The past year was a difficult one for the Federal Reserve as a monetary
policymaker. Although the U.S. economy continued to expand and inflation
remained subdued, the Fed's narrow measure of the money supply (M1)
leaped far above its announced range. The Fed thus had to choose between
trying to bring this measure back within its range, which could jeopardize
the recovery, and ignoring the money measure's faster-than-expected
growth, which could lead to higher inflation. The Fed chose the latter
The Fed's situation did not go unnoticed. Many seemed to blame
the Fed for allowing the money supply to grow so fast; they criticized
the Fed for a lack of commitment to its own strategy of targeting
the money supply and thus to its own long-run goal of reducing inflation.
Others seemed to blame the Fed for its choice of targets; they criticized
the use of money measures and called for a look at other variables
that might be more controllable.
While public scrutiny of monetary policy is, of course, appropriate,
such criticisms are not. They seem to be based on a misunderstanding
of the role that money ranges play for the Fed. It uses these ranges
as economic theory says is best, and that is not as targets. That
is, they are not meant to be goals which the Fed will aim to achieve
regardless of what else is happening. The only things the Fed treats
that way are things like the price level, employment, and output;
information on anything elseincluding moneyis only useful
for what it can tell the Fed about whether or not those goal variables
are on target. What the money ranges are meant to be are indicators
to the public of the general course of monetary policy if the economy
performs as expected. The ranges give the public a simple, shorthand
form of the complicated policy rule which the Fed implicitly uses
to decide when and how to act given its goals, the economy's interrelationships,
and uncertainties. Any specific ranges tell the public just what
the Fed's actions will imply for the growth of money during that
period if the usual economic patterns persist. The ranges also provide
a simple, though not infallible, way for the public to monitor the
From this perspective, the experience of 1985 should look quite different
to Fed-watchers. The exceptionally rapid growth in M1 was good reason
for the public to ask for an explanation, since it could have indicated
a change in the Fed's policy. But the M1 growth surprised the Fed
as much as anyone. It turned out to be due to a change not in Fed
policy but in the economy, in particular, in the way the public
was managing money. While this change increases the uncertainty
about the relationships between money and the rest of the economy,
it does not make the money ranges useless for their role as indicators
of Fed policy. Instead, it simply suggests that M1's range for 1986,
to reflect the increased uncertainty, should probably be somewhat
wider than those for recent years.
The Best Way to Make Monetary Policy
The situation of a U.S. policymaker is not easy in any year. The
Fed has a somewhat vague general objective of maximizing the current
and future welfare of society, which all public policy institutions
share. Congress has translated that into a few broad operating goalsstable
prices, high employment, and economic growth, for example but these
are not necessarily compatible goals, the Fed has no direct control
over them, and they are measured only infrequently. The Fed does
have direct control over a few financial instrumentsbank reserves
and the discount rate, for example which it can change as often
as daily, but these are far removed from the goals; movements in
the instruments can influence the goal variables only through a
long chain of other variables. The Fed has data on these other variablesincluding
various measures of the money supplysome of which are available
more frequently than data on goal variables. But these it can't
control directly either. It can only influence them to varying degrees,
with varying degrees of uncertainty, by adjusting its instruments.
What's a policymaker to do? The Fed does what economic theory
says is best for a decisionmaker in this situation: It uses all
the information available at each point in time to move as close
as possible to its broad goals. This means not targeting anything
except those goals.
Targeting in this context means just what one might guess: aiming
to hit particular values. Again, the Fed targets the variables that
represent its broad goals (variables like a price index, the unemployment
rate, and the gross national product). For any period, the Fed aims
at its targets by determining as best it can using everything it
knows about the past and current values of all variables and their
relationships paths for the goal variables which for that period
represent the best possible outcome, the closest the goal variables
can get to their targets from where they currently are. This involves
ranking the various possible outcomes that the various settings
of its instruments can achieve, since movement toward one target
can unavoidably interfere with movement toward another. The Fed
then sets its instruments as is consistent with the best (the highest-ranked)
possible outcome. As new information becomes available, the Fed
uses it to take aim again to determine how far from the targets
the goal variables now seem to be and how close they might be able
to get and adjusts its instruments accordingly.
