all sources of the monetary base.

JULY 1969

‘3There may be some justification for including debt held inthe Government’s trust funds in the total because the Treas-ury manipulates purchases and sales by the trust fundsaccording to the needs of smooth debt management.

141n the context of this article, the normal interest rate isone at which the financial systens is in long-mn equilibrium.Theoretically, that would equal the real rate of return onrisk-free investment plus an adjustment for price expecta-tions. Most studies indicate that when prices are changingrelatively slowly (as in the United States), price expecta-tions are adjusted after a 15-20 year lag.

t5This concern about future inflation should not be confusedwith stabilization objectives. Stabilization objectives repre-sent a concern with present levels of income and employ-ment. The financial objective in this case represents aconcern that the highly liqnid state of financial institutionswould make future anti-inflationary actions less effective.The Federal Reserve did not expect that its raising reserverequirements in 1937 would do anything more than “sopup’ the unneeded excess reserves of member banks. Thefact that it led to a sharp recession in 1938 was an un-intended and undesired consequence.

lOThe Federal Reserve also has an array of regulations, Athrough Z, which are designed to influence conditions incertain specified markets. It is our position that howeversubstantial the impact of these regulations on the affectedmarkets, their impact on the total economy is small; thus,they are not consideied in this article.

‘7See Leonall c. Andersen and Jerry L. Jordan, “The Mone-tary Base — Explanation and Analytical Use,” in the August1988 issue of this Review.

18Without the reserve adjustment, Federal Reserve holdingsof Government securities is a component of the source base.The difference between the source base and the monetarybase is this same reserve adjustment.

Page 11

The monetary base (B) can be defined as:

B = GSA + Rn + F + (C + FC) + CT + 0

where Federal Reserve holdings of Government se-curities (adjusted) are under direct control, and othercomponents, such as float, gold and foreign currencyholdings, and Treasury currency, are not under di-rect control of the Federal Reserve. Float dependsupon the amount of cheek transactions and thereforeon the level of business activity; gold and foreigncurrency holdings are related to the U.S. balance ofpayments and international monetary conditions.

The sources of the monetary base which are out-side direct control of the Federal Reserve couldhave an important impact on domestic money marketconditions because of their effect on the reserve posi-tions of member banks. Consequently, if the FederalReserve wishes to prevent these flows from influenc-ing money markets, it must take defensive actionsby changing its holdings of Government securities.Thus, in addition to the primary goals of economicstabilization, even-keel and financial objectives of theFederal Reserve have a narrow technical objectiveof avoiding disturbances to the money markets causedby movements in these noncontrollable sources ofthe base.

To analyze how much Federal Reserve actions aredirected toward offsetting the influences of these non-controHable sources of the monetary base on moneymarkets, a regression of the following first differenceform was tested:

~GSA = a0 + ajARn + a2AF + aaA(G + FC)

+ a4Aer + a5A0

Changes in adjusted holdings of Government securi-ties is on the left-hand side, and changes in the othersources of the monetary base, which the Federal Re-serve does not directly control, are on the right-hand

Page 12

JULY, 1969

side. If the Federal Reserve acts to prevent all or partof the movements in these uncontrolled sources ofthe base from influencing money markets, it wouldshow up in the form of statistically significant coeffi-cients between (GSA) and each of the variables onthe right-hand side, Using monthly data from January1953 to December 1968, the following results wereobtained (numbers in parentheses are t values):’9

~GSA = .132 — .81 aRn — .49 ~F 1,02 A(G + FC)(2.49) (11.01)(5.11)

+ .50 AC’r + .91 tO(.91) (7.68)

Except for Treasury currency, allare statistically significant at thewhich means the probability thatrelation between the dependentvariables is less than one in twenty.

Not only does the Federal Reserve respond to theseother components of the monetary base, but its re-sponse is such as to offset their influence on themonetary base. That is, if the amount of float, mem-ber bank borrowings, or gold inflow should increase,this would, ceteris paribus, add to the monetary baseas can be seen in Table 1. Because the coefficients ofeach of these variables are negative20 and close toone in absolute value, it is possible to deduce thatadjusted Federal Reserve holdings of Governmentsecurities has been manipulated in a way that themonetary base will not change significantly. In theprocess of achieving its short-term money market ob-jectives, the Federal Reserve has tended, in effect,to offset uncontrolled movements in the monetarybase.

Under these circumstances, Federal Reserve ac-tions can be measured either as changes in adjustedholdings of Government securities, with this measurerelated to three primary objectives and one technicalmoney market objective, or as changes in the mone-tary base related to just the three primary objectives.Because it has been demonstrated that the monetarybase has an important impact on total demand, it isdesirable to use this variable. In addition, it is neces-sary to use the monetary base if we wish to analyze

lUThe variables in all regressions are seasonally adjustedunless otherwise specified.

‘°tO has an expected sign and magnitude of + 1 because itrefers to changes in other Federal Reserve accounts. Theseother accounts consist largely of Treasury and foreign de-posits which are liabilities of the Federal Reserve, and, assuch, are entered as negative values of the source base asillustrated in the above table. In this case, an increase inthis variable would decrease the monetary base, and there-fore the appropriate offset would be an increase in FederalReserve holdings of Government securities.

