The Fed's Transition from Monetary Targets to Interest Rate Targets Introduction The Federal Reserve appeared to be taking on a completely different stance in 1994 versus 1993. During 1993 there were no changes in the policy directives of the Federal Open Market Committee and short-term interest rates remained steady. In contrast, during 1994, the FOMC announced six different policy changes while at the same time making an adjustment to the short-term interest rate. This change in policy was due to two factors. First, the economic environment had changed. The Fed's monetary policy during 1993 was accommodative to permit the recovery of the economy from a recession, while the policy became more restrictive in 1994 as the economy appeared to be recovering and possibly heating up. Another cause of this apparent shift was growing consensus that price stability should be the ultimate long-term goal of the Federal Reserve. Also, the Fed adjusted its intermediate targeting strategy, !

placing more emphasis on interest rate targets over monetary aggregate targets. Monetary Goals To understand why the Fed changed its targets and goals the way it did, we should first

tween monetary aggregates or interest rates. This is an either/or decision because the Fed cannot pursue both of these targets simultaneously. Setting an intermediate target in terms of a monetary aggregate means that any shift in money demand will result in changes to the interest rate. Similarly, setting an intermediate target in terms of an interest rate means that any shift in the money demand will have to be met with an adjustment to the money supply if we want to hold the interest rate constant. The bottom line is that if we choose one target, the other must be permitted to float. When the Fed makes a decision on which intermediate target to use, it evaluates them on the following three criteria: 1) measurability, 2) controllability and 3) predictability. The intermediate target has a direct impact on the desired monetary goal, but cannot be directly influenced by the policy tools. For this reason the Fed also establishes operating targets. Operating targets are directly!

rket operations, and to a lesser extent, changes to the discount rate or reserve requirements, to create the planned change to the federal funds rate, and subsequently to the market interest rates. Although control is quite effective it cannot be absolute because there are other factors and participants in the economy which the Fed cannot control. For example, although the Fed may lower the discount rate or its reserve requirements, it cannot force the banks to borrow from the discount window or use its excess reserves to make new loans. Likewise, although the Fed can use OMO to manipulate the market interest rate, it cannot directly control nominal rates since it cannot so easily adjust the public's view of expected inflation. The control the Fed exerts over monetary aggregates is also significant, but not absolute, as the Fed cannot control the banks and the non-bank public, who are capable of influencing the money supply as well. The actions of these two groups can have a s!

ubstantial influence on monetary aggregates. Additionally, their actions, particularly those of the non-bank public can be unpredictable to the Fed and change over time. An example of this is the introduction and rise in popularity of bond and stock mutual funds. This has caused a shift out of some of the assets comprising M2, making M2 growth behave uncharacteristically. Another development in the marketplace may have contributed to the slowing growth of M2 during 1993 - a slowing in refinancing activity caused a run-off of liquid funds. Also contributing to the change in the behaviour of M2 has been an increased opportunity cost of holding M2 assets during 1993 as interest rates on 3-month Treasury bills increased, making it less likely that people would choose to hold these assets. While all of the previous examples contributed to the fact that M2 growth slowed in 1993, they were generally short adjustments and explainable. The bigger issue was that even when taking these f!

inconsistent with the goals of steady economic growth or price stability (in the short-term). However, what we are not deciding on the merits of interest rate stability as a goal, but on the merits of the interest rate level as an intermediate target. As an intermediate target the interest rate is not necessarily held constant, but is adjusted to the appropriate level that is necessary to keep the economy on track toward the Fed's stated goal of price stability. The ability of interest rates to predict the Fed's ability to achieve its goals is quite effective. As we know there is a strong correlation between interest rates, price levels, and economic growth. Monetary aggregates are also effective at predicting the desired goal. As an example, during an economic expansion, the rising demand for money causes interest rates to rise, which in turn causes a reduction in consumer and business spending, keeping the economy from over heating. Conclusion Based on the preceding analysi!

actors into consider

Some common words found in the essay are:
M1 M2, Multi-Stage Process, M2 M2, Instead Fed, Monetary Goals, Fed OMO, Market Committee, Federal Reserve, Intermediate Target, Alan Greenspan, intermediate target, monetary policy, policy tools, monetary aggregates, price stability, rate targets, intermediate targets, operating targets, m1 m2, monetary aggregate, fed's policy tools, rate reserve requirements, monetary policy goals, rate targets monetary, discount rate reserve,
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