In this strategy, the Fed's money measures are not targeted. They
are instead among the many variables the Fed uses to determine how
next to aim at its goals by adjusting its instruments. (They are
thus known as information variables.) At each point in time, the
Fed predicts paths for information variables that seem historically
consistent with the current best paths for its goal variables and,
as new data arrive, compares them to the predictions. Since information
variables are not targeted, not every deviation from their predicted
paths will warrant a response or an attempt to fully offset the
deviation. What matters to the Fed is not what these deviations
mean for the information variables, but what they mean for the goal
variables' movements toward their targets. The Fed determines when
and how to respond by studying the estimated historical relationships
and uncertainties among all known variables and the Fed's instruments.
Given any new bit of information, a deviation of a variable from
its predicted path, the Fed decides whether and how its best possible
outcome has changed and how it should adjust its instruments so
they now lead to that outcome. In practice, this complicated policymaking
process may be somewhat informal and unsystematic. Nevertheless,
the process is best characterized as a policy feedback rule that
describes the best setting for the Fed's instruments given its goals,
their rankings, and all the available information. (This rule is
generally what is meant by the term Fed policy.)
This monetary policy strategy of using variables like the money
measures as providers of information about targeted goal variables
is better than targeting the information variables themselves. Unlike
targeting, the information variable strategy uses all available
information and is not likely to lead the Fed to act in ways inconsistent
with its goals. If an information variable were targeted, the Fed's
efforts to keep it on target might make the Fed ignore information
that other variables were offering about its real goals. Not targeting
anything but those goals means every piece of available information
is noticed. Similarly, if an information variable were targeted,
the Fed's actions to keep it on target might make it mistakenly
lead the economy away from the real goals. Not targeting information
variables means responding to their deviations only to the extent
necessary to keep the economy moving as close as possible to those
Note that this best way to conduct monetary policy is quite different
from the view many people seem to have of the Fed's strategy, at least
with regard to its money supply measures. The Fed does not, in a strict
sense, target these measures, as many seem to believe. Moreover, in the
information variable strategy, predicted ranges for these measures have
no particular purpose. Every movement in the money measures away from
their predicted paths is noticed and valued for whatever significance
it has for movements in goal variables.
This is not to say that money supply ranges are useless to the Fed.
They are valuable as indicators to the public and Congress of the
Fed's policy intentions and performance.
Certainly telling the public something about monetary policy is
appropriate. This policy affects people, individual decisionmakers,
not just impersonal variables. They are the society whose welfare
the Fed is aiming to maximize. And that welfare is affected by how
much they know about what the Fed intends to do.
Of course, not every individual is made better off by any particular
government policy. People in different circumstances can be affected
quite differently. Borrowers and lenders, for example, are affected
differently by a policy that results in lower interest rates, after
adjusting for inflation (lower real interest rates, that is). Lower
real rates would help borrowers because they would have to give
up less real income to pay off their loans. But lenders would obviously
be hurt by this policy since their investments (the loans) would
earn them less real income. The choice of the policy that results
in lower real interest rates, like any other, is a choice with individual
gainers and losers.
Making such a choice in a democracy weighting the interests of
different groups of peopleis generally considered a political
task, one appropriately done by the public's elected representatives.
Monetary policy choices are not exceptions. However, Congress established
the Federal Reserve as a fairly independent unit within the government,
because some independence was considered important for implementing
policy. The Fed contains no elected officials.
(Its governors are appointed by the President.) The Fed thus has
a responsibility to announce its policy plans to the public, to
provide an opportunity for Congress, their elected representatives,
to evaluate and influence those plans.