FEDERAL RESERVE BANK OF ST LOUIS

Table IMONETARY BASE (B)

(Millions of dollarslDecember 1968

Adjusted Holdings of GovernmentSecurities (GS..l $37,008;

Member Bank Borrovdngs (Rn) 765Federal Reserve Float ~Fj 3.251Gold Plus Foreign Currency (C FC) 12,560-:-;Treasury Currency Outstanding I

0r) 6,810Other (0) ‘ - 2,B87

Total $77.50?

‘A slJ is.’ s~.i fir ru. -rv,- rn si r.-mci,: s-hsr,sr.,, ansi shifts. n di ssss.,is~L,s-t~s9-n e I,. of b,sn k—.

i .~fl,’ I -rig,, curn-ssc~ r, pr’s.. I, h:d, rd li’~cr’t hoIsting. in~’.’n—sc ith ‘WiLl,

— I - luclusl,’ Irs a sr’ ninE, hol,fj~si..’, ‘Jrs.u..s,r,, ‘nil (‘sri igr,slr-p’’.ip.~~stF.th. I’s-ds-r:,i lt,-s..s’s”,az.sl ,-‘hr 1,1, rssl l{ns.,-r~,-s-.ns-,-unt—.

R2= .52

of the coefficients5 per cent level,there is no “real”and independent

FEDERAL RESERVE DANK CE ST. LOUIS

the actions of the monetary authorities in the prewar serve action variable ~B and the monetary policyperiod when the Treasury department exercised a or economic stabilization variable FR.dominant role in monetary actions. AB = .428 + 0d1(FR)

For the postwar period, equally satisfactory and (.86)

consistent results are obtained using either AB or The value of the coefficient (0.11) is not statistically~GSa to measure Federal Reserve actions. A choice significant, and explains only 1 per cent of the varia-between these two variables depends upon whether tion in Federal Reserve actions (AB). We will cx-or not one desires to give explicit consideration plain this discrepancy between stated monetary policyto technical money market objectives. If these and Federal Reserve action by its desire to achieveobjectives are important, then ~GSA is appropriate, even-keel and financial objectives.If not, ~B is appropriate.

There are undoubtedly other influences on FederalReserve actions, such as changesin the personnel of

Federal Reserve Actions — The Explanationthe Federal Reserve s decisionmak~ngapparatus, and

The beginning of this article referred to the alleged changes in Presidential Administration. In spite ofdiscrepancy between monetary policy and Federal these obvious limitations, we believe our attempts toReserve actions. We have defined monetary policy as explain Federal Reserve behavior are reasonablyreflected in the directives of the FOMC and proxied satisfactory.by the level of free reserves. In addition, FederalReserve actions other than those related to short-termmoney market considerations can be measured bychanges in the monetary base. It is clear from evencasual inspection of the chart on page 17 that thetwo series are not closely related. There is a pro-nounced cyclical pattern in both series, which movedtogether in 1958-59 and 1966-67, but not in 1953, 1955,1963-64 and 1968. The absence of a systematic rela-tion between the two series is confirmed by thefollowing regression, which relates the Federal Re-

The accompanying table shows the regression rela-tionships between our measure of Federal Reserveactions (SB) and proxies of the stabilization, even-keel and financial objectives which this paper assertsthe Federal Reserve has desired to achieve. Thereare two panels of results, one for quarterly centraldifferences and one for quarterly first differences. Ineach panel, the first column presents the results forthe period since the Korean War, 1953 to 1968. Thesecond column shows the results for the war and

JULY 1969

R2= .012

Table Ii

RELATIONS BETWEEN FEDERAL RESERVE ACTIONS (AR) AND OBJECTIVES

FEDERAL RESERVE STABILIZATION (FR), EVEN-KEEL (aD), AND FINANCIAL Cr-rU(Billions of Dollars)

Quarterly Central Differences Quarlerly First Differences

1953 1/1940 III / 1933 . 1/1953 - Ii 1940- III’ 1933 -

V.68’ lV/52 IVJ’l 939 IV, 68 lV/52 IV’ 1939

Free Reserven .21 .010 .29 .21 .01 .33(stabilization (2.36) (.35) (5.64) (2.16) (.37) (5.70)objective)

to (even-keel .031 .077 —.70 .030 .07 .43objeclivel (1.56) (9.67) (‘4.37) (1.51) (6.32) (2.89)

r,, (financial .279 .254 .241 .287 .469 .362obieclive) (6.73) (.61) (1.44) (6.13) (.81 ) (2.15)

X (Dummy .885 .955Variable)’ (3.53) (2.52)

.61 .67 .72 .52 .46 .70

N “-n Fig ore’,. gst , r, tsr,. r,~rre ‘,i.sa -‘‘viTi s-i,.i,ti : the- .cati-’i irs dope-ar beh,w u-arh soy‘Fink-nt. s-nc lusod by psrt.nsths.u,:..

