The federal reserve operating procedure, 1984–1990: An empirical analysis

THOMAS F. COSIMANO RICHARD G. SHEEHAN

University of Notre Dame

Notre Dame, Indiana

The Federal Reserve Operating Procedure, 7984- 7990: An Empirical Analysis*

The operating procedure employed by the Federal Reserve has important implications for the

behavior of interest rates and money growth. We present a simple theoretical model that encompasses both a Federal Funds Rate operating procedure and a Borrowed Reserves operating procedure. We then examine a VAR model of the reserve market from February 1984 through April 1990 to ascertain the actual behavior of reserves and interest rates. Comparing the alternative predictions of the theoretical model with the results of the estimated VAR model

gives us another perspective on the operating procedure employed by the Federal Reserve. The evidence suggests that the Fed’s operating procedure has been closer to a Borrowed Reserve than to a Federal Funds Rate procedure.

1. Introduction Economists now generally agree that the Federal Reserve (Fed) em-

ployed a Nonborrowed Reserves operating procedure from October 1979 to October 1982 and a Federal Funds procedure prior to October 1979.1 In contrast, current U.S. monetary policy has been characterized both as a Federal Funds operating procedure and as a Borrowed Reserves operating procedure. In this paper we investigate the Feds current operating procedure. Do the observed patterns of reserves, federal funds rates and money growth allow us to distinguish between the Fed using a Borrowed Reserves or Federal Funds Rate operating procedure?

*The Center for Research in Banking provided financial support. Data was provided by the Jesse H. Jones Research Data Base. James Holmes, Raymond Lombra, Bill McDonald, Ken Robinson, Dan Thornton, Dave VanHoose and the participants at seminars at University of Notre Dame, Southern Methodist University and the Federal Reserve Bank of Dallas provided helpful comments. The authors also thank two referees for suggestions that substantially im-

proved the paper. Any remaining errors are entirely our responsibility. ‘See Bradley and Jansen (1986), Cosimano and Jansen (1988) and Thornton (1988) for

descriptions of how alternative Fed operating procedures have influenced the reserve market.

louma1 of Macroeconomics, Summer 1994, Vol. 16, No. 4, pp. 573-588 Copyright 0 1994 by Louisiana State University Press 0164-0704/94/$1.50

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Thomas F. Cosimuno and Richard G. Sheehan

When the Fed first switched to a Borrowed Reserves operating procedure there initially was discussion that it effectively was returning to targeting the federal funds rate. The model presented below indicates that that need not, in fact, be the case.

The distinction between these two operating procedures is important for at least three reasons. First, we believe that it is important in its own right to understand how the Fed behaves. While a substantial literature has examined the Fed’s behavior, we believe that the approach here provides incremental information about the Feds recent conduct of monetary policy. Second, shocks to borrowed reserves, nonborrowed reserves and the federal funds rate will have different impacts depending on the operating procedure employed. For example, a shock to nonborrowed reserves would not affect the funds rate under a Funds Rate operating procedure but would have an impact under a Borrowed Reserves procedure. Thus, what type of shock is more common should be one criterion employed in determining the Feds optimal operating procedure. And third, a broad literature addresses the role of the Fed in determining or influencing interest rates. This study presents some evidence on whether the Fed has attempted to influence one interest rate directly or whether the Fed has been content, for example, to alter borrowed reserves and thus influence interest rates by altering the supply or demand for funds.

The next section describes Meulendyke’s (1990) view of the Feds current procedure. In Section 3 we present a simple theoretical model that should be capable of mimicking either a Federal Funds Rate or Borrowed Reserves operating procedure. The empirical evidence from the estimated vector autoregressive (VAR) model presented in Section 4 suggests that since February 1984 Fed actions appear closer to a Borrowed Reserve procedure than to a Federal Funds Rate procedure. In Section 5, we examine how empirical estimates of the reserve market VAR model change under different operating procedures. In particular, we consider how the relationship between the federal funds rate and borrowed reserves has changed over time. Section 6 briefly concludes.