But the choices of individual members of the public will be influenced
by the Fed's plans whether or not they are announced. People making
economic decisions pay attention to all relevant information, and
most recognize that Fed policy is relevant; it will no doubt have
some effect on the value of their dollars, for example. If the Fed
does not tell the public its policy, therefore, people will try
to guess it, and that could make many people worse off. It means
resources which might have been used productively will instead be
used to reduce the uncertainty about policy. That means consumption
and output will be less than they would have been otherwise. And
since uncertainty about policy will not be eliminated, just reduced
to varying degrees, people will not be able to make decisions which
will make themselves as well off as they might be. Announcing monetary
policy plans, in other words, helps individuals maximize their own
How the Fed announces its plans matters, too. It must be in some
way the public can use to watch how the Fed actually performs so
that the Fed knows it must explain if it seems to act differently.
For if the Fed does not face such discipline, it may find a change
from the best plans tempting. And if the public cannot easily monitor
the Fed's performance, they may act to make such a change inevitable.
The Fed's announced plans, remember, should be those based on
its (and Congress') judgment of the best possible outcome for its
goal variables. The achievement of that outcome usually depends
on how committed the public believes the Fed is to its best policy.
If the Fed is viewed as committed, the best outcome will likely
be achieved. But if there are no formal ways to guarantee Fed commitment,
the public will have good reason to be skeptical about it. For like
many other government policies, the best monetary policy is not
time consistent; as time goes by, that is, the Fed may no longer
want to follow it. Instead, the Fed may want to change policy in
order to take advantage of decisions the public commit themselves
to, to achieve outcomes it could not have achieved otherwise. Eventually,
though, the public will come to expect the Fed to change its policy,
and they will act to protect themselves when it does. Those actions
will, then, ensure a policy change and an actual outcome worse than
To make this more concrete, consider a simple hypothetical example
involving inflation and wage contracts. Suppose first that the Fed
must commit to implement what it sees as the best policy plan. As
it makes that plan, it notices that the economy includes some wage
contracts that were negotiated in previous periods; that is, the
dollar amount of the wages of some workers is fixed for the current
period. Then, in that period, the Fed's best policy may be to inflate,
or raise the price level, more than people who negotiated the contracts
expected in order to reduce the real value of wages and so stimulate
the economy. (If workers' dollars buy less, the workers cost less;
so higher inflation encourages firms to hire more.) In future periods,
though, the Fed's best policy may be to not inflate at all, because
otherwise people would build the inflation into their wage contracts
and the result would just be higher inflation with no higher employment.
So, in sum, the Fed's best policy is to inflate only in the current
period. Since here the Fed must implement its plan, it does. People
expect it to and act accordingly. And the result is no inflation
after the first period.
Now suppose the Fed is not forced to commit to its best policy.
The Fed will still observe fixed wage contracts, based on particular
expectations for inflation. And the Fed will still initially decide
to inflate in the current period and not to inflate in future periods.
If people believe the Fed is committed to that policy, they will
negotiate new contracts expecting no inflation in future periods.
But as each new period arrives, the Fed will want to reconsider
its policy. In each period, just as in the first, the Fed will observe
wage contracts based on expectations of no inflation, so that it
will decide to inflate in that period and never again. The policy
(rule) it will actually be following, though, will be to inflate
every period a clear change. This policy cannot work for long, of
course. People will quickly begin to expect the Fed to inflate more
than before and will begin to build that expectation into their
contracts. This will make the Fed want to at least match that expectation
in order to prevent a drop in employment (due to a rise in the real
cost of workers). The inflationary spiral will continue until the
inflation/unemployment tradeoff is no longer attractive to the Fed.
No formal commitment in this example, then, will lead to some inflation
rather than no inflation, without any increase in employment.
In summary, the policy that is best when the Fed is committed
here, no inflation is not time consistent when the Fed is not committed.
And the policy that is time consistent when the Fed is not committed
here, some inflation is worse than the best when the Fed is committed.
Announcing Fed policy in a way that the public can easily monitor
can increase the Fed's commitment to the best policy and the likelihood
that the best outcome will be achieved. If the Fed knows the public
can see its behavior and demand an explanation or enforce discipline
if the Fed seems to be acting in a way inconsistent with its plan,
the Fed is less likely to act that way. And with such a monitoring
system working, the public is less likely to expect such a change
and act in ways that encourage it.
