A Memorandum to the Fed by Milton Friedman Wall Street Journal, 30 January 1981 Reprinted from The Wall Street Journal 1981 Dow Jones & Company. All rights reserved. On Oct. 6, 1979, the Federal Reserve announced a change in the method used to conduct monetary policy to support the objective of containing growth in the monetary aggregates. Despite vigorous efforts by the Fed to implement the policy, monetary growth has varied over a wider range since Oct. 6, 1979, than in any period of comparable length for at least the last two decades. That fact is recognized by the Fed itself, by its defenders and by its critics. There is, however, much disagreement about, first, why monetary growth has varied so widely and, second, whether the Fed has the ability to achieve steady monetary growth in line with its targets over periods measured in weeks or months rather than quarters or years. Chairman Paul Volcker, in testimony to Congress, blamed last year s abnormal fluctuations in money supply and interest rates on a sharp second quarter recession followed by a stronger-thananticipated recovery, the temporary imposition of credit controls last spring, market uncertainty over the Fed s decision to let interest rates fluctuate more widely and irresponsible inflationary expectations. This explanation reminds me of the man on trial for murdering his parents who asked for mercy on the ground that he was an orphan. The sharp second-quarter recession very likely was produced, and certainly was intensified, by the Fed s own actions: first, a decline in M1-B at the annual rate of 5.1% from February to May the sharpest decline during any three-month period in at least the last two decades; second, the imposition of credit controls in March at the request, it is true, of President Carter but under the authority of the independent Fed. The stronger-than-anticipated recovery was sparked by a rise in M1-B at the annual rate of 15.9% from May to October the most rapid rise during any five-month period in at least the last two decades reinforced by the removal of credit controls. These were entirely the Fed s doing. By sharply intensifying the recession, the initial decline in money supply led the Fed to overreact in the opposite direction a pattern that has frequently occurred in the past. As to irresponsible inflationary expectations, what is irresponsible about such expectations in view of (1) the past record of inflation a roller coaster about a rising trend; (2) the past record of government monetary policy a similar roller coaster about a rising trend? The wide swings in interest rates also were not, in my opinion, a result of the Fed s decision to let interest rates fluctuate more widely but rather of the Fed s failure to match the change in its announced objectives with a comparable change in its operating procedures. Of this, more later. 1
Over the years, two major excuses have repeatedly been offered by the Fed and its defenders for erratic and inflationary monetary policies: first, large federal government deficits; second, unpredictable changes in the demand for money. The first excuse has merit on a political level, none whatsoever on a technical level. The same political forces that have fostered rising deficits pressures to increase government spending without legislating additional taxes and to react promptly to offset any increases in unemployment have also affected the Federal Reserve and induced it to become an erratic engine of inflation. On the technical level, however, there is no necessary connection between deficits and monetary growth. To illustrate: As a percentage of GNP, deficits in the U.S. have varied from a low of 0.4% for the fiscal year ended June 30, 1974, to a high of 4.6% for the year to June 30, 1976. But growth in M1-B was almost the same in the two years: 4.3% from July 1973 to July 1974; 4.7% from July 1975 to July 1976. For the year ended Sept. 30, 1979, the deficit was 1.8% of GNP, yet M1-B grew 7.8% from October 1978 to October 1979. To illustrate in a different way: Deficits have been running about 6% of gross national product in Japan, or roughly three times ours, and about 2% in Germany, or the same as ours. Yet both countries have a better recent record than we do of achieving monetary growth targets and holding down inflation. In short, there is no technical reason why the Fed must monetize deficits. Insofar as it does so, it is because of political pressures to hold down interest rates or to stimulate the economy. The second excuse, alleged instability in the demand for money, involves a serious intellectual confusion between money and credit. Most credit is not money, by any definition of money; much money is not credit (as is clearest with a commodity standard such as gold). Federal Reserve notes used to be described as promises to pay. They are clearly not that today. They are simply flat, not in any meaningful sense a credit instrument, and that is equally true of deposits at Federal Reserve Banks. Interest rates are the price of credit, not the price of money. The price of money is the quantity of goods and services that will buy a piece of money (the reciprocal of the price level). Fluctuations in interest rates reflect instability in the demand for credit rather than for money properly defined, though interest rate changes may indirectly affect the quantity of money demanded. The so-called money market is really a credit market. Yet the excuse in terms of instability in the demand for credit does have some validity because and only because the Fed continues to try to control the money supply through interest rates, in particular the federal funds rate. That is neither the only nor the best way to control the money supply. The key defect in trying to control the money supply by pegging the federal funds rate is that mistakes are cumulative and self-reinforcing, and so lead to the kind of wide swings in monetary aggregates that we have increasingly experienced in recent years. If the Fed picks too low a federal funds rate, it has to add excessively to the supply of federal funds, that is, the monetary base (currency plus Federal Reserve deposits), in order to maintain that rate. As the money supply responds, monetary expansion tends to stimulate spending and the 2