2. The Fed’s Stated Operating Procedure While monetary researchers debate the actual operating procedure

employed, the Fed portrays its operating procedure since October 1982 as attempting to manipulate the reserve market by controlling borrowed reserves. Henry Wallich (1984), a member of the Board of Governors, first described in detail the Borrowed Reserves operating procedure, in contrast to the Nonborrowed Reserves procedure that it replaced. Meulendyke (1990)

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The Federal Reserve Operating Procedure

confirms that the same basic procedure remains the basis for the day-to-day conduct of monetary policy.

With a Borrowed Reserves procedure, the Trading Desk establishes a level of borrowed reserves (the borrowed reserve assumption) that is consistent with the Federal Open Market Committee’s (FOMC) targets for the money stock and the federal funds rate. Next, the Trading Desk, when conducting its day to day open market operations, attempts to keep actual borrowed reserves consistent with the FOMC’s assumed borrowed reserves.

If the FOMC desires tighter monetary policy, it must initially raise the borrowed reserve assumption. The Trading Desk then forces banks to increase borrowed reserves by reducing the amount of nonborrowed reserves. This change would occur whether the Fed has a Funds Rate, Nonborrowed Reserve or Borrowed Reserve operating procedure. The critical issue is the nature of the feedback rule the Fed uses to alter nonborrowed reserves. This contraction of reserves forces banks either to adjust their assets and liabilities or to borrow additional reserves from the Fed. This contraction also reduces the reserves available in the federal funds market, bids up the federal funds rate and increases the spread between the funds rate and the discount rate.

Banks respond initially to this tighter monetary policy by increasing their discount window borrowing with the increase in the spread and the reduction in nonborrowed reserves.2 In the long run, increases in interest rates will reduce the total demand for reserves and cause banks to reduce their borrowings relative to their previously higher levels. With the Borrowed Reserve operating procedure, the FOMC then will lower its borrowed reserve assumption.

Looser monetary policy works symmetrically to the process described above assuming that banks do not maintain a substantial amount of excess reserves.

3. VAR Model of Fed Operating Procedures To aid in testing the type of operating procedure actually employed by

the FOMC, we first present a simple illustrative model of the reserve market. This model, with appropriate parameter choice, could be consistent either with a Borrowed Reserves or a Federal Funds operating procedure. While we attempt to model the fundamentals of the reserve market, we do not develop a complete characterization of the dynamics (Cosimano 1987, 1988; VanHoose 1988). The model stated algebraically is

Mt = mO - m,F, + eMt ; (1)

‘This discussion assumes that the spread typically is positive. In our sample the spread is negative only during three settlement periods.

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Thomas F. Cosimano and Richard G. Sheehan

Nt = no + nlB, - nzFt + eNt ; (3)

B, = b, + b, (F, - D,) + eBt ; (4)

where M equals the money stock (Ml), N is nonborrowed reserves, B is aggregate borrowed reserves, F represents the federal funds rate, D is the discount rate and e, is the random disturbance to the variable i. Following Butkiewicz and Lewis (1991) and Cosimano and Jansen (1988) we include extended credit in nonborrowed reserves since the Fed quickly offsets increases in extended credit through defensive open market operations.3 The four constants (m,, fo, n, and b,) are assumed positive.

The first relation, Equation (l), represents a standard demand for money function. Money demand is inversely related to the federal funds rate while a scale variable such as income is excluded given that our estimation is based on biweekly data. Seasonal factors also could be important in a more general model but are not germane to our discussion.

Equation (2) states the Fed’s federal funds rate policy. We assume that the Fed tolerates an increase (possibly temporary) in the funds rate when it constricts nonborrowed reserves under a Borrowed Reserves operating procedure. In contrast, if the Fed is following a Federal Funds Rate operating procedure we would expect the funds rate to be exogenously determined and equal to f. absent any shocks to this system (fi = 0).

