Interest Rate Targeting

Central banks in relatively advanced countries generally employ interest rate targeting to implement discretionary monetary policy. Excluding the four-year interlude from 1979-1983, the Federal Reserve System in theUnited States has targeted interest rates for several decades. While the analysis that follows applies to interest rate targeting more generally, the issue is framed within the context of U.S. monetary policy.

Federal Reserve interest rate targeting conforms to the transmission mechanism described as Model I in the previous chapter. The instrument variable is open market operations (OMO). The immediate target is the short-term interest rate (ist). The rate selected for this purpose is the federal funds rate, or the rate on immediately available funds. While it is a nominal interest rate, the intermediate target is the long-term real interest rate (rlt). The ultimate policy objectives are the price level and aggregate spending.

The Fed encounters two very difficult problems when attempting to implement policy through this transmission mechanism. First, it is using a nominal interest rate target in a world where rational economic agents think in real terms. The interest rate of importance, then, is the unobservable real interest rate. Second, the transmission of monetary policy occurs across the term structure of interest rates. The immediate target is a short term interest rate, but the critical variable is the long-term rate of interest.

The Nominal/Real Dichotomy

The success of Federal Reserve monetary policy is contingent upon control of the real interest rate. Rational economic agents on both sides of the credit market think in real terms and, if one is to change their behavior through policy, it is the real interest rate that counts. Unlike the nominal interest rate, however, the real interest rate is unobservable. The difficulty presented here is that one cannot readily control something that does not

lend itself to measurement. Tat problem is compounded when precision is required. That is generally the case, however, because policymakers employing nominal immediate targets most often change those interest rate targets in increments of one-quarter to one-half percent.

Control of the unobservable real rate of interest is hypothesized to occur via changes in the Federal Reserve's nominal interest rate target (the federal funds rate). As noted in Chapter 3, however, the nominal rate of interest, too, is comprised of nonobservable components: inflationary expectations; default, money, and income risk premiums; and, time preferences. Each of these components reflects the subjective valuations of millions of market participants. Because subjective valuations of individual economic agents are prone to change, one must operate on the premise that they do. Tat is, inflationary expectations, risk premiums, and time preferences are incessantly changing.

If these nonobservable components of the nominal rate of interest are unstable, when the Fed changes its nominal interest rate target, it cannot know whether the real interest rate is increasing, falling, or staying the same. If a policy-induced higher real interest rate indicates a tighter monetary policy, and a policy-induced lower real rate the opposite, the Federal Reserve does not know whether its monetary policy is tighter, easier, or neutral. To illustrate, three different scenarios are presented in Table 6.2. They are designated as Cases I, II, and III. The first scenario (Case I) is the initial condition. The nominal interest rate is 5%, which is also the Fed's targeted interest rate. With a 2% expected rate of inflation, the real interest rate is 3%. The latter is apportioned into a risk premium and a marginal rate of time preference.

Table 6.2 The Nominal Interest Rate and Its Components

i r (dp/p)* Risk premium Marginal rate of time preference

Case I 5 3 2 2

Case II 6 4 2 3

Case III 4 2 2 1

Assume, initially, that the Federal Reserve attempts to tighten monetary policy. In Case II, it raises its target for the nominal interest rate to 6%, and provides reserves less liberally to the banking system. With tighter credit conditions, the nominal rate increases to the desired level. Assuming no change in inflationary expectations, the real rate increases to 4%. Te higher real rate of interest leads to reduced capital goods expenditures, and a higher marginal rate of time preference. In this scenario, the Fed thinks that monetary policy is tighter and, indeed, it is. This is how monetary policy with interest rate targeting is supposed to work.

With the subjective preferences of economic agents constantly changing, however, the world is much more complex than this. For example, do these Case II numbers still constitute tighter monetary policy if the higher real interest rate would have occurred as a result of market activity alone? Commence again with Case I initial conditions, i.e., i = 5% and r = 3%. Now, assume an increasingly robust economy with businessmen becoming more optimistic. Their increased time preferences for current expenditures are expressed in the form of a greater demand for capital goods. Tighter credit conditions lead to a higher nominal rate (6%) and a higher real rate (4%). Case II numbers again prevail.

Superimpose upon these events an increase in the Federal Reserve's target for the nominal interest ratefrom 5% to 6%. The Fed's objective is to increase the real interest rate by 1% (from 3% to 4%). In this case, the Fed does not need to adjust how it is providing reserves to the banking system. The higher interest rates come about through market activity alone, and do not reflect any change in Fed policy. When the Federal Reserve adjusts its interest-rate target upward, that target is simply following the market rate.

