Contents

[Pages:265]Contents

Foreword

i

Acknowledgments

ii

Chapter 1 Monetary Policy and the U.S. Economy

1

Overview of the Book

2

Money and the Economy

8

The Tools of Policy

16

Chapter 2 The Federal Reserve and U.S. Monetary Policy: A Short History

19

The Federal Reserve's Beginnings and World War I: 1914 to 1920

20

Adapting to a Changed Environment in the 1920s

24

Major Contraction: 1929 to 1933

28

Active Policymaking by the Administration: 1933 to 1939

30

Accommodating War Finance in the 1940s

33

Resumption of an Active Monetary Policy in the 1950s and 1960s

34

Targeting Money Growth and the Federal Funds Rate: 1970 to 1979 42

Targeting Money and Nonborrowed Reserves: 1979 to 1982

48

Monetary and Economic Objectives with Borrowed Reserve Targets:

1983 to the Late 1980s

52

Further Modifications in the 1990s

55

Chapter 3 The Role of Depository Institutions

57

The Business of Banking

58

Banking Risks

63

The Elements of Bank Risk

64

Marketability of Bank Risks

69

Strategic Considerations

69

Tactical Considerations

70

Chapter 4 The Financial Markets

79

Financial Intermediaries and the Financial Markets

83

Bank-Related Financial Markets

84

Nonbank Financial Instruments

93

Chapter 5 The FOMC Meeting: Developing a Policy Directive

121

Preparation

122

The Meeting

125

U.S. MONETARY POLICY AND FINANCIAL MARKETS

Chapter 6 The Trading Desk--Policy Guidelines and Reserve Measures

139

Implementing FOMC Policy Decisions

139

Preparing Reserve Paths

142

Estimating Reserve Availability

147

The Banking System's Responses to Federal Reserve Actions

148

Chapter 7 The Conduct of Open Market Operations

163

The Framework of Reserve Management

163

Tools of Open Market Operations

164

A Day at the Trading Desk

173

Communications within the System

186

Adjunct Desk Responsibilities

187

Chapter 8 Responses to Federal Reserve Policy

189

Evolving Views of Policy Transmission

190

Monetary Policy and Yield Curves

196

Policy's Effect on the Economic Sectors

199

The Role of the Fed Watchers

204

Chapter 9 International Aspects of Monetary Policy

207

The Shift to Floating Exchange Rates and International

Capital Mobility

208

The Special Role of the Dollar in International Financial

Markets

209

International Transmission Channels of U.S. Monetary Policy

211

International Influences on U.S. Monetary Policy

216

Chapter 10 Reflections on Recent Monetary Policy

221

Fighting Inflation

222

Guidelines for Federal Reserve Monetary Policy

224

Implementing Policy

224

Notes

227

References

243

List of Charts, Tables, and Diagrams

249

Index

251

Foreword

Understanding how monetary policy is formed and implemented is of considerable importance to economists, market participants, students and, indeed, the general public. This edition of U.S. Monetary Policy and Financial Markets seeks to advance that understanding by providing a detailed look at Federal Reserve policy procedures. The book benefits from the extensive knowledge and experience of author Ann-Marie Meulendyke, a recently retired officer who worked nearly twenty-six years in the open market and research areas of the Bank. Ms. Meulendyke prepared her first version of this book in 1989 and has now made significant revisions.

This updated edition reflects recent changes in the approach to monetary policy by the United States. It begins with a historical review of monetary policy priorities and a discussion of the U.S. banking system and financial markets--the institutions that form the setting for policy. It then provides a comprehensive account of the steps involved in choosing and implementing monetary policy. The implications of policy decisions for the domestic and international economies are discussed in the closing chapters.

Designed to supplement monetary economics textbooks, U.S. Monetary Policy and Financial Markets will interest anyone who wishes to learn more about monetary policy and its effect on the marketplace. Earlier editions of the book have been widely read and consulted in the United States and abroad. We hope this updated version will prove useful to all readers, including central bankers in emerging market economies who are attempting to shift their monetary policy procedures from direct controls on bank credit and money to open market operations.

William J. McDonough President February 1998

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Acknowledgments

Many people helped make this edition of U.S. Monetary Policy and Financial Markets possible. Paul Meek, who wrote the first edition of this book, published in 1982, set the stage for my earlier version, published in 1990. His book, which provided the public with detailed information about the process of making and implementing Federal Reserve monetary policy, proved to be a valuable and widely used resource for students and financial market participants in the United States and abroad. The climate for and the techniques of monetary policy underwent extensive changes during the 1980s, which motivated the 1990 edition. Changes have continued in the 1990s. Consequently, another edition seemed appropriate to restore the timeliness of the material. This latest volume has largely preserved the structure of its predecessors while incorporating a considerable new amount of information.