Equation (3) presents a reduced form expression for nonborrowed reserves. The demand for total reserves (N + B) is positively related to Ml because banks need more reserves when deposits increase. In addition, following Muelendyke the supply of total reserves at least in the short run responds positively to a change in borrowed reserves so that the borrowed reserves assumption is maintained. Thus, the funds rate has a negative effect on the demand for nonborrowed reserves since a higher funds rate decreases the demand for the money which in turn decreases the demand for nonborrowed reserves. Nonborrowed reserves also are positively related to borrowed reserves when the supply effect dominates the demand effect of borrowed reserves on total reserves (nl > 0).

3Banks that suffer substantial and prolonged deposit withdrawals use extended credit (65% of total borrowed reserves during our sample period) while small banks that can demonstrate a seasonal pattern to their loan portfolio employ seasonal credit (11% oftotal borrowed reserves). See Stevens (1990) for a description of the rationale for each of these credit programs. The Fed’s operating procedure suggests that adjustment credit should be the borrowed reserve variable included in the VAR model. Following Meulendyke’s (1990) description of the Trading Desk’s operating procedure, changes in borrowed reserves absorb temporary changes in the excess demand for reserves.

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The Federal Reseme Operating Procedure

Equation (4) is a reduced-form expression for borrowed reserves, with the actual level of borrowed reserves potentially influenced by both demand shocks and supply shocks. The Fed does not have complete control over borrowed reserves in the sense that the Fed makes loans to banks that come to the discount window under the appropriate circumstances. Banks’ willingness to approach the discount window in a general setting is hypothesized by Goodfriend (1983) to be a function of the current spread between the funds rate and the discount rate as well as expectations of future spreads and the previous levels of borrowing. Nevertheless, under a Borrowed Reserve operating procedure, the Trading Desk attempts to equate borrowed reserves and the borrowed reserve assumption, b, in Equation (4).4 One can view this procedure as setting b, equal to zero in the case of a shock in the demand for reserves.s

An increase in reserve demand, ceteris paribus, will prompt the Fed to increase the supply of nonborrowed reserves. That is, the Fed, to maintain its borrowings assumption, would take the necessary actions in altering the supply of nonborrowed reserves and any concomitant short-run changes in the spread. When setting its borrowed reserve assumption the Fed already has incorporated banks’ willingness and ability to borrow at the discount window. Alternately, consider the impact of a shift in the supply of reserves. A decrease in the supply of nonborrowed reserves would be expected to increase the spread as well as the level of borrowed reserves. In this case, b, would be positive. From the Feds perspective, however, demand shocks would appear to be much more likely than supply shocks.

This simple theoretical model is consistent with Meulendyke’s characterization of the Trading Desk’s operating procedure. It also is consistent with either a Federal Funds Rate or Borrowed Reserve operating procedure. With a Federal Funds Rate procedure we expectf, = 0. In addition, a positive shock to borrowed reserve demand would have a negative impact on nonborrowed reserves,f, = 0 and n, c 0 (see Thornton 1988). In contrast, with a Borrowed Reserve procedure we expect b, = 0 and n, > 0.

Before discussing the empirical results, it is worthwhile to examine the impact of a shock to any of the equations in the model. Table 1 presents these results under three scenarios. The first line presents the results for the most

4The borrowed reserve assumption is not included in the VAR as a separate variable since actual borrowed reserves and the assumed level of borrowed reserves are highly correlated,

especially after 1985. Thornton’s (1988) Chart 2 graphically demonstrates this point. In addition, while the actual level of borrowed reserves changes frequently, the target changes infrequently.

Thus, movements in actual borrowed reserves appear to be dominated by demand shocks rather than supply shocks.

‘Alternately, we could assume that the Fed set the discount rate equal to the federal funds

rate.