‘Tb is sarsaubl.ss;s~used ti stiesnt f, , r hit’ Ha’ in roll 5’nc’ Ins I’ i-linen- 1134. Ii us—mu s S ttic- vlsi sue .51 un I/l ge.j u11ii 11 1934 nail (‘fur allr quar Or,.

2 It is a~ is, us—,- ustistr.r lv data for eons parishility with othpr nuenod~.A s’t si,Ii~’, i ii, n—siIts. :srt’sv.-is bitt, r ‘sc(ng ns’snthly d;s’ a Jan,I.: Of c-sniDer

— .2:1 FR .024AD -i :109 5r-r,,’ Ic .4411.171 2:121 ,iu.51

ii— I numb l,,w,’’ t,,n,su’e ‘f greeter r;unsli,mnts ii,. tb, ~ariHblss. b-st tE:s i_~~.n--_sun, significss’st itt a luighs’r r,unfldrnco ls.ve-I. prul.ssl,’t,,-ea,s’..- tb- Pp~,nil R.-syrve’, turn,- I.onzs,u with r,Mseri tu, st_s ,,ts_’e’ntise— Is-.,.,- In,’,,,, ,r,r,ntIu t’uuu-.n’me’,uuus tsr. The .,,,i-.i~aI iu:1 s’’e,d salt’ i -

‘ten int’l WilE, stat sing ‘:‘sssrts-r,’- clue e .rr —.

Page 13

FEDERAL RESERVE SANK OF ST. LOUIS JULY, 1969

early postwar years, 1940 to 1952. The third columnshows the results for the period 1933 to 1939. Eachof these results will be analyzed in turn.

Mature Postwar Period — 1/1953 to IV/1968A substantial proportion of the variations in Fed-

eral Reserve behavior (AB) is explained by ourproxies of Federal Reserve stabilization, financial andeven-keel objectives. The signs of all the coefficientsare positive, which is as would be expected. Anincrease in FR would indicate an easy money policyand therefore an increase in AB. An increase in thenational debt would require additional even-keel ac-tions of the Federal Reserve and therefore an increasein AB. An increase in interest rates would cause anincrease in the Federal Reserve’s concern for the sta-bility of the financial system and therefore an increasein aBY1

tecting the financial system, while stabilization policyand even-keel objectives were of secondary and aboutequal importance.23 If we attempt to scale FederalReserve behavior with respect to these explanatoryvariables, about one-fifth can be explained by stabili-zation objectives, while the remainder can be ex-plained in terms of achieving even-keel and financialobjectives.

Similar results are achieved when Federal Reserveactions are measured by changes in adjusted FederalReserve holdings of Government securities (AGSA)when the short-term money market objective is in-cluded. Using monthly central difference data fromJanuary 1953 to December 1968, the results are asfollows:2~

AGSA = + .207(FR) + .03 AD + .309(r-rn) — .93 tRa(2.38) (2.39) (8.39) (7.16)

— .59 AF — .85 A(C+FC) — .74 ACT + .oo to(3.82) (10.89) (1.58) (9.11)

fi2 = .89

The coefficients are almost identical with respect tostabilization, even-keel and financial objectives, as inthe case of using the monetary base (AB) as thedependent variable. With respect to the short-termmoney market objective, the results are about thesame as those presented on page 12. The monetarybase and adjusted Federal Reserve holdings of Gov-ernment securities are equally consistent measures ofFederal Reserve actions. As stated earlier, the choicebetween them depends upon whether one wishes toexplain these actions with or without reference toshort-term money market objectives.

War and Early Postwar Period —

1/1940 to 117/1952

During World War II and the early postwar periodit has been generally considered that Federal Re-serve actions were dominated by the desire to sup-port the U.S. Treasury in financing the large andrising national debt. Our results clearly indicate thatfinancing the national debt played the dominant rolein Federal Reserve behavior during this period. Thedebt variable is highly significant statistically, while

To evaluate properly the policy implications ofthese results, we must determine which of the ex-planatory variables has made the largest contributionto changes in the monetary base (AB ) - Such anevaluation cannot be done by simply comparing thevalues of the regression coefficients, because the ex-planatory variables are all in different dimensions.However, the regression coefficients can be standard-ized by computing beta coefficients.22 The beta co-efficients for the 1953-68 period are 0.21 for the stabi-lization objectives, 0.16 for the even-keel objectivesand 0.68 for the financial objective. These resultssuggest that in the postwar period Federal Reservebehavior was dominated by the consideration of pro-

21The normal interest rate in the financial objective, Tn, 15

the product of a ratio computed from the coefficient withrespect to r and the value of the constant term. Thisprocedure simultaneously suppresses an unrealistic negativeconstant term and eliminates the implication that any posi-tive value for r will lead to an increase in the monetarybase. Using this procedure, the normal interest rate is 2.8per cent for 1953-88, 2.9 per cent for 1933-39 and 2.4per cent for 1940-52. Considering the method of calcula-lion, the values are quite close,

A variety of other techniques were tried to determine thevalue of r-rn. Various arbitrary values of rn were selectedand deviations were computed of a cubic, quadratic andlinear form. The results of these experiments are similar totlue results reported here,

22’teta coefficients” are used to determine the “typical im-pact or importance of the explanatory variables in aregression. It should be noted that beta coefficients areequivalent to the regression coefficieats of a regression runon “standardized” variables of the form ~ where X

5is the variable, and Sjj is its standard deviation. Ananalysis based on beta coefficients, instead of regression co-efficients, eliminates the necessity of assessing the impactthat the units of measurement have on the relative sizesof the coefficients in a regression, and this reduces thepossibility of a faulty interpretation of the regression re-sults. See Arthur S. Coldberger, Econometric Theory (JohnWiley & Sons, 1964), pp. 197-98.

