Journal of Monetary Economics 19 (1987) 107-123. North-Holland

THE FEDERAL RESERVE’S NEW OPERATING PROCEDURES A Post Mortem*

Paul A. SPINDT Board of Governors of rhe Federul Resenre S~~sfem. Wmlringrot~. DC ~0551. US.4

Vefa TARHAN Lqvola Uniuersiry, Chicago. IL 6061 I. USA

Although money stock targeting has been the strategic focus of Federal Reserve policy since the mid-1970’s. operating policy - the tactics whereby the longer-run strategy is implemented over short-term intervals - has been changed by the Federal Reserve at least twice over this period. A particularly dramatic change in operating policy was announced by the Federal Reserve in October 1979. This paper provides empirical evidence that settles questions about the nature of this change and suggests that the new operating procedures may have contributed to the heightened interest rate volatility experienced over the 1979 to 1982 period.

1. Introduction

In one of the more dramatic events in the recent history of monetary policy, on October 6, 1979, the Federal Reserve announced changes in its operating procedures that replaced the old Federal funds rate operating strategy with a new reserves-oriented procedure.’ Although explicit targets for money growth had been a central feature of monetary policy for several years prior to 1979, the Federal Reserve had become skeptical of a stable and predictable relation between the funds rate and money growth. The new operating procedures were designed to avoid dependence on this relation by focusing tactically on the quantity of reserves available to support deposits instead of on the funds rate. The expectation was that closer, and more automatic, control could be exercised over money growth using the new procedures than had been possible under the old.2

*The views expressed herein are those of the authors and do not necessarily reflect the opinions of the Board of Governors or its staff. Anil Kashyap. Gerhard Fries and Garland DeMarco provided excellent research assistance.

‘The October 6, 1979 action also involved the imposition of a special marginal reserve requirement on increases in the managed liabilities of large commercial banks.

‘In conducting policy under the old Federal funds rate procedures, the Federal Reserve faced the practical political constraint that increases in already high interest rates, even if required to restrain money growth, brought severe public and Congressional criticism. By adopting the new reserves-oriented procedures for monetary control, the Federal Reserve was able to blunt this criticism by arguing that the market, and not the Federal Reserve, determined how high interest rates would be.

0304-3923/87/%350Q1987, Elsevier Science Publishers B.V. (North-Holland)

108 P.A. Spindr and V. Tarhan. The Federal Resetwe’s new operaring procedures

It was widely recognized that the adoption of the new operating procedures was likely to result in increased volatility in short-term market interest rates, and indeed this happened. What was not foreseen was that long-term interest rates and money growth would also become as volatile as they did. The unexpected nature of these developments stimulated an intense interest in the new procedures both within the Federal Reserve System and among monetary economists generally. The workings of the new procedures themselves became the subject of controversy. In the ensuing debate, the Federal Reserve main- tained that the primary objective of its short-run operating policy was to achieve a targeted volume of non-borrowed reserves. Critical observers charged that the actual goal of Federal Reserve operating policy was to achieve a targeted volume of borrowed reserves and that the setting for the borrowings target was chosen to produce a Federal funds rate thought to be in line with objectives for money growth. The October 1979 changes were thus more cosmetic than real. In late 1982, the Federal Reserve again changed its operating procedures, this time replacing the ‘new’ procedures instituted in October 1979 with a set of procedures that neither directly targets interest rates nor focuses narrowly on a reserves aggregate.)

The published debate over the workings and effects of the new operating procedures has suffered from two important shortcomings. First, there has been no successful attempt to distill the opposing arguments into competing hypotheses susceptible to empirical testing so that appeal can be made to the data record. And second, no formal model of the mechanics of the operating procedures has been exhibited to clarify the question of how, if at all, the procedures may have contributed to the heightened volatility in money growth and capital market prices that was experienced during the period. This paper remedies these two oversights. By way of brief preview, we find that while the evidence supports the Federal Reserve’s characterization of the new proce- dures as non-borrowed, and not borrowed, reserves targeting over an operat- ing horizon of several months, the procedures may have contributed to increased volatility in money growth and long-term interest rates by introduc- ing non-stationarity in the market for borrowed reserves.

2. The target of operating policy: Was it non-borrowed or borrowed reserves?

Monetary policy is carried on with respect to several planning horizons at once. For the longer run, the Federal Open Market Committee (FOMC) establishes annual targets for the growth of several monetary aggregates and bank credit and reviews these targets semiannually. With respect to the shorter run, the committee meets more frequently (presently eight times per year) to

‘See Wallich (1984) and Solomon (1984) for a description of the post-1982 operating proce- dures.