Why Money Ranges?
To completely communicate monetary policy to the public, the Fed
might give them its feedback rulehow any particular new piece
of information will result in an instrument change given the Fed's
goals, the economy's interrelationships, and the inherent uncertainties.
This rule, however, is mainly implicit in the Fed's behavior; it
is too informal, complex, and possibly unsystematic to describe
explicitly. What the Fed tells the public thus must be simpler than
this rule but clearly related to it.
Congress must have considered ranges of growth in the Fed's various
money supply measures adequate ways to indicate policy, because
it enacted laws specifying their use. In regular monetary policy
reports to Congress, the Fed is required to reveal planned annual
growth ranges for these measures, along with planned annual values
for its goal variables.
Congress' choice of the money growth ranges is not unreasonable.
The money measures are in the right position to stand in for the
Fed's feedback rule; they are influenced by the Fed's instruments
and have had quite stable relationships to its goal variables. Planned
growth in these few measures is not hard to understand. And growth
ranges are better than paths as policy indicators because they are
more representative of the feedback rule. Ranges take into account
the fact that the Fed doesn't, in a strict sense, target money.
Again, it responds to deviations from money's predicted path only
to the extent that the feedback rule says is appropriate to get
the targeted goal variables back on track (moving as close as possible
to their targets). Given what is happening to the other variables
and inherent unpredictability in economic relationships, the Fed's
response to money deviations will not generally keep money on track
(on its predicted path) too. Thus, a range of money growth rates,
not just a path, is consistent with any particular policy.
Besides to some degree representing the Fed's feedback rule, announced
money supply ranges give the public a fairly easy way to monitor
the Fed's performance and strengthen the Fed's commitment to its
announced (best) plan. By just comparing the actual growth in the
money measures to the Fed's announced ranges, the public can detect
possible policy changes and call on the Fed to explain them.
The public should keep in mind, however, that this monitoring
method is imperfect. The money growth ranges are, after all, not
perfect representatives of the feedback rule. Discrepancies between
predicted and actual growth may thus be due to changes in the public's
behavior rather than the Fed's. If longstanding behavior patterns
change, the relationships between the money measures and goal variables
change, and the Fed's announced ranges will no longer be appropriate
for its (unchanged) best policy.
An Exemplary Year
The experience of 1985 illustrates the need for caution when using
the Fed's money growth ranges to monitor monetary policy.
At a glance, at least one of these monitors seems to have detected
a policy change in 1985. Although the Fed's broad measures of money
(M2 and M3) grew fairly comfortably in their announced ranges, its
narrow measure (M1) did not. (See Charts 1-3.) M1 grew nearly 12
percent during the year, much more than the 4-7 percent growth which
as the year began the Fed said would be consistent with its planned
best policy. Such unexpected growth surely is good reason to suspect
that the Fed might actually have been doing something other than
That suspicion could easily be wrong, however. Money growth outside
a range, remember, could be caused by the public rather than the
Fed acting in some unexpected ways so that the announced range no
longer fits the best policy. A closer look at economic activity
in the year is necessary to determine which suspect is responsible.
The most readily available evidence for 1985 seems to point at the
public. That evidence is an apparent change in the simplest expression
of the relationship between general economic activity and money:
the annual ratio of the gross national product (GNP) to M1. Historically,
this ratio has risen, over the last 20 years an average of around
3 percent. A rise in the ratio means that any increase in the denominator
M1 is more than matched by an increase in the numerator GNP. If
a change in Fed policy had caused the great M1 jump of 1985, therefore,
GNP should give the Fed away by jumping even more. This is not what
the data show, however (Chart 4). While M1 grew nearly 12 percent
in 1985, GNP grew only about 5 1/2 percent. Rather than rising in
1985, that is, the ratio of these two indicators fell.