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TABLE 1. Predicted and Estimated Responses to Shocks 1984-1990 I , I I

NOTE: The three lines labeled “Predicted” refer to the predictions of the theoretical model based either on the general solution or on the solutions imposing a Federal Funds Rate operating procedure or a Borrowed Reserves operating procedure. All three predictions assume that the Jacobian is positive or (1 + f,(b,n, - n,) > 0). This condition will be satisfied at a minimum when nonborrowed reserves are not overly sensitive to changes in the federal funds rate. The last line, labeled “Estimated,” refers to the solution ofVAR model using the full sample of data when all four variables are constant over time.

general case (assuming nl > 0). All calculations assume that the Jacobian is positive where the Jacobian equals (1 + fi(b,n, - n2)). This condition is satisfied at a minimum if nonborrowed reserves are not “too sensitive” to interest changes, an assumption that appears plausible in light of the discussion above.

In the general case, a positive shock to the money stock (Q) influences only money. A positive shock to the funds rate (+) increases the funds rate which in turn decreases the money stock. It also increases borrowed reserves by increasing the spread between the funds rate and the discount rate. The change in nonborrowed reserves, however, is ambiguous. A positive shock to nonborrowed reserves (eN) increases nonborrowed reserves and thus lowers the funds rate. In turn, borrowed reserves decrease while the money stock increases. Finally, a positive shock to borrowed reserves (Ed) leads to an increase in nonborrowed reserves, again producing a lower funds rate and a higher money stock. The change in borrowed reserves is ambiguous, however, with the initial increase potentially offset by a decrease due to the change in nonborrowed reserves.

The second line in Table 1 considers the case of a Funds Rate operating procedure (fi = 0 and n, < 0). The principal change from the general case is that shocks to borrowed and nonborrowed reserves have no impact on the funds rate-since it is exogenously determined by the Fed-and thus on the money stock. The only other change of note is that a positive shock to borrowed reserves yields a decrease in nonborrowed reserves. This result follows from the assumption n, < 0 based on Thornton (1988).

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The third line considers a Borrowed Reserve operating procedure (b, = 0). Analogously to the Funds rate operating procedure above, we assume that the Fed sets a borrowed reserve target that may be influenced by shocks in the demand for borrowed reserves, for example. In this case, the results differ from the general case primarily in that borrowed reserves are unaffected by innovations in nonborrowed reserves and the federal funds rate, here because borrowed reserves are exogenously determined by the Fed. A borrowed reserves shock, in fact, will increase borrowed reserves if nonborrowed reserves do not change substantially with changes in the federal funds rate or if the funds rate does not change substantially with a change in nonborrowed reserves. Algebraically, the condition is: 1 - fin2 > 0. This condition also is sufficient to yield a positive Jacobian for the Borrowed Reserves operating procedure.

4. Empirical Results We estimate a four-variable VAR model of the reserve market with a

view of the alternative Fed operating procedures and the above model in mind. The spread (S) is included in the VAR model while the federal funds rate is included in the theoretical model. No difference exists between these two specifications. Changes in the federal funds rate apparently drive changes in the spread.6 The estimation uses biweekly observations over the sample period from March 28, 1984 to April 4, 1990.7 Biweekly observations are

a~ncluding the discount rate as a separate variable is not a viable alternative since it was

changed only eleven times (spanning eighteen settlement periods) during this period. The VAR model did not change when individual dummy variables were included for each change in the discount rate. Only one of eighteen discount rate dummies was significant at the 5% level in the nonborrowed reserves and the spread equations, while none were significant in the borrowed

reserves and Ml equations. We also estimated the equations using the funds rate as an independent variable rather than

the spread to ensure that using the spread rather than the funds rate did not bias the results against a Funds Rate operating procedure. The results basically were unchanged from those reported in the text.

70~r data sources are described in the appendix. The sample begins in March 1984 and runs through April 4, 1990. While earlier data is available, it is not employed to avoid complications associated with the change from lagged to current reserve requirements. In addition, reserve

requirement changes beginning in January 1991 make it impossible to generate a consistent series for nonborrowed reserves since then. Current reserve requirements begin in February 1984, and the first few observations are lost due to differencing and lags. We also include dummy variables for May 23,1984, June 6,1984, and December 4,1985. The first two dummy variables are included to account for a large two-week increase in adjustment borrowings, shifted in the

next week to extended credit, associated with Continental-Illinois. The third dummy variable is included to deal with a dramatic one-week increase in adjustment credit resulting from the Bank of New York’s computer software failure.