P.A. Spittdt ond V. Tarhan. The Federal Reserve> new operaritrg procedures 109

monitor progress in achieving its goals and to adjust the course of policy when needed. At each meeting, the committee issues a directive to the manager of the System Open Market Account in New York (the ‘desk’) instructing him to conduct operations during the intermeeting period designed to keep money growth on a designated path. For operating policy, the relevant horizon is the 6-8 week intermeeting period. The October 6, 1979 changes altered proce- dures at the operating horizon but did not change policy procedures at longer planning horizons.

The FOMC directive under the new reserves-oriented operating procedures instructed the desk to manage the ‘behavior of reserves aggregates’ consistent with the desired growth of money subject only to a loose - typically a 400-500 basis point band - constraint on the funds rate.4 Translation of the seemingly vague prescription in the directive into concrete operational terms required the Federal Reserve staff to undertake a series of preliminary calcula- tions. In the directive, the FOMC specified target growth rates for seasonally adjusted monetary aggregates over a three-month horizon. From these targets, the staff judgementally allocated growth of the aggregates to the individual months in the quarter, not necessarily in straight line fashion. These seasonally adjusted levels of the aggregates were next allocated to the individual weeks of the intermeeting period and deseasonalized. The staff then estimated the volume of required reserves corresponding to the targeted levels of money taking into account the expected behavior of currency, the composition of deposits by type and maturity and other factors. The result was a projected path for required reserves over the weeks of the intermeeting period. By adding in forecasts of excess reserves, the staff arrived at a projected path for total reserves that was thought to be consistent with the FOMC targets for money growth. From the weekly projections of total reserves, the staff sub- tracted an assumed volume of discount window borrowing - a constant amount, the same for each week of the intermeeting period - that had been initially agreed to and specified by the FOMC. This produced a weekly path for non-borrowed reserves over the intermeeting horizon.

It is over this last step, and specifically over the strategic status of the initial borrowings assumption, that the controversy about the workings of the new

4From the record of policy actions for the FOMC meeting held on October 5-7, 1981, for example. the directive specified that ‘in the short run. the Committee seeks behavior of reserves aggregates consistent with the growth of Ml-B from September to December at an annual rate of 7 percent.. The Chairman may call for Committee consultation if it appears.. that pursuit of [this objective] is likely to be associated with a federal funds rate persistently outside the range of 12 to 17 percent.’ [Federal Reserve Bulletin, December 1981, p. 910). A referee pointed out that the funds rate band may actually have been more restrictive than its size would indicate since the band was not set symmetrically around the rate prevailing immediately prior to an FOMC meeting: ‘During periods when interest rates were under upward pressures [the funds rate] often fluctuated near the upper boundary of the band and vice versa when interest rates were tending to decline.’

110 P.A. Spindt and V. Tarhall, The Federal Reserve’s new operariugprocedures

procedures has developed. The initial borrowings assumption was clearly an important policy parameter. But the question is, did it have the status of an operating target, the achievement of which was the goal of week-to-week desk operations, or was it simply a device used to initially calculate the non-bor- rowed objective that the desk actually sought to achieve?’ The Federal Reserve and its critics answer this question differently.

The Federal Reserve says that the non-borrowed reserves objective calcu- lated as above was the target of its week-to-week open market activity. The monetary control mechanism envisioned under the procedures was to work largely automatically: The market would be provided with a policy-prede- termined volume of non-borrowed reserves; then any deviations of money from its longer-run target path - reflected in projection errors in required reserves developing over the intermeeting policy period - would be absorbed endogenously in net borrowed reserves. Resulting surfeits or shortages of net borrowed reserves would, in turn, generate changes in money market rates that would work to bring money growth back in line with target. A straightforward implication of this mechanism is that in data generated under such a regime, innovations in money would act as incremental predictors of - that is. ‘Granger-cause’ - innovations in net borrowed reserves (which play the role of endogenous shock absorbers) and would not be observed to Granger-cause innovations in non-borrowed reserves (the non-reactive target path for which is preset by policy).6

Critics on the other side of the debate interpret the role of the initial borrowings assumption differently. They contend that the actual target of operating policy under the new procedures was the quantity of borrowed reserves specified in the initial borrowings assumption and that the monetary control mechanism was, therefore, essentially the same as under the old Federal funds rate pegging procedures. Poole (1982, p. 577), for example, argues: ‘Non-borrowed reserves [were] managed day by day in an effort to induce a level of borrowing each statement week equal to the target average level [specified in the initial borrowings assumption] over the interval to the next FOMC meeting. Thus, fluctuations in required reserves [were] transmitted dollar for dollar to . . . non-borrowed reserves until the Fed [made] a policy

‘The issue is not merely a semantic one as it would be in a world in which the policy maker has no uncertainty about required reserves over the operating horizon. In such a world. there is no real choice between a non-borrowed and a net borrowed reserves objective because a policy which sets one of these also uniquely determines tire other via the reserves identity. The issue is substantive and the choice of operating objective real, however. when required reserves are subject to projection errors over some part of the policy interval. Such projection errors arise, for example, when there is an unanticipated deviation of money from its target path. Es post. in view of the reserves identity, these projection errors must be absorbed somewhere. An operating policy that successfully targets non-borrowed (free) reserves sets these exogenously and implies that free (non-borrowed) reserves must adjust endogenously over the operating horizon to absorb projec- tion errors in required reserves.