The change in behavior that this ratio change suggests is a critical
slowdown in the rate that the public is spending its dollars. (The
ratio is popularly known as the velocity of money.) The change may
be critical because stability in the velocity of money is often
considered necessary for monetary policy to be effective. In this
simple version of how policy works, the total amount of economic
activity, or spending, in the nation is thought of as equal to the
total amount of money in the economy multiplied by the number of
times each dollar is spent (velocity). The Fed is seen as influencing
economic activity as it desires by varying the money supply appropriately.
But to do that effectively, velocity must be predictable; otherwise,
the Fed cannot know what effect any particular money change will
have on spending.
But the apparent change in this simple ratio is not adequate evidence
of an unusual change in how the public handles money. Though the
ratio has increased on average in the past, it has decreased in
individual years beforeas recently as in 1982, in fact. Besides
that, the relationship between money and economic activity is much
more complicated than the simple ratio suggests. Many more economic
variables than just the money supply influence the level of spending,
and their changes often have effects over time which the ratio ignores.
If all this were taken into account, the public's behavior as reflected
in the 1985 ratio may have been predictable. And then the rapid
money growth in the year may have been due to a Fed policy change
A better way to determine what happened in 1985 is to take the
Fed's more sophisticated view as expressed in its announced ranges
of growth for M1, one of its information variables, and GNP, a goal
variable. These ranges were based on the complicated interrelationships
and uncertainties among all available economic variables. They thus
take into account the way the ratio of GNP to M1 is usually influenced
by other variables over time. If the relationship between spending
and money did not change unusually in 1985, but the Fed surreptitiously
changed its policy, the greater- than-expected increase in M1 implies
that the growth in GNP should have been greater than expected too.
But again, that is not what the data show (Chart 5). while M1 grew
more than initially expected in the year, GNP grew less than expected:
only about 5 1/2 percent rather than between 7 and 8 1/2 percent.
Thus, although the Fed did miss its announced range for GNP, it
doesn't seem to have meant to.
Yet even this is not unquestionable evidence that a change in
the public's behavior is responsible for the rapid money growth
in 1985. Just comparing the actual M1 and GNP growth to the Fed's
ranges is not good enough because the Fed doesn't tell us enough
about those ranges. Presumably they correspond to some probability
about where these variables will fall if historical relationships
and uncertainties don't change. How high the probability is determines
whether or not the apparent change in the GNP/M1 relationship is
statistically significant. If the ranges represent regions where
GNP and M1 can be expected to fall, say, 95 percent of the time,
then, since GNP was below its range while M1 was above its range
in 1985, we can say with a high degree of confidence that the relationship
changed in that year. But if the ranges represent only, say, 50
percent probability regions, then we cannot be very confident about
what happened; the variables' movements in 1985 could have been
as likely due to chance as to anything else. The probabilities matter
because the more confident we can be that the behavioral relationship
changed, the more confident we can be that Fed policy did not change.
Researchers at the Minneapolis Federal Reserve Bank have built
a statistical model of the U.S. economy that can objectively determine
whether or not the unexpected movements in 1985 M1 and GNP were
significant. The model can, in effect, replicate the Fed's policymaking
process. Using only the statistical interrelationships among economic
variables evident in any chosen historical period, the model can
predict for any variable a path and various intervals around that
path within which the data say with any selected degree of confidence
that the variable will fall if the relationships don't change. For
the 1985 experience, a historical period of 1982-84 seems appropriate
because the Fed's operating procedures and the regulatory environment
of financial firms were fairly consistent across those years. To
find a significant change, a 70 percent confidence interval seems
adequate. It means, again, that history says the variable can be
expected to fall in the range 70 percent of the time if historical
relationships remain the same; a variable will fall by chance above
(or below) the range only 15 percent of the time. (Those are 1-in-7
The model does find the 1985 unexpected movements in M1 and GNP
to statistically significant (Charts 6 and 7). The actual paths
of M1 and GNP growth are outside their 70 percent confidence intervals
and in the same unusual pattern that the Fed's evidence shows. Clearly
the movements of these measures are most likely due to a change
in relationships among economic variables, just as the simple GNP/M1
ratio suggests. All this evidence implies, then, a 1985 change in
the public's behavior, not Fed policy.