Several people earn special mention because they worked extensively on two of the chapters. Donald Morgan and Philip Strahan of the Research and Market Analysis Group made significant revisions to the sections of Chapter 3 that cover the structure of the banking system and banking risks. The spread of interstate banking and the implementation of risk-based capital requirements have significantly influenced the functioning of the U.S. banking system in recent years. (In the last edition, a large part of the chapter was written by Donald Vangel, some of whose work has been retained.) Susan Charrette and Tanya Ghaleb, also of the Research and Market Analysis Group, were primarily responsible for extensive revisions to Chapter 9 (prepared by Christine Cumming in the 1990 edition). The international nature of the U.S. dollar and the financial system has continued to evolve, calling for modifications.

The book also owes a great deal to colleagues in the Markets Group. William Gorgas provided a wide range of support for the book. He undertook library work, data collection, and preparation of tables and charts. He also drew on his knowledge and contacts in the financial markets to provide more extensive help in updating

U.S. MONETARY POLICY AND FINANCIAL MARKETS

ii--

Chapter 4. Deborah Perelmuter and Marc Tishfield also made useful comments and suggestions for Chapter 4.

Spence Hilton, Dino Kos, Sandra Krieger, John Partlan, and Eileen Spinner all provided valuable comments on Chapters 5-7, the chapters that describe formulating and implementing monetary policy. Gerald Cohen and John Partlan assisted with the sections in Chapter 1 that review the performance of the monetary aggregates. Eileen Steigleder assisted in the revision of Chapter 2. Kenneth Guentner and Betsy White also offered helpful suggestions on that chapter.

A number of the members of the Research and Market Analysis Group assisted. Beverly Hirtle provided helpful comments on Chapter 3. John Kambhu reviewed part of Chapter 4. Ronnie Lowenstein, Cara Lown, Patricia Mosser, Eli Remolona, and Charles Steindel all made helpful suggestions on Chapter 8.

The completed manuscript was reviewed by Peter R. Fisher and Frederic S. Mishkin of the Federal Reserve Bank of New York and David Lindsey of the Board of Governors.

Some people outside the Federal Reserve System also provided valuable assistance on portions of the book. Thanks go to James Paterson of Chase Manhattan Bank, Cary Leahey of High Frequency Economics, Ltd., Maureen Lee and Robert Clinton of Morgan Guaranty Trust Company, and Lawrence DiTorre of Prebon Yamane (U S A) Inc.

Other forms of support were also invaluable. Valerie LaPorte, Michael De Mott, Elizabeth Miranda, and Ed Steinberg edited the book, encouraging clarity. M. Akbar Akhtar, Peter Bakstansky, and Robin Bensignor of the Public Information Department oversaw aspects of the editing and production. Joel Kent, Gina Lukaszewicz, Joanna Barnish, and Robert Van Wicklen of the Markets Group and Martina Heyd of the Research and Market Analysis Group assisted in chart preparation. Finally, special thanks go to my secretary, Evelyn Schustack, who made numerous revisions to the documents and to Elisa Ambroselli, who helped with final revisions to prepare the document for publication. While all of the people named helped to make the book much more accurate and readable than it might otherwise have been, I bear the responsibility for remaining errors.

Ann-Marie Meulendyke.

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Chapter 1

Monetary Policy and the U.S. Economy

Few components of economic policymaking are as important to

the nation's economic well-being as monetary policy. This book describes monetary policy from the vantage point of the Federal Reserve Bank of New York's Open Market Trading Desk, the area responsible for carrying out most monetary policy actions. The book emphasizes the process of formulating and implementing policy.

As the central bank for the United States, the Federal Reserve has been entrusted by Congress with the responsibility for conducting monetary policy--that is, the terms and conditions under which money and credit are provided to the economy. Money comprises currency issued by the Federal Reserve and coin issued by the U.S. Treasury, as well as various kinds of deposits at commercial banks and other financial institutions. Credit encompasses loans made by depository institutions and by other types of financial or nonfinancial entities; it includes loans evidenced by debt instruments such as notes or bonds.

Congress, through the Federal Reserve Act and other legislation, has long provided the rules and guidelines for Federal Reserve policymaking. Currently, the framework for the monetary policy process is the Full Employment and Balanced Growth Act of 1978, usually referred to as the Humphrey-Hawkins Act for its primary sponsors. The act calls for the Federal Reserve to establish annual growth targets for monetary and credit aggregates and to explain how these targets relate to goals for economic activity, employment, and prices. Monetary policy is carried out through the

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