6Granger causality is interpreted here in the conventional sense: see, for example, Schwert (1979) and Guilkey and Salemi (1982).

P.A. Spindr and V. Tarhan. The Federal Reseme’s new operating procedures 111

decision to change its target level of bank borrowings at the discount window . . . . When money growth [ran] high, say, the Fed suppl[ied] the extra non-borrowed reserves consistent with holding to the average borrowings target.’ This interpretation of the new procedures implies that innovations in money resulting in projection errors in required reserves would be observed empirically to Granger-cause innovations in non-borrowed reserves (which act here as the shock absorber) and would not Granger-cause innovations in borrowed reserves (the path for which has been preset by policy). Thus, the alternative interpretations of the new operating policy imply contrasting hypotheses that are susceptible to empirical testing.’

Using not seasonally adjusted weekly average (week ending Wednesday date of record) data generated during the period in which the new procedures were operational, we conducted direct Granger tests of the hypotheses that (a) changes in Ml do not Granger-cause changes in non-borrowed reserves and (b) changes in Ml do not Granger-cause changes in borrowed reserves (net of emergency borrowings under the Federal Reserve’s extended credit facility). Tests were also conducted using free (net borrowed) reserves. Our version of the direct Granger test follows closely the one given by Guilkey and Salemi (1982). In particular, the hypothesis that AX, does not Granger-cause AZ, is examined by testing the joint hypothesis that bj = 0 for j = 1,. . . , J in the regression

AZ, = a + /?t + xajAZ,-, + ~a,sAZ,-, + ~bjAX,-j + e,,

where s denotes seasonal lags. Since our data are weekly, we selected J = 8 so as to ‘reach back’ sufficiently to cover the length of the typical intermeeting period. The relevant regressions were estimated on data beginning with the week ended 15 October 1980 and ending with the week ended 22 October 1982 so that the seasonal lags at the beginning of the sample extend back to October 10. 1979. These regressions and the test statistics are reported in table 1.”

‘It is important to remark explicitly that the kind of policy we (and other parties in the debate) are concerned with is a short-run non-reactive one. In such a policy, a target value (or path) is established ex a?rle at the outset of each policy interval; once this is done, then during the period, operations are conducted so as to achieve, as closely as possible, equality of the realized es post value of the variable with its ex atrre targeted value. Both camps in the debate we are addressing here interpret operating policy under the new procedures to have been non-reactive in this sense. For the Federal Reserve’s part, this is evidenced by their emphasis on the ‘automaticity’ of the procedures; see Levin and Meek (1981). And it is evident from the Poole quote in the text that he also has a non-reactive (over the short-run operating horizon) interpretation of policy. The disagreement is over which variable - non-borrowed or borrowed reserves - was es anfe targeted.

‘Note that the F test is conducted by estimating the regression given in the text once freely (unconstrained) and once in truncated form forcing the coefficients on lags of AX to be zero (constrained). Both unconstrained and constrained regressions are reported in the tables along with the associated F statistic.

112 P.A. Spindt and V. Tarhan. The Federal Reserve’s new operatingprocedures

Table 1 Direct Granger tests of the hypothesis that X does not Granger-cause Z; weekly da1a.l

Z=ANBR,X=AMl Z=ABR, X=AMl

Constrained Unconstrained Constrained Unconstrained

Constant - 330.18 - 396.08 295.90 251.88 Trend

z-1 z-2 z-3 z-4 Z-5

z-6 Z-7 Z-8 z- 13 z-26 z-51 z-52 Z-53 x-1 x-2 X-3 x-4 X-S x-6 X-7 X-8

R2

SER

F Tail Status of Ha

0.98

- 0.22b - 0.01 - 0.09

0.07 0.07

- 0.09 -0.16b - 0.13b

0.16b 0.2P

-0.11 0.21b 0.04

0.57 686

6.510 0.000

Rejected

0.98

- 0.20b - 0.02 - 0.05

0.02 - 0.07 - 0.02 - 0.16b - 0.07

0.00 0.07b

- 0.05 0.08b

- 0.05 0.01 0.08b

- 0.02 0.02

-0.00 0.01

- 0.02 0.03

-0.89

-o&lb - 0.31b - 0.05

0.17b - 0.04 - 0.10 - 0.22b -0.14

0.08 0.06

-0.16b -0.12 - 0.07

0.53 0.31 566 356

- 0.84 - 0.41b - 0.30b

0.03 0.11

- 0.07 - 0.12b -0.12b - 0.05

0.02 - 0.02 - 0.09 -O.lSb -0.11

0.01 0.01 O.Olb 0.00 O.Olb

- 0.00 0.02b 0.00 0.41 342

1.955 0.062

Rejected

‘Data are not seasonally adjusted weekly average (week ending Wednesday) figures as described in the text. Estimation period fc: these regressions: October 15, 1980 through October 27, 1982. Thus seasonal lags at the beginning of the sample extend back to October 10, 1979. Borrowed reserves are measured exclusive of extended credit. The fact that dollar changes in money are much larger than dollar changes in reserves should be borne in mind when interpreting the magnitudes of coefficients of lagged changes in Ml.

bThe coefficient differs significantly (at the 5 percent level) from zero.