Page 14

23When the coefficients were estimated for the period 1953-65their values were about the same as those reported for theperiod 1953-68. However, the beta coefficient for interestrates was lower and about equal to the product of the othertwo, This is as would be expected because the financialobjective has been of increased importance in the 1968-68period.

2~FRand r-r0 are variables measured at monthly levels, sothe estimated monthly coefficients were multiplied by threeto make them comparable with the coefficients estimatedwith quarterly data,

FEDERAL RESERVE BANK OF ST. LOUIS

the other variables are not. The beta coefficients forstabilization and financial objectives are insignificant,and for AD are .809. The debt variable dominatedAB in the war and early postwar period.

Prewar Period — 111/1933 to 117/1939The Federal Reserve went through a chaotic and

trying experience during the 1929-33 period becauseof the Great Depression, the international monetarycollapse and the domestic financial panic. The Fed-eral Reserve apparently withdrew from active mone-tary management during the period 1933-39. Thislack of action can be seen from the fact that FederalReserve credit changed very little from early 1933 tothe end of 1939 and varied on the average by lessthan $47 million per quarter, compared with $635million per quarter in l953~68.25

In effect, the Treasury Department carried on ac-tive monetary management during this period by therate at which it permitted the monetization of thelarge gold inflows. It is interesting to note that in spiteof the different economic conditions and the Treas-ury’s performing the active role of monetary manage-ment during much of the period, the behavior of themonetary authority was similar to its behavior in the1953-68 period relative to the same set of explanatoryfactors. The stabilization (FR) and financial sys-tem (r-r,) objectives are significant, and their coef-ficients have about the same value in both periods.The even-keel variable (AD) is statistically signifi-cant; however, the sign of its coefficient is oppositethat of the sign for the mature postwar period.26 For

23See various issues of the Federal Reserve Bulletin.

JULY, 1969

reasons explained in footnote 26, this is largely dueto the Treasury Department assuming active mone-tary management in this period. The beta coefficientsfor this period were 0.85 for stabilization, 0.25 for fi-nancial and —0.62 for even-keel objectives. Consider-ing the magnitude of the decline in employment,prices and income, which occurred in the early Thir-ties, it is not surprising that the beta coefficients implythat the major factors determining monetary author-ity behavior in the middle and late Thirties werestabilization objectives related to increasing incomeand employment. An important factor explaining therelatively low beta coefficient for the financial objec-tive was that r-r~did not change much during thisperiod. The large size of its coefficient implies that,if it had varied significantly, it would have playeda more significant role in determining Federal Re-serve actions.

A Statistical Digression

Page 15

Au examination of the differences between thevalue of AB estimated by the equation and theactual value of AB for the period 1953 to 1968indicates the presence of what, in statistics, is calledserial correlation in the residuals. The usual interpre-tation is that some important explanatory variablehas been omitted. As indicated before, a potentiallyserious deficiency in our explanation of Federal Re-serve behavior is not taking account of the changesin Presidential Administration. Although the laws es-tablishing the Federal Reserve and the practices whichhave developed over the years provide it with moreautonomy than is enjoyed by most central banks, itis not completely insensitive to the desires and wishesof the President and his immediate advisers. Thus,it is possible that Federal Reserve’s behavior maydiffer between Presidential Administrations. This pôs-sibility was tested very crudely by introducing a“dummy” variable, X1, to see if Federal Reserveactions other than for previously stated objectivesdiffered between the two admin’strations,2~The re-

general Government funds, thereby increasing the nationaldebt by more than would otherwise have been the case.The Treasury increased the growth in the monetary baseby monetizing current gold inflows plus accumulated Treas-ury gold stock through sales of gold certificates to theFederal Reserve, thereby reducing the size of the nationaldebt from what it otherwise would have been,

2~Thedummy variable assumes the value of zero for 1/1953 to11/1962 and the value of one from 111/1962 to IV/1988.The third quarter of 1962 was selected for two reasons. First,this was the first quarter when the Federal Governmentbudget was under the complete control of the incomingDemocratic Administration. Second, the link between thePresidential Administration and the Federal Reserve is in-formal and adaptive, and it is reasonable to assume that achange in Federal Reserve behavior would occur gradually.