This is a case where the Federal Reserve thinks monetary policy is tighter when, in fact, it is not. Errors of this kind are likely when the real interest rate follows a pro-cyclical pattern. If business managers and consumers become more optimistic during a business cycle expansion, their greater optimism is expressed in the form of an increase in their time preferences for current expenditures. The real (and nominal) interest rate rises. If the Federal Reserve simultaneously becomes concerned about the exuberant economy, it will move to tighten monetary policy. As in the example above, however, it will erroneously interpret the market-driven rise in interest rates as policy-induced.

The Federal Reserve is prone to making the opposite kind of error when the economy is contracting. Business managers and consumers become more pessimistic. They experience decreases in their time preferences for current expenditures, and the real (and nominal) interest rate falls. The Fed, in an attempt to stimulate aggregate demand, lowers its interest rate target. With the nominal and real rate already falling, the Fed is unable to distinguish market-induced declines in rates from those occasioned by Fed policy.

This scenario is captured in Case III (Table 6.2). Commencing with the initial condition (Case I), declines in the real and nominal rate occur in response to reduced time preferences. The nominal rate falls from 5% to 4%; the real rate, from 3% to 2%. Simultaneously, the Federal Reserve lowers its target for the nominal interest rate from 5% to 4%. Its intent is to lower the real rate by a similar amount (from 3% to 2%). The Federal Reserve does not need to adjust its provision of reserves to the banking system, because both the nominal and real rates reach their targeted levels through market activity. Tis is a case where the Fed thinks that monetary policy is easier when, in fact, it is not.

Thus, there are serious reservations concerning the Federal Reserve's ability to effectively control the real rate of interest. When the Fed changes its nominal interest rate target, it does not know with any assurance either the magnitude or direction of policy-induced changes in the real rate of interest.

The Term Structure Problem

A second problem the Federal Reserve confronts when targeting interest rates relates to the term structure of interest rates. Not only does the Fed not know whether adjustments in its immediate target result in the desired change in the real interest rate, but those policy changes also must be transmitted across the term structure of interest rates. The Federal Reserve's operating target is the short-term nominal rate, but its intermediate target is the long-termreal interest rate.

The rationale for this transmission mechanism (Model I) is discussed in Chapter 5. Outlays for durable goods, both business and consumer, are more easily deferred than are expenditures for nondurable goods. As a consequence, durable goods account for much of the volatility in aggregate spending. Attempts by policy makers to influence aggregate spending (and the price level), then, are geared towards controlling expenditures for those types of goods. With durable goods purchases frequently financed through the issue of long-term bonds, those purchasing durable goods are sensitive to the long-term rate of interest. It follows that, when the Fed employs interest rate targeting, it must target the long-rate.

Precisely how the Federal Reserve successfully navigates the term structure and, simultaneously engineers changes in the real interest rate, is not clear. Moreover, various theories of the term structure (discussed in Chapter 3) do not provide much help. If anything, they cast additional aspersion upon the Fed's ability to successfully implement discretionary policy through interest-rate targeting.

Explanations based on the segmented markets hypothesis, for example, are not encouraging. If market participants adhere strongly to their maturity preferences, there is little likelihood that policy-induced changes in the short-term interest rate target will be transmitted across the term structure to long-term rates of interest. Federal Reserve control, in turn, is marginalized.

On the other hand, information requirements implied under the unbiased expectations and the liquidity preference theories present an even more serious obstacle for those conducting monetary policy. First, the Fed must have prior knowledge of the term structure of inflation premiums and the term structure of risk premiums. Second, it must know how those term structures are changing independent of monetary policy. Finally, it must also know how a given change in its short-term interest rate target will affect both of those underlying term structures. Compounding the Fed's information problem is the fact that both inflationary expectations and risk premiums are imbedded in the term structure of interest rates, and not directly observable.

It is clear that the U.S. central bank faces serious information problems when attempting to target long-term real interest rates through use of a short-term nominal operating target. If the Federal Reserve acts as if it can orchestrate desired changes in aggregate spending and the price level through this procedure, it is committing what Friedrich von Hayek called "the pretense of knowledge." It is pretending to know things that, in fact, it does not.

A Twenty-First Century Case Study

This knowledge problem confronting the Federal Reserve is a good illustration of what happens when the criteria for selecting monetary targets (discussed in the previous chapter) are not satisfied. Because it is not possible to accurately measure the long-term real interest rate, the Federal Reserve is employing a target it cannot control. Moreover, lack of knowledge of the long-term real rate also means the linkages in Model I are not predictable.

U.S. monetary policy from 2004-2006 exemplifies the difficulties encountered when these monetary target criteria are not met. Starting in June, 2004, the Federal Reserve increased its target for the federal funds rate fifteen consecutive times. As a consequence, the federal funds rate target in April, 2006 was 4.75% versus 1.00% in the first half of 2004. Those changes are chronicled in Table 6.3.