We have observed above that if the Federal Reserve’s characterization of the new procedures is correct, then in these tests we should find that changes in money Granger-cause changes in borrowed reserves. Furthermore this finding would be inconsistent with the interpretation of the new procedures as borrowed reserves targeting. Indeed we do find this causal link in the results presented in table 1. But it is also apparent from table 1 that it is not proper to characterize the new procedures as a strict textbook form of non-borrowed reserves targeting since the data also reject the hypothesis that changes in

P.A. Spittdt atut V. Turhun. The Federul Reserve’s new operutitgprocedures 113

money do not Granger-cause changes in non-borrowed reserves. Indeed, the magnitudes of the coefficients on lagged changes in Ml in table 1 suggest that of an increase in required reserves caused by an increase in money almost 2/3 were supplied in non-borrowed form and about l/3 in borrowed form.9

In an effort to more sharply resolve the question of causality between non-borrowed reserves and money stemming from the operation of the new procedures, we also conducted direct Granger tests of the stated hypotheses using data on non-borrowed reserves, borrowed reserves and money averaged over the weeks of the inter-FOMC-meeting periods from fall 1979 through fall 1982. As we shall explain more fully below, this may be a more appropriate specification of the causality tests in light of the announced objective of Federal Reserve operating policy under the new procedures. These results are reported in table 2. lo In these tests, we find that changes in money Granger- cause changes in borrowed reserves but do not Granger-cause changes in non-borrowed reserves. Thus, the tests using intermeeting averaged data provide more unambiguous support for the Federal Reserve’s characterization of the procedures as non-borrowed reserves targeting over the operating horizon.

Finally, table 3 summarizes the results of the complete battery of tests we conducted including tests carried out on data generated under the old Federal funds rate pegging regime. We interpret this evidence as rejecting critics’ assertions that the new procedures were ‘qualitatively the same as the old [Federal funds rate targeting] procedures’ [Poole (1982, p. 579)]. But neither were they, in view of table 1, a pure textbook version of non-borrowed reserves targeting.

3. How did the new procedures affect the determination of prices in the capital markets?

To characterize the new procedures more precisely and to assess their impact on the capital markets, it is useful to describe their workings in a

‘This interpretation of the results in table 1 was suggested to us by a referee: ‘. . . the sum of the coefficients on lagged money [in the non-barrowed reserves equation] is 0.11 with 0.08 of this coming at lag 2. From these results, the Federal Reserve did not offset the [lagged reserve accounting] eRect of money on non-borrowed reserves at lag 2 by introducing negative effects at other lags. [Comparing the lagged money coefficient sums on the right and left sides of the table shows] that the Fed permitted non-borrowed reserves to increase by 0.11 of a jump in Ml while permitting borrowed reserves to increase by 0.06 of the jump. Thus. of the increase in required reserves caused by a jump in money, about 2/3 were supplied in non-borrowed form and about l/3 in borrowed form. [Some readers] will be especially interested in the finding that at lag 2 practically all of the increase in reserves was supplied in nonborrowed form.’ A similar interpreta- tion was suggested for the results in table 2.

“The results presented in table 2 should be interpreted with some caution in view of the small number of degrees of freedom. In the sample there are 17 observations so the regressions have only 9 degrees of freedom. Also, note that in these tests, lags 8 and 9 reflect the annual ‘seasonal lags for intermeeting period averaged data.

114 P.A. Spindr and V. Tarhan. The Federal Reserve> new operatingprocedutes

Table 2 Direct &anger tests of the hypothesis that X does not Granger-cause Z; intermeeting average

data.” -

Z=ANBR,X=AMI

Constrained Unconstrained Z=Ai#i.X=Am

Constrained Unconstrained

Constant 692.41 881.32 - 140.61 - 244.13 Trend - 30.42 - 21.93 3.13 -4.17

Z-1 - 0.27 - 0.32h 0.09 - 0.08 Z-2 - 0.37b - 0.29b - 0.37h - 0.48’ z-3 - 0.41b - 0.53b - 0.07 - 0.04 Z-U - 0.21 -0.17 0.03 - 0.03 Z-9 - 0.61b - 0.68b -0.29h - 0.32’ X-l - 0.01 0.03b X-, - 0.07 0.04b x-3 - 0.03 0.03b R’ 0.40 0.48 0.28 0.58 SER 1225 1225 559 468 F 0.821 4.000 Tail 0.500 0.025 Status of He Accepted Rejected