20The different signs of the coefficient of the even-keelvariable (AD) in the prewar and mature postwar periodscan be explained by two factors:(1) In the prewar period even-keel needs were insignificant,while in the mature postwar period they were large.(2) The Treasury was the major monetary authority in theprewar period, while the Federal Reserve performed thatrole in the mature postwar period.

Even-keel considerations were not important in financingthe growing Government debt in the middle and lateThirties because short-term money markets were on averagevery liquid, and the demand for default-free Governmentsecurities by a strongly risk-averting public was great. Inthe mature postwar period, short-term money markets wereon the average much less liquid, and the public’s demandfor Government securities as a protection against the riskof default of private securities was small. This explains whythe even-keel variable (AD) was positive in the maturepostwar period and nonpositive in the prewar period.

The even-keel variable (AD) was negative in the pre-war period because the Treasury Department was in activecontrol of monetary management. This control of the mon-etary base was achieved by regulating the rate at whichthe Treasury monetized the heavy gold inflows of themiddle and late Thirties. The Treasury reduced the growthin the monetary base by financing the gold inflow out of

FEDERAL RESERVE BANK OF ST. LOUIS

suits of the test using quarterly central differencedata (billions of dollars) and the monetary base(AB) from 1953 to 1968 are as follows:

AB = .18(FR) + .03 AD + .112(r-rn) + .428X1

(2.92) (2.00) (3.11) (7.85)= .81

The results using adjusted Federal Reserve holdingsof Government securities monthly for the same periodarc as follows:

ACSa = .159(FR) + .04 AD + .117(r-r~) + .155 Xi(2.01) (3.25) (2.67) (6.71)

— 1,02 ARn .50 AF .89 A(G + FC)(8.69) (3.41) (12,70)

.70 ACT + .85 AO — -

(1.65) (9.56) II-

The fact that the coefficient of the dummy variable,using monthly data, is only one-third of the coefficientwhen quarterly data was used (.155 versus .428) isdue to the difference in time dimension (monthlydata compared to quarterly data). The results ofthese tests are very similar. In both cases a largerpercentage of Federal Reserve actions is explainedby explicitly accounting for the change in administra-tions, and serial correlation in the residuals is substan-tially reduced. The values of the coefficients of theother variables were not changed significantly exceptfor r-r,, which has a lower value. The dummy variableundoubtedly oveistates the difference between thetwo administrations because it seems to capture someof the influence of the interest rate variable.

Summary of Results

Before summarizing our results, it is important tonote that Federal Reserve behavior in the period1929-33 has been characterized by most students as“inappropriate.” The monetary policy objective of sta-bilizing income and employment was pursued in amost timid manner and was easily displaced by in-ternational monetary concern.28 For example, whenthe United Kingdom ‘vent off the gold standard inSeptember 1931, the Federal Reserve temporarilyswitched to a highly restrictive policy, even thoughit was widely recognized that the United States wasin the midst of a serious depression. As that depres-sion deepened, some banks failed because the Fed-eral Reserve did not perform the fundamental centralbanking task of acting as the “bank of last resort.”This weakened public confidence in the financial

~~Milton Friedman and Anna Jacobson Schwartz, A Mone-tary History of the United States, 1867-1960 (Princeton:Princeton University Press, 1963), chapter 7. This is themost detailed and complete history of the monetary eventsin the 1929-33 period.

Page 16

In contrast with the early Thirties, the results pre-sented in this paper indicate that the monetary au-thorities have since behaved in a more consistentmanner. Three objectives have determined their be-havior: a stabilization objective with respect to in-come, employment and prices; a financial objectivewith respect to protecting the financial system fromthe recurrence of the events of the early Thirties, andthe objective of supporting the Treasury Depart-ment in its debt-financing role, otherwise known as“even-keel.” This consistency of behavior is observedirrespective of whether the Treasury (1933-39) or theFederal Reserve (1953-68) is performing the mone-tary management role.

During the middle and late Thirties when employ-ment and income were at historic lows relative tothe previous business cycle peak, our results indicatethat stabilization objectives related to increasing em-ployment and income dominated the behavior of themonetary authority.29 The monetary authority’s be-havior related to protecting the stability of the finan-cial system can he detected during this period, butit was of secondary importance because those finan-cial institutions which had survived the “events” ofthe early Thirties were highly liquid. The even-keelobjective was insignificant in this period because thepublic, at that time, needed little encouragement topurchase defanlt-frce Government securities.

During the Fifties and Sixties employment wasrelatively high and income was growing at a gener-ally satisfactory rate. Our results indicate that duringthis mature postwar period Federal Reserve actionswere dominated by a desire to insure the stabilityof the financial system, especially in later years. This,of course, does not mean that income stabilizationobjectives never influenced Federal Reserve actionsin the postwar period. On a number of occasions,such as in 1959 and 1966, stabilization objectivesdominated Federal Reserve actions. Ho~vever,whenthere was a conflict between objectives, the financialinvariably dominated.