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employed since total reserves are available only biweekly since February 1984.

Under appropriate assumptions about the sources of shocks to the system, the model specifies that the target level of the funds rate is constant under a Federal Funds operating procedure while the target level of borrowed reserves is constant under a Borrowed Reserves operating procedure. Changes in the targets must then be included in the error terms. In a more general model the targets themselves would be functions of variables like inflation and the unemployment rate (VanHoose 1990). That extension, however, is beyond the scope of this paper.

Before estimating our VAR model we checked all four variables for stationarity using the Dickey-Fuller, augmented Dickey Fuller and CRDW tests (Engle and Granger 1987). These tests indicate that the spread and borrowed reserves are stationary in levels while Ml and nonborrowed reserves are stationary in first differences. Thus, we use changes in Ml and nonborrowed reserves in the VAR model.8

We use the Final Prediction Error (FPE) criterion to choose the lag lengths in the VAR model including a maximum of six lags (approximately three months) for each variable. While alternate lag selection procedures are employed given the results of Hafer and Sheehan (1991), the results do not change substantially using alternate selection procedures. Following Hsiao (1981), we also over-fit and under-fit the model using Zellner’s seemingly unrelated regression technique. The final estimate of the VAR model is presented in Table 2. The table indicates the estimated lag lengths as well as the coefficient estimates. A zero in the table of lag lengths indicates that the FPE criterion chose no lags of that variable to be included in the regression.

The estimated model appears to be consistent with several aspects of Meulendyke’s (1990) d escription of Trading Desk operations. First, the Desk

‘Regressing the change in Ml on the lagged level of the funds rate is equivalent to regressing the level of M 1 on lags of the funds rate and of M 1 with the coefficient on lagged M 1 constrained

to equal one. The rationale for including lagged money generally is based on a partial adjustment mechanism. The slower the adjustment, the closer the estimated coefficient on lagged money will be to one.

Hafer and Jansen (1991), using quarterly data, find that the coefficient on lagged money is not significantly different from one. Other studies generally have not tested that restriction but have found coefficients on lagged money close to one indicating an extremely slow speed of

adjustment. One would expect less complete adjustment with biweekly data (and thus a coefficient closer to one) than with quarterly data. Thus with biweekly data, using the level of Ml and the change in the funds rate is not inconsistent with prior findings. This procedure effectively assumes that individuals’ holdings of money on a biweekly basis are at least in part predetermined by factors like income that do not change appreciably from week to week. Interest rates then alter money demand only at the margin.

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TABLE 2. Estimated VAR Model 1984-1990

Ml, %dl) %Z@> a1361 0 ait EM 0.52

cc&) %@) 0 0.73 a3&) a33(3) %4(2) At + : 0.26

4 0 0 0 %@> & EB 0.72 .

Note: CX#) indicates k lags of thejth predetermined variable are included in the ith equation. The parameter estimates follow where L indicates the lag operator. IO+ is the sum of the coefficients C@).

EM1 I II 121.55 0.55 7981.7 472.42 ES = 0.12 0.17 5.12 25.11 EN 0.71 0.01 1.04 x lo6 -6890.2 EB 0.18 0.25 -0.03 55961 1

Note: The elements on or above the diagonal are the covariances while those below are the correlations.

all(l) = -0.6241; k,, = -0.624 (11.34) (0.000)

a,,(2) = 2.597L-6.51OL' ccc,, = -3.912 (1.46) (3.69) (0.000)

a,,(5) = -0.0001L-0.0009L2 xa,, = -0.0073 (0.14) (1.25) (0.000)

-0.0003L3-0.0004L4-o.00171d5 (6.02) (0.79) (3.54)

a,,(3) = 0.481L + 0.269L2 + 0.164L3 ax,, = 0.914 (6.39) (3.33) (2.06) (0.000)

a,,(2) = 0.00003L-0.00006L2 ca, = -0.00003 (0.84) (2.14) (0.459)

a,,(3) = 421L-692L2 2x,, = -271 (2.40) (3.98) (0.007)