“Data are intermeeting period averages of not seasonally adjusted weekly figures. Estimation period for these regressions begins with the intermeeting period ended October 22, 1980 and ends with the intermeeting period ended October 6, 1982. Borrowed reserves are measured exclusive of extended credit. The fact that dollar changes in money are much larger than dollar changes in reserves should be borne in mind when interpreting the magnitudes of coefficients of lagged changes in Ml.

hThe coefficient differs significantly (at the 5 percent level) from zero.

formal, if somewhat stylized, way. According to Federal Reserve descriptions, the policy objective of desk operations under the new procedures was to achieve a targeted average volume of non-borrowed reserves over the course of the period between FOMC meetings. l1 At the beginning of an intermeeting period the staff calculated a particular weekly sequence of non-borrowed reserves by deducting the initial borrowings assumption from the projected path for total reserves; the average value of this sequence was the desk’s operating objective for that intermeeting period. But the sequence itself was viewed more as a reference path than as an actual target path; deviations from the reference path could be tolerated because they could be subsequently offset to preserve consistency of the realized non-borrowed reserves sequence with the desired average value.

” The diRerence between this and a textbook version of non-borrowed reserves targeting is that in the textbook version there is only a single sequence of realized weekly values for non-borrowed reserves that is consistent with the policy objective (i.e., the path is the objective), while under the new procedures, any realized sequence that averages over the intermeeting period to the target value is technically consistent with the policy objective.

P.A. Spindt und V. Tarhan, The Federal Reseruef new operating procedures 115

Table 3 Summary of Granger tests of the hypothesis that X does not Granger-cause Z.

Data type’

Sample period’ Degrees of freedom

Intermeeting average data

1979-1982 3,17

Weekly data

1975-1979 1979-1982 8,171 8.85

Z=AMl X= ANBR

Z= ANBR X=AMl

Z=AMl X=ABR

Z=ABR X=AMI

Z=AMl X=AFR

Z=AFR X=AMl

F 3.00 Tail 0.06(R)

F 0.82 Tailb 0.50(A)

F 1.41 Tailb 0.28(A)

F 4.00 Taiib 0.03(R)

F . 1.36 Tailb 0.29(A)

F 3.15 Tailb 0.05(R)

1.31 0.24(A) 8.i9

c 0.01(R) 0.75 0.65(A) 1.37 0.21(A) 0.65 0.74(A) 1.19 0.31(A)

2.51 0.02(R) 6.51

< 0.01(R) 0.53 0.83(A) 1.95 0.06(R) 0.77 0.63(A) 1.90 0.07(R)

“See tables 1 and 2 for description of data and exact sample period coverage. bTail area probability. Following this value an (A) indicates that the null hypothesis is accepted

and an (R) indicates the null hypothesis is rejected.

Formally, we can represent the process as follows: suppose that intermeet- ing periods consist of K weeks. FOMC meetings take place after the close of week 0, but before the opening of markets in week 1. At meeting time, money in week - 1, M-r, is known. Although Ma has already been determined and cannot be affected by policy, it has not yet been observed so that the FOMC has only a projection of it based on ‘flash’ information. We will denote this projection by P,(M,) where P is the projection operator and its subscript designates the week as of which the projection is made. Given the FOMC directive, the staff computes a not seasonally adjusted weekly target money path [My], t=l,..., K, for the intermeeting period and from this projects a consistent path for total reserves:

t = 3,..., K, (1)

where a! is the average reserve requirement ratio against money and X is excess reserves. Denoting the FOMC-specified initial borrowings assumption

116 P.A. Spindr and V. Turban, The Federot Reserve’s tlew operuting procedures

by &, the initial-period non-borrowed reserves reference path is computed as ()N,* = P,(T) - B,, r = l)..., K, where the leading subscript designates the week as of which the reference path is calculated. The stated target of operating policy under the new procedures was the average of this reference path over the intermeeting period:

iv*=(l,K&N,*= P,(T) -Ba, (2)

where the superbar over a projected sequence indicates the average value of the sequence.