JULY 1969

system, triggering a run on many banks. The massivenumber of bank failures which ensued, deepenedand intensified the depression of income andemployment

2ttThere was one relatively short period in the first half of

1937 when monetary policy related to stabilization objec-tives became restrictive, This was the only period in themiddle and late Thirties when monetary authorities’ con-cern for the stability of the financial system overrode theirconcern for increasing employment and income. See page11, footnote 15 for further discussion of this issue.

FEDERAL RESERVE BANK OF ST. LOUIS JULY, 1969

A clear example of this fact can be found by con-trasting Federal Reserve behavior in 1966 and 1968.In the first half of both years, monetary policy, re-lated to economic stabilization, was equally “tight.”However, Federal Reserve actions, measured bychanges in the monetary base, were tight in 1966,while they were not tight in 1968. (Contrast free re-serves and the monetary base in the above chart.)The difference between these two experiences wasthat the Federal Reserve was far more sensitive toconsequences of its actions on financial markets in1968 than it \vas in 1966. After the “credit crunch” of1966, a great deal had been written about the“disorderly” financial markets and the threat this hadposed to the stability of the financial system. Anotherfactor contributing to the relatively easy monetaryactions in 1968 was the large growth in the nationaldebt, which had required that the even-keel objectivebe implemented frequently. This was not half soimportant in 1986 because of the smaller Governmentdeficit.

ConclusionsThe intent of this article is to show that Federal

Reserve actions are not solely dictated by economicstabilization objectives. The Federal Reserve has in-dependent even-keel and financial objectives whichhave, at times in the past, interfered with economicstabilization. This article by no means provides adefinitive explanation of Federal Reserve actions.There may be other objectives which the FederalReserve attempts to achieve, or there may be better

ways of measuring the even-keel and fi-nancial objectives than the ones we havechosen. With this caveat, certain conclu-sions can be offered.

The behavior of the monetary authoritywith respect to stabilization and other ob-jectives has been consistent. Our resultsimply that the monetary authority does infact make some value judgments whichdiscriminate between important objectivesand less important objectives. The mone-tary authority cannot be criticized for be-having in an inconsistent manner.

A criticism which might be directed atthe Federal Reserve is that some of theobjectives they have chosen, or their rela-tive weights have not been appropriate.The question as to whether or not theFederal Reserve has acted in an appro-priate manner is not attempted in this

paper. The answer to such a question would requiremore knowledge about the structure of the economythan is presented here. In general, the answer woulddepend on whether or not Federal Reserve actionshave their dominant influence directly on income,employment and prices. If they do, the monetarybehavior should be directed exclusively towardachieving desired levels of these variables becauseof their overwhelming impact on the welfare of ourcitizens.

If, on the other hand, monetary actions have theirdominant influence on the financial system and per-haps on interest-rate-sensitive segments of the econ-omy, such as the housing industry, it would bemore appropriate for financial objectives to dominatethe behavior of the monetar authorities. Becausemonetary actions would have relatively little directinfluence on income, employment and prices in sucha case, the monetary authority could only influencethem indirectly by achieving its financial objectives.30

A considerable amount of evidence has developedin recent years which indicates that the behavior ofthe monetary authority has a substantial direct influ-ence on income, employment and prices, which op-erates with a relatively short lag. Under such con-ditions, the appropriate behavior of the FederalReserve in the 1953-68 period should have been to sta-bilize income, employment and prices, while, in fact,

5’Outside of major war and national mobilization, there isno reasonable set of circumstances in which Federal Re-serve actions should he dominated by even-keel objectives.

Page 17

their behavior was dominated by a desire to preventshort-run instability in the financial system.

Behavior dominated by financial objectives is poten-tially destabilizing. Federal Reserve actions designedto protect the financial system in a period of highand rising interest rates result in a more rapid growthin the monetary base than would otherwise be thecase. This, in turn, leads to a rapid growth in income,employment (until the full employment constraintis reached) and prices. The inflationary price rises

The present study, which relates the actions of theFederal Reserve to its objectives, differs from previoussimilar studies in two fundamental ways. First, the pres-ent study uses free reserves as a measure of the FederalReserve’s intent of policy with respect to its economicstabilization objectives, instead of relating the FederalReserve’s actions directly to its ultimate stabilization ob-jectives. The use of free reserves as a proxy for the intentof economic stabilization policy, we feel, surmounts sev-eral serious structural problems which existed in earlierempirical models of Federal Reserve policy and actions.

Second, the present study relates Federal Reserveactions to a larger and more comprehensive set of Fed-eral Reserve objectives than was previously consideredrelevant. In addition to the traditional economic sta-bilization objective with its output, price level, employ-ment, and balance-of-payments dimensions, a case wasdeveloped in the text for the inclusion of even-keel andfinancial stability objectives.

Page 18

ULY 1969

MICHAEL W KEBAN

CnrusTo~namT B~sn

The use of free reserves as a measure of the FederalReserve’s intent of economic stabilization policy becomesmore reasonable after an examination of previous studiesof the Federal Reserve’s behavior. We will consider suchstudies by Dewald and Johnson (1963)1 and John Wood(1965) •2 In addition, Christian’s (1968) critique of theDewald and Johnson article is also examined,3 No at-tempt is made in the following discussion to present1See William G. Dewald and Hany C. Johnson, “AnObjective Analysis of the Objectives of American MonetaryPolicy, 1952-1961,” Banking and Monetary Studies,” ed.Deane Carson (Homewood, Illinois: Richard D, Irwin, 1963).

tmJohn Wood, A Model of Federal Reserve Behavior, Staff

Economic Study No. 17, Board of Governors of the FederalReserve System.