~~(3) = -0.166L + 0.014L2-0.268L3 Zcx,, = -0.420 (2.37) (0.20) (3.97) (0.000)

c&2) = 0.6251; + 0.214L2 Ccc, = 0.839 (3.34) (1.43) (0.000)

~~~(2) = 0.127L + 0.122L2 Ca,, = 0.249 (2.15) (2.63) (0.000)

NOTE: Absolute values of the T-statistics are included in the parentheses below the individual coefficients, and the significance levels are included in parentheses under the coefficient sums.

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appears to attempt to keep borrowed reserves at the assumed level of borrowed reserves. Borrowed reserves are unaffected by changes in nonborrowed reserves or the federal funds rate, for example. The results also are consistent with the contention that there has been an unreliable relationship between borrowed reserves and the spread, although the cause of that breakdown-additional shocks to the system or systematic policy actions by the Fed--cannot readily be ascertained.a In addition, the Trading Desk allows the funds rate to increase when they want an increase in reserve pressure. The coefficients for nonborrowed reserves in the spread equation, however, appear very small and the coefficient sum is not significantly different from zer0.l”

While the evidence suggests a Borrowed Reserve operating procedure, it also suggests that fr in the theory and as3 in the VAR are close to zero, consistent with being close to a Federal Funds procedure. Nevertheless, the joint hypothesis that the coefficients in cx 23 equal zero can be rejected at the 5% level while the joint hypothesis that the coefficients in ad2 equal zero cannot be rejected. These tests are consistent with a Borrowed Reserve procedure and not with a Federal Funds Rate procedure. These results indicate the difficulty of drawing a sharp contrast between the alternative operating procedures even while we interpret them as suggesting that the Fed has followed a Borrowed Reserves operating procedure.

It generally is problematic to attempt to interpret the individual coefficient estimates in a VAR model. Thus, we focus in addition on the long- run responses. The last line in Table 1 presents the steady-state responses of the four endogenous variables in the VAR model to the four exogenous disturbances. The impulse response functions yield essentially the same sign pattern after one year.

Table 1 indicates that predicted responses of the Borrowed Reserve operating procedure are almost identical to the estimated responses. The only exception is the impact of a random change in borrowed reserves on the federal funds rate. A positive shock to borrowed reserves leads to an estimated increase in the spread rather than the decrease predicted by the theory. This result suggests that the Fed tolerates an increase in the spread perhaps to mitigate the impact of the shock on the level of borrowed reserves. Comparing the predictions of the Federal Funds Rate operating procedure with the estimated responses yields more inconsistencies.

With the advent of contemporaneous reserve accounting the level of excess reserves has increased somewhat. In addition, seasonal borrowing has grown as a share of total borrowing although it is not included in our measure of borrowed reserves.

‘Orhe VAR variance decompositions corroborate this result and indicate that little variability in the spread can be attributed to nonborrowed reserves.


5. Alternative Operating Procedures The last issue we examine is the temporal stability of this model.

Bradley and Jansen (1986) and C osimano and Jansen (1988) suggest breaking a longer period into three subperiods: (1) before October 1979 when the Fed followed a Federal Funds Rate operating procedure, (2) from October 1979 through September 1982 when the Fed used a Nonborrowed Reserve procedure, and (3) since September 1982 when the Fed arguably employed a Borrowed Reserve procedure.

Up to this point we have examined only the last subperiod. We now present limited results for the same model during the first two subperiods. Lacking consistent weekly observations for the first two subperiods, we employ monthly data (obtained from Citibase) for those intervals. Following Bradley and Jansen (1986), we begin the first period in June 1971. The results are presented in Panel A of Table 3. To conserve space, we report only the results for the federal funds rate and the borrowed reserves equations. The notation a,(k) follows Table 2 by listing the effect of variablej on the variable i with the optimal number of lags equal to k.