Now consider the operation of the procedures during the first week of the intermeeting period. Suppose, for the moment, that the desk focused its attention entirely on non-borrowed reserves. Since the reference path ON,* incorporates all the available information prior to the start of the policy period, and we assume that no new information becomes available until the close of week 1, the first step in achieving the policy objective (2) would be to conduct open market operations during week 1 designed to result in a realized volume of non-borrowed reserves, N,, equal to the reference value aNi*. The volume of non-borrowed reserves actually realized in week 1 depends not only on the open market operations conducted by the desk but also on the combined influence of exogenous technical factors such as float and U.S. Treasury account balances about which the desk is ex ante uncertain. We model this feature of the environment by assuming that the desk combines initial conditions with a projection of the net effect of these technical factors to obtain a projection of the exogenous (to the desk) supply of non-borrowed reserves. Denoting this projection by P,(Ni\), the desk would compute the open market operation for week 1 as & =a N;” - PO( NC). If this operation were conducted, then ex post, non-borrowed reserves for the week would turn out to be Ni = Nf +,,zF. The ‘targeting’ error in this strategy, Ni -ON,*, is just equal to the projection error Nf” - Pr,( Nf) made in forecasting exogenous influences on reserve supply.

In actual practice, however, the desk did not focus its operational attention exclusively on non-borrowed reserves; it also expressed a proximate term interest in borrowings. Their reasoning was that if, early on in a given week, borrowing were to run well above (below) the borrowings value that had been assumed in calculating the reference path, then with the desk adhering strictly to the reference value for non-borrowed reserves a substantial abundance (shortage) of excess reserves would have developed by week’s end. The desk sought to avoid this kind of unintended end-of-week ease (tightness) in the reserve markets by managing the intraweek course of open market operations so as to keep borrowings in line with the assumption on which the non- borrowed reference value for the week had been based. Indeed, ‘when borrow-

ing deviated significantly from [its assumed value for the week] . . . the desk chose to accept a miss on its weekly non-borrowed reserves objective rather than provide over-abundant total reserves or force a huge end-of-week rise in borrowing’ [Levin and Meek (1981, p. 12)]. The result was that in any given week, the realized level of borrowings never deviated very far from the level that had been assumed in constructing that week’s reference value for non- borrowed reserves.

Algorithmically. we can capture the effect of this attention to borrowings by modifying the open market operation calculation to include an adjustment term that reflects the desk’s efforts to minimize the absolute difference between realized and assumed volume of borrowings. Thus, in the initial week of the intermeeting period, instead of conducting ,)z? as above, we suppose that the desk monitors discount window borrowings and conducts the open market operation Ozl = a:: + A, where A, is selected to minimize ]B, - B,]. Es post, realized non-borrowed reserves will differ from the reference path value by

N1-oNl”= [N;-P,(Nf)] +A,

which under lagged reserve accounting is simply the week 1 projection error in excess reserves if the desk succeeds in obtaining B, = 3,.

In subsequent weeks, this error must be offset if the desk is to achieve the average objective (2). The offset is accomplished by adjusting the weekly non-borrowed reference path as follows. Given that N, was realized in week 1. (2) can still be achieved if non-borrowed reserves average [K( N*) - N,]/ (K-l)=N*-(Ni-N*)/(K-1) over the remaining K-l weeks of the period. In light of the updated projection of the total reserve path, this implies that borrowing must average

B,= P,(C) -N*+(N,-N*)/(K-1).

where

P,(T) = [ Ii hwJ (K-l), 7 over weeks I = 2 ,..., K. This revised borrowing assumption is used to calcu- late a new weekly non-borrowed reference path ,N,* = P,(q) - B,, I = 2 ,..., K.” Given the revisions incorporating information up through the end

with the pollcv ob,~‘t,!?. “Note that IV, + (z , N,*)/( K- 1) = N* so that the new refcrcncc path maintains consistency

. . .

of week 1, in week 2 the desk conducts the open market operation ,zl = , :t + A, and the procedures iterate through successive weeks of the policy period. The continued recalculation of the borrowings assumption and the remaining reference path in light of current information and given past deviations insures consistency of the unfolding realized non-borrowed sequence with the operat- ing policy objective (2).‘j

In the preceding section we provided evidence that the new procedures possessed the basic characteristic of a non-borrowed reserves targeting strategy that projection errors in required reserves were absorbed by free reserves and not, at least over the operating horizon, by non-borrowed reserves.lJ This is not, as might first appear, inconsistent with the role given borrowings in the above representation of the procedures. The reason is that although in any particular week the volume of borrowings was determined by desk action. the revision in the borrowings assumption from one week to the next directly reflected innovations in money. To see this, recall that at the close of each week of the intermeeting period (except the last) the borrowings assumption was recomputed, as for example in (3). to maintain consistency of the non-borrowed path over the remainder of the period with the new projections of total reserves and the average non-borrowed reserves objective (2). The borrowings assumption was revised from that made at the close of week II - 1 (which was the focus of desk activity in week )I) to that made as of the close of week tr, where 1 I )z I K - 1, by the quantity

B,,- B,-, = @,,-, -4,)/(K- ,I)

+K[ P,,(T) - p,,-,(T)]/(K-d. (4)