:mJames W. Christian, “A Further Analysis of the Objectivesof Asnerican Monetary Policy,” The Journal of Finance,volume XXIII, June 1968.

IFEDERAL RESERVE BANK OF ST. LOUIS

lead to an increase in interest rates and to greaterstrain on the financial system, inducing a furthergrowth in the monetary base.

If Federal Reserve actions have their dominant in-fluence on income, employmetit and prices, whileFederal Reserve behavior is dominated by financialobjectives, this will lead not only to increased insta-bility in income, employment and prices, but also toincreased instability in the long run for the financialsystem.

This article is available as Reprint No. 42.

Two important issues not yet dealt with will be dis-cussed in the following Appendix. Raising these issuesearlier would have interrupted the development of themain body of the article.

APPENIMX

Various Approaches Relating the FederalReserve’s Objectives to Its Actions

FEDERAL RESERVE BANK OF ST. LOUIS JULY. 1969

a complete review of these articles. John Wood’s modelis considered first, because at first glance it appears toembody the ideal approach to studying the FederalReserve’s behavior.

A Model of Federal Reserve BehaviorUsing the tools of micro-economic analysis, Wood de-

velops a consistent model which connects an assumedFOMC disutility preference function to a policy modelwith economic structural relations. Within each of hismodel’s structural equations, an adjusted first differenceof free reserves is included as the Federal Reserve’sintermediate financial target variable. The basic justifi-cation for this specification is that through its ability toaffect free reserves, “the Federal Reserve conceives itselfas influencing the economy.”4 Yet, in spite of the theore-tical sophistication of his economic model, the empiricallybased conclusions of Wood’s study about FOMC be-havior and policy add little to what was already knownfrom much simpler models. The economic relations inWood’s model are such as to prevent him from“partitioning” the regression coefficients of his reduced-form equation into the preference and structural param-eters contained in his theoretical model.

The specification of Wood’s contemporaneous struc-tural model within the disutility framework made itimpossible for him to disentangle the mixtures of“weights” and “effects” present in the reduced-form re-gression coefficients, Whether or not these consequencesmight be remedied by an “appropriate” specification oftime lags appears to be an unanswered question. Thepresent study avoided the problems associated with“utility” functions through the use of free reserves as asummary measure of the intent of the FOMC’s economicstabilization policy.

One implication of Wood’s work appears to be thateconomists might profitably study the behavior of theFederal Reserve within the context of reduced-formmodels, involving time lags. This implication holds be-cause the results of using fully specified structural modelsmay be undecipherable. If appropriate time lags existbetween actions and their impacts, reduced-form mod-els can be set up where causation operates predomi-nately in one direction. Such situations permit a relativelyunambiguous interpretation of regression coefficients.

A Reduced-Form ModelIn setting up our model of Federal Reserve behavior,

we also benefited from an examination of some of theexisting reduced-form models in this area. Specifically,an examination of certain problems inherent in Dc-wald and Johnson’s reduced-form model guided us in thespecification of our model.

Using the regression equation of the “reaction func-tion” type, Dewald and Johnson (D-J) attempted tounearth two aspects of monetary behavior: (1) the rel-ative importance of the various monetary policy objectives,and (2) the average lag period between a change in the“performance measure” of a policy objective and the re-sponse of monetaiy policy to that change. Related to

~Wood,p. 16.

the latter goal of the study was an attempt to deter-mine which indicator best measures monetary policy.

From an examination of the standard errors of theirregression coefficients, Dewald and Johnson concludedthat high employment and growth were the principalmonetary objectives pursued by the Federal Reserveduring the period of the study (1952-62). Also, whenthe money supply was used as the monetary policyvariable, a long and possibly destabilizing lag of ninemonths was implied for the response 0f monetary policyto undesired changes in the economy. Nevertheless, theyselected the money supply as the best proxy for mone-tary policy. Free reserves also provided acceptablestatistical results.