Before October 1979, the variance decompositions indicate that the spread primarily is explained by lags of the spread, nonborrowed and borrowed reserves. Borrowed reserves largely are determined by the same three variables. In contrast, from October 1979 to September 1982, the role of reserves drops sharply while the role of money growth increases. These results are consistent with prior studies in at least two dimensions. First, a change in regimes occurs in October 1979. And second, the equations’ explanatory power drops substantially after that change in regimes. Perhaps of most interest here, however, is the contrast between the results in Table 2 and those in Panel A of Table 3. The results in Table 3 indicate that the period since 1984 represents a considerable break from both prior subperiods. The included right-hand-side variables and lags differ substantially, while the variance decompositions also appear to differ markedly.

Pearce (1993) and Mitchell and Pearce (1992) suggest further dividing the last subperiod. They contend that the behavior of the spread and borrowed reserves changed after the October 19, 1987 stock market crash. To further examine potential changes over time in the VAR model, we follow Mitchell and Pearce’s suggestion and break the biweekly VAR reported in Table 2 into two subperiods, pre- and post-stock market crash. We omit the period from October 1982 to March 1984 since it is not long enough to allow estimation using monthly data while consistent biweekly data is unavailable. The results (for the spread and borrowed reserves) are presented in Panel B of Table 3.

Some differences exist between the results in Table 2 and the pre-crash biweekly results. For example, in the pre-cash period additional variables

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TABLE 3. VAR for Reserve Market Over Alternative Subperiods

A: Monthly Data 1971 :vi-1979:ix Spread and Borrowed Reserve Regressions

M S N B R2 s C$1(3)= -0.013" a&2)= 0.737 C&(3)= 0.000 C&4(3)= 0.001 0.935 B [ cafe= 57.6 t&(3)= 30.4 CL&)= 0 a&3)= 0.873 1 0.868

Variance decomposition

[:;%::I

1979:x-l 982:ix Spread and Borrowed Reserve Regressions R2

[ (X21(3) cq1(3)= = 0.605 226 ad2(0)= az2( 1) = 0.655 0 CX~~(~) a43(0) = = 0.001 0 aed(l) c&2)= = 0.001 0.958 1 0.720 0.650


[:5 ;': 1; ,!I

B. Biweekly Data 1984:&1987:x Spread and Borrowed Reserve Regressions E2

[ C$,(3)=0.039 CX41(5)= 10.3 C&(3)= c'&(4)= 0.722 90.8 a&2)=O.OOO CX43(0)=0 ~~24(2)=0.000 C&,(2)=0.236 1 0.530 0.859


[: ‘ii 4 ~~1

1987:x-l 990:iv Spread and Borrowed Reserve Regressions iI2

[ C&(d) a41@) = = 0 0.007 O&(l) 0~42(6)= = 0.973 1.15 0$,3(3) a43(0)= = -0.001 0 (&4(O) a44(0)=0 = 0 1 0.927 0.137


[i :: '; ,:]

*Number is the sum of coefficients

beyond lags of borrowed reserves are significant in the borrowed reserves equation. This result, by itself would suggest that the Fed did not follow a strict Borrowed Reserves (or Federal Funds Rate) operating procedure

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during this period. In contrast, the implications of the variance decomposition support prior results. The spread and borrowed reserves both are explained primarily by their lagged values. This result appears consistent with the prior finding that borrowed reserves are set by the Fed and that the federal funds rate, while endogenously determined, is relatively insensitive to changes in reserves.

One key difference exists in the borrowed reserves equation from pre- to post-crash. The explanatory power of the equation drops dramatically.ii This result suggests a deterioration in our ability to forecast borrowed reserves in the most recent period and begs the question of whether monetary policy is best conducted using a Borrowed Reserve operating procedure. The equation also indicates that lagged values of the federal funds rate are included in the borrowed reserves equation, in contrast to the prediction of the Borrowed Reserve procedure model. The sum of the coefficients, however, does not differ significantly from zero, suggesting that any Fed deviation from a Borrowed Reserve procedure occurs only in the short run.12 In addition, the results for this period do not support a Federal Funds Rate procedure.

An alternate hypothesis exists for the deterioration in the borrowed reserves equation that is consistent with the Borrowed Reserve operating procedure: The borrowed reserves equation deteriorated dramatically simply because the Fed attempted to control borrowed reserves. Thus, by focusing on borrowed reserves and offsetting systematic influences the Fed ensured that only shocks to the borrowed reserve equation influenced borrowed reserves, causing the estimated equation’s performance to deteriorate. It appears that the process may have changed from the pre-crash period, but the results of both sub-samples generally are consistent with a Borrowed Reserve operating procedure.