To the extent that the desk succeeded in inducing actual borrowings in week

“If, in practice this is the way the desk carried out the new proccdurcs, then in a rcgrcssion of actual borrowings, S,, on the borrowings assumption E, , used by the desk at the beginning of week I IO calculate the non-borrowed rcfercncc path, wc should lind an intcrccpt cocthcicnt very close IO zero and a slope coetlicient very close IO one Unfortunately. apart from the initial borrowings assumptions - that is, the borrowings assumptions used IO calculate the rcfcrcncc path for weeks immediately following FOMC mectings - that arc public, data on rhc borrowings assumptions is highlv conlidential and unavailable for research. Using the available data on initial borrowings assumptions reported in the fall issues of IIW Fcdcral Rcscrvc Bank of NW York’s Quurler!). Retiew and actual borrowings (net borrowings under the cxrendcd credit program) in the weeks following FOMC meetings, we estimated the relevant rcgrcssion with the following result:

E ,,,, = 0.067 + O.Y37 3 ,,,,, + t’“,. R2=0.7Y1, DM~‘=2.‘4.

(0.130)(0.100) where the subscript ,n indexes FOMC meetings, The initial borrowings assumption series in similar regressions does not well explain actual borrowings in weeks other than the tirst of the intermeeting period.

“Neverthclcss as we have made clear. it is inaccurate IO label the policy under the new I. procedures as open-loop non-borrowed reserves control. A rcfcrce has suggcstcd the label ‘feedback borrowed reserves [control] policy’ as a belter description.

P.A. Spindt and V. Tarhan, The Federal Reserve’s new operutingprocedures 119

n, B,, = @,-l, this revision depends entirely on the revision in the average projected total reserves path which in turn depends on the innovation in money generated in week n - 1 but observed at the close of week n. In week n + 1 desk activity is managed so as to induce the volume of borrowings B n+l = & which incorporates the money innovation uia (4). It is through this mechanism that innovations in money affected free reserves under the new procedures. Although the weekly non-borrowed reserves ‘miss’ incorporates the current projection error in total reserves, the money innovation is not transmitted into non-borrowed reserves because under lagged reserve account- ing current required reserves are known.

The significance of the desk’s proximate attention to borrowed reserves under the new procedures is that it moves the locus of Federal funds rate determination from the market for total reserves where it is determined joint-endogenously with the volume of borrowings given an exogenous (to the market) current supply of non-borrowed reserves under the textbook proce- dure to the market for borrowed reserves. Under the new procedures repre- sented above, the supply of borrowed reserves function has the non-stationary form

where the supply disturbance term reflects the innovation in money as transmitted through (4). If the demand for borrowed reserves is described by

B; = n, + ul( r, - d,) + u,, (6) and the market clears each week in the sense that B,S = BP = B,, then (5) and (6) together determine the quantity of borrowings and the Federal funds rate, T, given the discount rate, d. But in the sequential solution of this market, the resultant B, and r, processes are both non-stationary. The non-stationarity of B, is evident from (5) and the market clearance condition. From (5), (6) and the market clearance condition, the funds rate evolves according to

Ar, = Ad, + (l/a,)( e, - Au,), (7)

so that the r, process is also non-stationary if the supply disturbance terms which reflect Federal Reserve misestimation of money in the preceding week are white noise.

Clearly, the conduct of monetary policy at the operating horizon involves the exercise of considerable discretion and judgement that is not captured in this algebraic representation of the new procedures. And we are not suggesting that the desk mechanically followed the algorithm set forth above. But to the extent that the model accurately reflects a basic feature of the new procedures as they were actually practiced, then (7) should provide a reasonably adequate

Table 4

Standard deviations of weekly changes and deviations from a live-week centcrcd moving average for selected interest rates (bond cquivalcnt yields).

Security

Federal funds 4-week T-bill 13-week T-bill 26-week T-bill 52-week T-bill S-year T-note 20-year T-bond

1970-79

Changes

1979-82 1982-X4

Deviations

1970-79 1979-82 1982-X4

0.25 0.83 0.30 0.22 0.81 0.28 0.22 0.66 0.29 0.20 0.60 0.27 0.20 0.57 0.25 0.12 0.37 0.22 0.09 0.30 0.17

0.14 0.48 0.22 0.14 0.51 0.24 0.14 0.39 0.24 0.12 0.34 0.22 0.12 0.32 0.1X 0.0x 0.2’ 0.12 0.05 0.19 0.09

description of funds rate data generating process over the period. A simple OLS regression of weekly changes in the funds rate on a constant and weekly changes in the discount rate using data from October 1979 through October 1982 yields estimates that differ insignificantly from zero and one for the intercept and slope parameters respectively, with the residuals exhibiting no significant autocorrelation. Similar regressions using data from periods before and after the new procedures have slope coefficient estimates significantly smaller than one, and their residuals exhibit strong negative serial correlation consistent with an operating policy that administers changes in the funds rate. In addition, the hypothesis of non-stationarity in the level of the funds rate is accepted in Dickey-Fuller tests, against both the hypothesis that the mean level is a linear function of time and the simpler hypothesis of constant mean, for data generated under the new procedures while this hypothesis can be rejected in both the earlier and later periods.15