Why the Change?
The change in behavior that confounded the Fed's M1 monitoring range
seems to be a decision by the public to hold more of its funds than
usual in what the Fed has classified as M1 types of accounts. This
change seems to have been caused by a combination of institutional
and interest rate changes.
M1 is meant to be a measure of the funds readily available for
spending. As such, it includes not only coins and currency in circulation,
but also various types of checking accounts. Traditionally, financial
firms were not allowed to pay interest on these accounts, so the
public held in the accounts only what they thought they would need
for transactions. This kept a clear separation between the nation's
spending and savings money.
Since 1981, however, that separation has been breaking down. The
financial industry has been progressively deregulated since then,
and the public has been offered the opportunity to earn interest
on accounts with checkwriting privileges (NOWs and Super-NOWs, for
example). Though initially restricted (with low interest rate ceilings
and high minimum balances), these types of accounts have been very
popular and increasingly so as their restrictions have been loosened.
The Fed has counted many of these accounts as M1 money because of
their heavy use for transaction purposes. But because they bear
interest, the accounts have undoubtedly held some funds which in
previous years would have been held in savings accounts.
Until 1985 this element of savings in M1 accounts may not have
been large, because interest rates on the competing savings instruments
were much higher. But in 1985 the continued deregulation of such
accounts was joined by a drop in market interest rates to make MI
accounts even more attractive for saving. With market rates close
to rates on checking accounts, the public had less incentive than
before to move funds from checking accounts to savings accounts.
Thus, fewer did, and the Fed's M1 money measure grew more than expected
as a result.
The experience of 1985 increases the uncertainty about the future
relationships between money and other economic variables, especially
interest rates and GNP. A significant rise in interest rates, for
example, might now result in a flow of funds from checking accounts
to savings instruments, a change which history would not have predicted.
How much of a rise in rates would cause such an outflow? How large
would the outflow be? And what effect would this have on the total
level of spending? With very little evidence on the new relationships
and interest rates still low, such questions are hard to answer.
The increased uncertainty, though, does not mean the Fed must
abandon its money supply measures. Its feedback rule, after all,
takes into account the uncertainties about the historical relationships
among the Fed's instruments, information variables, and goal variables.
With one year of unusual data to go on, that rule will simply tell
the Fed to respond less to any deviation of M1 from its predicted
path because a wider range of growth rates may now be consistent
with its goals. To be a good representative of this rule (and a
good communicator of Fed policy), then, future M1 ranges must be
wider than their predecessors to encompass that wider range of growth.
Just how wide the Fed's announced M1 range should be in any year,
however, is hard to determine. The range for 1986, for example,
shouldn't necessarily match those any statistical model might produce,
for they would be based on a particular historical data period and
a particular level of confidence, both of which are to some extent
arbitrary. But the announced range shouldn't necessarily be the
result of any such objective procedure. For in selecting a range
to announce, the Fed (and Congress) must moderate the need for the
range to reflect increased uncertainty by a perhaps less quantifiable
need for it to effectively monitor policy. The wider the range is,
to take account of uncertainty, the less often it will detect policy
changes, which may make such changes more likely. The narrower the
range is, though, to make policy changes more obvious, the more
often it will mistakenly detect such changes and the more often
the Fed will have to waste resources explaining such mistakes. The
choice of an appropriate width for the M1 range, therefore, is at
least partly a judgment call.
Despite the unusual experience of 1985, the Fed's money supply measures
will remain useful to the Fednot as targets, but as providers
of information about its goals, just like many other variables.
The announced growth ranges for these measures will remain useful
too, as communicators to the public of Fed policy intentions and
deeds, even though M1's range will likely be somewhat wider than
recently. Still, questions remain: Are the money measures the best
variables to use to indicate policy? And are policy indicators best
expressed as ranges? These are important questions, worth serious
attention by researchers. The best answer to both today may be We
think so? Congress directed the use of money ranges, and so
far no clearly better options have been proposed.