Weaknesses in the Approach

Christian suggests that certain weaknesses existed inthe D-J approach which would call their conclusionsinto question. Christian observed an instability in re-gression coefficients when the model was run for variousoverlapping subperiods contained within the total periodused in the D-J study. This finding raises a number ofquestions. Since each of the D-J regression equationsfits within the framework of the Koyck distributed-lagmodel, the instability in the coefficients of their respec-tive lagged dependent variables suggests that there is nosimple average period of policy response. In addition,policy objectives which appeared to be very importantin one regression period turned out to be insignificantin another. The latter result has two possible interpreta-tions. First, the Federal Reserve’s appraisal of its dis-utility associated with being off target for one policyobjective may not be independent of how close otherpolicy objectives are to their targets. Second, “instablecoefficients” reflect a structural incompatibility amongcertain pairs of policy objectives which prevents theirbeing achieved simultaneously through the use of onepolicy tool. Yet, even if policy goals are both independ-ent and stable, regression coefficients may be biased insome indeterminate way as a result of insufficient varia-tions in some of the “performance measures” of theeconomy, in either all or part of the regression periodselected.5

Another problem with the D-J model is that the con-temporaneousness of the policy function with the struc-tural relations of the economy means that the coefficientsof the D-J regressions are indeterminate mixtures of“effects” among the variables within the economy and“weights” of the respective “performance measures”within the Federal Reserve’s preference calculus,0 Thelast-mentioned assumption of the D-J study (which alsoplayed an important role in John Wood’s study) effec-5Christian, pp. 465-477. Ia addition, the lack of consistencyamong the regression results for different periods may alsoreflect the exclusion of “performance measures” of policyobjectives which are considered to be very important by theFederal Reserve. This problem was considered in the mainbody of the article and in the discussion of nonstabiizationobjectives.

61n his article “A Model of Federal Reserve Behavior,” JohnWood was perhaps the first economist who explicitly criti-cized Dewald and Johnson for failing to recognize thisproblem when they analyzed their regression results (seefootnote 32).

Page 19

FEDERAL RESERVE BANK OF ST. LOUIS

tively eliminated the possibility of drawingconclusions about policy preferences from theD-J reaction function model-

Dewald and Johnson attempted to achievetoo much within the confines of a simplemodel. Basically, there are two problems withthe D-J study which we feel were effectivelyeliminated from the present study. The firstproblem concerns the difficulties of relating theeconomic stabilization component of FederalReserve actions to the ultimate economicstabilization objectives- The second problemis that of indeterminate mixtures of economicfeedback “effects” and policy “weights” withinthe regression coefficients.

Relative to the first problem, instead ofrelating monetary policy directly to a set ofstabilization objectives, the present study usesa single variable, free reserves, as a proxy forthe Federal Reserve’s intent of policy with respect to theeconomic stabilization objectives. The actual level of freereserves which indicates a certain degree of tightness orease allows us to avoid the problem of measuring thetradeoffs between the various stabilization objectives.

Relative to the second problem, the present studyarrived at a regression equation relationship between thethree proxy variables of the Federal Reserve’s objectivesand the monetary base, which involves a one-way direc-tion of causation due to the lag in the effect of changesin the base on total demand, as shown in other studies.With policy decisions and the proxy variables being pre-dominantly influenced by the level of current economicactivity, the coefficients of the regression equation appearto be fairly unbiased measures of policy weights.

The Logical Consistency of Using

Three Proxy Variables Within The

Reduced-Form Equation

In the process of setting up the reduced-form equa-tion, the question arises as to the logical consistency ofincluding the even-keel and financial stability objectivesin the regression equation separately from the free re-serves variable which, we argue, accurately reflects thenet thrust of FOMC directives. This approach is reason-able because the open market desk operates in a contextin which there is no rigid link between open marketoperations and the level of free reserves. That is, theFederal Reserve can control free reserves without chang-ing its adjusted holdings of Govermnent securities.

With its control of the discount rate, and its ability tobuy and sell in the open market, the Federal Reservehas enough tools to achieve both a free reserves targetand to carry on open market operations relative to itseven-keel and financial stability objectives, quite inde-pendently of the free reserves contraint. This condition

Page 20

JULY. 1969

Given the existence of the profit motive on the partof the member banks, the movements in borrowingfrom the Federal Reserve, which are the dominant com-ponent of free reserves, could be induced by changesin the difference between the discount rate and therate for alternative sources of funds, such as the Fed-eral funds rate. In fact, we feel that there is substantialevidence which indicates that this difference does asatisfactory job of explaining movement in free reserves.In the above chart, the difference between the discountrate and the Federal funds rate is plotted along withthe level of free reserves. The foliowing regression equa-tion expresses the extent of that association:

07/1954 to 11/1962:FR = —0.23 + 0.83 (RD-RE) R2

= .71(8.35)

111/1962 to IV/1968:FR = th104 ± 055 (Rn-Re) R2

= .63(6.32)

where Rn is the Federal Reserve Bank of New York discountrate and RE is the Federal funds rate.

This mode of explaining movements in free reservesoperates quite independently of the movements in themonetary base. The monetary base seems to be the bestmeasure of “effective” open market operations after al-lowing for the Federal Reserve’s defensive operationsagainst the other source components of the base. Con-sequently, the monetary base can legitimately be re-garded as an additive linear function of the separateproxies for the economic stabilization, even-keel andfinancial stabilization objectives.

serves as a justification for asserting that even-keel andfinancial stability objectives are not implicitly containedwithin the free reserves variable, but can be added toit in a regression equation which is used as an explana-tion of the movement in adjusted holdings of Govern-ment securities. If a rigid link existed between free re-serves and open market operations, then the trading deskcould not achieve even-keel and financial stability ob-jectives which were inconsistent with the desired freereserves target.