Many observers routinely describe these upward adjustments in the federal funds rate target as tighter monetary policy. There are serious doubts, however, about such an interpretation. It is true that other short-term nominal rates increased along with the federal funds rate. The three-month Treasury-bill rate, for example, rose from 1.17% to 4.60% between June 1, 2004 and March 1, 2006.

But, as previously noted, higher short-term nominal interest rates do not necessarily mean tighter monetary policy. Long-term nominal interest rates actually fell during the same 21-month period. The rate for 20-year U.S. Treasury securities declined from 5.45% to 4.74%. These changes in both long-term and short-term rates for U.S. Treasury securities are reflected in Figure 6.2. It depicts the shapes of the term structure of interest rates for U.S. Treasury securities on both June 1, 2004 and March 1, 2006. The yield curve in 2006 became noticeably fatter.

Lower long-term nominal interest rates, however, are not the issue. It is long-term real interest rates, and not nominal rates, that are critical for

Table 6.3 Federal Funds Rate Target

Date Level (percent)

2006

March 28 4.75

January 31 4.50

2005

December 13 4.25

November 01 4.00

September 20 3.75

August 09 3.50

June 30 3.25

May 03 3.00

March 22 2.75

February 02 2.50

2004

December 14 2.25

November 10 2.00

September 21 1.75

August 10 1.50

June 30 1.25

2003

June 25 1.00

Source: Board of Governors of the Federal Reserve System.

Figure 6.2 Term structure of interest rates U.S. treasury securities:

Constant maturity

Source: Board of Governors of the Federal Reserve.

economic decision makers. If monetary policy was, indeed, tighter during this 21-month period, long-term real interest rates must have increased while nominal rates were falling. Moreover, the increase in real rates must have occurred as a result of monetary policy and not due to other factors such as an increase in default risk or changes in time preferences for current expenditure. While such a scenario appears doubtful, no one knows for certain. Hence, the appropriate answer to the question about whether monetary policy is tighter is: "I don't know."

Monetary Aggregates and Monetary Control

Recent Issues with Monetary Control

After facing difficulties with interest-rate targeting during and after the Great Recession (2008-2009), the Federal Reserve embarked on several massive asset purchase programs described as quantitative easing. Those carried out during the Great Recession are discussed in Chapter 5 (pp.108-109).

While the Fed's asset purchase programs were not advanced with the stated intent of increasing monetary aggregates, they did. In doing so, these programs raised an additional issue relating to central bank control of the money supply. These issues are discussed in the context of the general money supply model in Chapter 4 (equation 4.2).

The magnitude of the Federal Reserve's asset purchases caused the monetary base in the United States to explode. Base money increased more than 360% from 2007 and 2014, and was largely in the form of increases in bank reserves. Under more normal circumstances, one would anticipate a massive increase in the money supply, huge increasesin spending, and the potential for the largest inflation in U.S. history.

To date, none of these things have happened. The reason is that banks have not used this infusion of bank reserves to extend additional bank credit (and expand deposit money). Instead, those reserves were almost entirely held in the form of excess reserves.

In the money supply model, an increase in the aggregate bank excess reserve ratio causes the money multiplier to decrease. In this case, because the increase in bank excess reserves was so massive, the multiplier collapsed.

As shown in equation (6.1), the large increase in the monetary base was virtually entirely offset by a fall in the money multiplier. In the context of these changes the consequences for money (which did rise) were minimal.

M = B m. (6.1)

This experience has important implications for monetary policy. It differs from the liquidity trap explanation advanced by early Keynesians. In that case, the central bank increases the money supply and it has no effect on spending. People hold rather than spend the additional money, and velocity falls. When this happens, monetary policy is ineffective.

In the present case, the effectiveness of monetary policy is questioned for a different reason. Unlike the previous case, the money supply does not increase, or it does so minimally. What distinguishes the recent experience is collapse of the money multiplier as shown in (6.1).

The precipitous fall in the multiplier represents a breakdown in a transmission mechanism for monetary policy. In Chapter 5, the transmission mechanism employing monetary aggregates as targets was Model II. In that transmission mechanism, what links base money to the money supply is the base money multiplier. The usefulness of that transmission mechanism is predicated upon a predictable relationship for transforming base money into money. It is that relationship that fell apart.

This experience raises serious questions concerning the ability of the Federal Reserve to control the money supply. When combined with the lackluster results from interest rate targeting, it appears that both transmission mechanisms I and II for implementing discretionary monetary policy did not perform as expected during and after the Great Recession (2008-2009).

Elaborate the advantages and disadvantages of Interest Rate Targeting.(20 marks)