FOMC Decision Making
The FOMC sets the target for the policy instrument at FOMC meetings. This is a decision about where to locate the money supply function. The decision, both before and after the October 1979 policy change, was to supply reserves to lead to desired outcomes for inflation and output growth. Each decision was also expected to result in particular outcomes for the federal funds rate and the growth in the targeted monetary aggregates, particularly M1.
Gavin and Kyland begin with this naive description of FED's function. They only wish to provide a setting. It is always assumed by just about everyone that interest rates and money supply are inversely related. Under that assumption the authors say FED targets money supply and they say the FED's assumption is there is a firm connection between rates and money supply.
A combination of theory, econometric models, and judgment went into these decisions. Before October 1979, monetary policy resulted in a high and variable outcome for inflation. After October 1979, the FOMC appeared to put relatively more weight on controlling money growth and inflation.
The truth is that FED which was and is dominated by demand management school types didn't believe that more money wouldn't generate more output. The fact is that more money generated more inflation than it generated more output. The officials including Volcker couldn't come to believe that and so the market which has to deal with the realities forced them to accept that by demanding ever greater premium on fed funds. When the FOMC wandered into the market word went out fast to make 'em pay up. The next increment of supply was causing rates to rise! All due to the lack of trust. So FED credibility was near zero. Sometimes this is called a backward bending supply curve. When this occurs the free market is default in charge. This created more fear among FED officials than the threat of hyper inflation, because it meant their authority, their ability to save the world, their ability to do good, was severely curtailed. In their panic they decided to change their operating procedures in Sept. '79 by targeting non-borrowed reserves.
This was quite a change from 30 years of ever growing abuse of Keynesian management tools (the pump) which led to what Gavin calls,"high and variable outcome for inflation". Targeting non-borrowed reserves is about the most intense way to control money supply, but it requires the abandonment of interest rate targeting:
On October 6, 1979, Fed Chairman Paul Volcker announced that the procedure would be changed so that the manager of the Desk would be required to adjust the Fed’s portfolio of securities to achieve weekly targets for non-borrowed reserves, rather than the federal funds rate. The policy change led to a dramatic, tenfold increase in the volatility of the federal funds rate and a high correlation among changes in interest rates across the term structure and across national boundaries. The increased interest rate volatility caught the attention of the markets and the public. It probably helped Paul Volcker achieve credibility for the disinflation policy
So what do we have now?
Although inflation fell to around 4 percent at the end of 1982, M1 demand became more unstable, so the Fed shifted to borrowed reserves and returned to an operating procedure that was an indirect form of interest rate targeting. In Alan Greenspan’s first term as Fed Chairman (which began in 1987), the FOMC returned to an explicit interest rate targeting procedure.
FED claims they target everything and now it seems they target the stock market which is a little like shooting the messenger. They target nothing but fed funds because to try to manipulate economy with rates is explicit disaster. What is the proper rate of interest? They don't know and they can't know. Only the market can know and it only knows instantaneously. The FED reacts to some quaint past. How stupid can they be? This is the best intellect has to offer.
In 1988 the economic environment was too weak to revert explicitly back to the good old days of demand management. That took five years and some lip service to the Friedman monetarists(and Milty was thankful), but the tightening in '94 set the stage for the coup de resistance. In '95 the FED opened the money flood gates and the financial world jumped on the dough. They didn't factor it through C&I loans, they put it in hedges. Now that Greenspan who will go down in history as the worst Chairman of all time once the imbeciles in academia are in a comfortable position to admit it, has got the price fixing all back in place. The disastrous result will be a return to an environment like the '70s and you won't hear Greenspan talking about WinXXX productivity.
The FED will pump up the economy only to see a rising floor put under inflation and then pull the rug out to prevent losing control when the inflation starts soaring. The consequence to the stock market will be that it will be stuck at current levels indefinitely, but will swing about 20% up or down in each cycle.
Where are we now? Close to the beginning or the end of a cycle. The stock market must decline, that is the DOW, must decline until FED's hand is forced. Then the FED will panic and pump and stock prices will recover, but so will indicators of inflation and to ever greater degree. The DOW hasn't declined and so FED has to hold tight. Therefore, DOW must decline and soon. |