The non-stationarity of r, under the new procedures may help to explain one of the more puzzling aspects of the post-October 1979 period. which is that coincident with the adoption of the new procedures there was a sharp increase in the volatility of interest rates throughout the term structure. Greater variability in the Federal funds rate was largely anticipated. But more surprisingly, the volatility of longer-term rates, even those on twenty-year T-bonds, also increased markedly. The extent of the phenomenon is docu- mented in table 4 where it can be seen that the standard deviation of weekly changes in the funds rate more than tripled after October 1979, and the standard deviation of deviations from a five-week moving average trend - a

“See Fuller (1976, pp. 366-3X2) for a description of these tests and a listing of critical values. An implication of a non-stationary borrowed reserves process is that cithcr non-borrowed or total reserves or both would also be non-stationary. Dickey-Fuller tests suggest that non-borrowed reserves were not non-stationary but that total reserves wcrc (the hypothesis cannot bc rqcctcd at the 5 percent level).

121

Tahlc 5

Correlations between movcmcnts (weekly changes and deviations from a live-week ccnrcrcd moving avcragc) in the Federal funds rate and sclcctcd intcrcst rates (bond cquivalcnt yields).

-..___- .-..- Changes Deviations

Securily 1970-79 lY7Y-82 19x2-x4 1970-79 lY7Y-x2- lY81-x4

4-week T-hill 0.16 0.54 0.30 0.01 0.43 0.07 13-week T-bill 0.14 0.65 0.15 0.01 0.61 0.05 26-week T-hill 0.24 0.63 0.29 0.05 0.59 0.10 52-week T-hill 0.29 0.55 0.30 0.07 0.51 0.13 5-year T-note 0.24 0.43 0.28 0.06 0.41 O.OY ‘O-year T-bond 0.13 0.33 0.1x 0.03 0.36 0.07

proxy for non-systematic or non-cyclical variation - nearly quadrupled. The volatility of rates across the maturity spectrum increased by about this same order of magnitude. In addition, as shown in table 5. movements in longer-term interest rates, which we have measured both by weekly changes and deviations from moving trend to abstract from cyclical effects, correlated much more closely with movements in the Federal funds rate after October 1979 than they had during the 1970’s. l6 This was a very surprising outcome.

But if the expectations theory of the term structure is satisfied, the non- stationarity of the ‘; process under the new procedures has important implica- tions for the behavior of longer term yields. The expectations theory asserts that long rates are weighted averages of expected future short rates. Apart from expected changes in the discount rate, according to (7) expected future Federal funds rates are just equal to the present funds rate. Funds rate changes, in other words, are all viewed as permanent changes. In particular. the non-stationarity in the r, process induces non-stationarity throughout the term structure - and in money growth if money demand has a non-zero interest elasticity - under the expectations theory. We suggest that these non-stationarities arising through the peculiar form of the borrowed reserves supply function under the new procedures may have contributed to the increased volatility of interest rates, short and long, and money growth that characterized experience during the practice of the new procedures.

4. Conclusion

The purpose of this paper has been twofold. First, we have sought to determine whether the Federal Reserve’s characterization of the new proce-

‘“Other writers have remarked the difference in the relationship between monetary innovations and interest rate movement before and after the October lY7Y regime change: sec. for example, Girton and Mattress (1985).

122 P.A. Spindt aud V. Turhan, The Federul Reserue’s new operntirrg procedwes

dures as a non-borrowed reserves targeting regime is accurate, or whether, as critics have claimed, the new procedures were not qualitatively different from the old Federal funds rate pegging regime. The evidence suggests that the Federal Reserve’s characterization is the correct one in the sense that under the new procedures innovations in money caused variation in free reserves and not non-borrowed reserves. This was not true under the old procedures. Second, we have exhibited a formal model of the procedures that suggests that non-stationarities arose in the borrowed reserves supply function which may have contributed to increased volatility in interest rates and money growth during the practice of the new procedures.

In late fall of 1982, the Federal Reserve again modified its operating procedures. Since then, the FOMC directive to the desk has spoken in terms of the ‘degree of reserve restraint’ sought by the committee rather than in terms of the desired behavior of a ‘reserve aggregate’. The present procedures can best be characterized as a form of borrowed reserves targeting and, in fact, are quite similar in content and monetary control philosophy to the interpretation of the new procedures given by Poole (1982). Under the present operating regime, the borrowed reserves supply function does not have the non-sta- tionary form that, it was argued above, was a characteristic feature of the new procedures. Not coincidentally - not, that is, if the arguments advanced above are correct - since the modification of the operating procedures in fall of 1982 the volatility of interest rates, both short and long, and of money growth has not been so pronounced as it was during the period when the new procedures were in practice.

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