If the Fed did switch operating procedures or switched the process of implementing a Borrowed Reserve procedure, the data do not allow us to identify the precise date of this change. A Chow test for a switch at the stock market crash easily rejects the null hypothesis of no break. To further examine the issue of potential structural breaks, we examined both sub- samples. Chow tests for the borrowed reserve equation calculated at alternate break points from March 28, 1984 through October 17, 1987 reject the null

“Feinman (1993), estimating the Open Market Desk’s reactions, also finds a substantial change in Fed behavior at this time.

‘-he variance decomposition results in any row must sum to 100. (In some cases this equality holds only approximately because of rounding.) The number 81 for borrowed reserves in the variance decomposition of borrowed reserves, coupled with the insignificance of lagged borrowed reserves, simply represents another statement of the lack of explanatory power of the borrowed reserves equation.

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hypothesis of stability at all points until May 21, 1986 with the lowest significance level on May 22, 1985. A similar experiment on the borrowed reserve equation during the October 31, 1987 through April 2, 1990 period rejects the null hypothesis of stability until May 18, 1988. These results suggest some ambiguity concerning whether a break occurred at the stock market crash. While the evidence unambiguously suggests a break occurred, we cannot pinpoint the breakpoint’s date and have no direct evidence to suggest that it occurred at the crash.

6. Conclusions The above analysis reports results generally consistent with prior stud-

ies on Fed operating procedures prior to 1984. Those studies also found results broadly consistent with Fed statements about their actual operating procedures. The Fed appears to have followed a Federal Funds Rate procedure through September 1979 and a Nonborrowed Reserve operating procedure beginning in October 1979. In contrast, since 1984 there appears to be more conflict about the actual procedure employed by the Fed. Our results suggest that the Fed at least initially did follow a Borrowed Reserves operating procedure. The results from the entire period, March 1984 to April 1990, support that contention and appear at odds with a Funds rate procedure. Our results also indicate the difficulty of distinguishing between a Federal Funds Rate and a Borrowed Reserve operating procedure. Fur- thermore, our results also suggest an additional potential source of the conflicting opinions about the Feds operating procedures. At some point apparently near the October 1987 stock market crash the Feds actions changed. Since that date, the Feds policy looks more like a Federal Funds operating procedure and less like a Borrowed Reserves operating procedure.

Received: December 1992 Final version: Febma y 1994

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Thomas F. Cosimuno and Richard G. Sheehan

Data Appendix B is the nonseasonally adjusted average of daily figures for biweekly or

monthly total borrowings at Reserve Banks minus seasonal borrowings at Reserve Banks minus extended credit at Reserve Banks. The source is the Federal Reserve Board release H.3 reported in the Annual Statistical Digest until 1988 and in the Federal Reserve Bulletin from 1988. The federal funds rate is the average of daily figures (‘i-days, ending Wednesday). The average is weighted by volume of transactions. The source is the Federal Reserve Board release H. 15. The discount rate is based on rate change approval and comes from the Federal Reserve Bank of St. Louis. Ml is the nonseasonally adjusted, average of daily figures for biweekly or monthly Ml from Federal Reserve Board release H.6. N is the nonseasonally adjusted average of daily figures for biweekly or monthly total reserves minus total borrowings at Reserve Banks plus extended credit. The source is the Federal Reserve Board release H.3 reported in the Annual Statistical Digest until 1988 and in the Federal Reserve Bulletin from 1988.

588

Documents

The federal reserve operating procedure, 1984–1990: An empirical analysis