demand for loans and to increase inflationary expectations. The result, after an interval, is upward pressure on market interest rates. To peg the federal funds rate at the initial level, the Fed must add more and more to the base, increasing still further the upward pressure on interest rates. Similarly, if the Fed picks too high a funds rate, it must drain an excessive amount from the base, discouraging spending, decreasing demand for loans and ultimately adding to downward pressure on interest rates. The short-term effect of higher monetary growth is to lower interest rates and of lower monetary growth is to raise interest rates. But the longer-term effects are in the opposite direction. These opposite effects mean that in using the federal funds rate as its operating target, the Fed is always balancing on a knife-edge. That is why this policy has produced such wide swings in both interest rates and monetary growth. The Fed unquestionably has the power to peg the federal funds rate within very narrow limits over short periods but only by surrendering control of the base in the short run, and of the interest rate itself in the longer run. It can regain control only by changing the pegged rate which it sooner or later does. But it takes time to recognize a mistake and further time to overcome bureaucratic inertia, so the ultimate changes in the pegged rate have to be sizable and are typically overdone. Last year provides an almost textbook example. The money supply peaked in mid-february 1980, when the funds rate was about 15%. But the Fed did not recognize promptly what was happening and kept pushing the funds rate up to over 19% by early April, which is just when the money supply started collapsing. The money supply reached its trough at the end of April, at which point the federal funds rate was again about 15%. Again, the Fed was late and kept pushing the funds rate down for two more months, to less than 9% by late July. By that time the money supply had exploded, rising at an annual rate of over 13% from the end of April to the end of July. The Fed then belatedly started pushing the federal funds rate up. The money supply peaked in mid-november when the funds rate was again about 15%. Again the Fed was late in recognizing the change and kept pushing the funds rate up to nearly 20% in mid-december and again in January. It looks as if the springtime pattern is being repeated. The money supply declined from mid-november to the end of December, at an annual rate of 15%. If history continues to repeat, we shall again have a precipitous drop in money and the economy followed by an inflationary overreaction. Had money supply growth been steadier during the year, interest rates would have been steadier as well and conversely. Note that a 15% interest rate in 1980 corresponded to a real interest rate, corrected for inflation, of about 3%, in line with long-run experience. These wide swings are unnecessary. An alternative procedure of controlling the base directly and letting the market determine interest rates could produce steady and predictable monetary growth and at the same time avoid wide swings in interest rates. The base consists of the Fed s own liabilities, on which it has accurate day-to-day figures. The Fed can add to its liabilities by purchasing government securities or making loans to banks; it can 3
subtract from its liabilities by selling securities or reducing lending. The only limitations to its ability to determine how much to add or subtract from the base are self-imposed: first, its policy of pegging the federal funds rate; second, its decision in 1968 to base reserve requirements on deposits two weeks earlier which means that the total reserves for the current week are predetermined, so that the only practical option the Fed has is whether to supply them through open-market operations or through the discount window. Eliminate these obstacles and the Fed can exercise highly precise and prompt control over the size of the base. Control of the monetary base will not produce rigid and precise control of a monetary aggregate such as M1-B. The link between the base and M1-B has elements of looseness deriving from changes in the public s desired ratio of currency to deposits, the banks management of their liabilities, which affects required reserves, and the banks desired ratio of excess reserves to deposits. Nevertheless, controlling the supply of money through the monetary base avoids the chief technical defect of trying to control the demand for money through the federal funds rate. Mistakes in controlling the base are not cumulative and self-reinforcing. If the Fed increases the base by, say 6%, when 7% would have been the amount required to achieve its target growth rate in M1-B, the error does not cumulate. The growth in M1-B simply falls short of its target by one percentage point, nothing more. Moreover, such errors are likely to be random from month to month and hence to average out, even if not corrected, whereas errors in the federal funds rate tend to get larger until corrected, and the correction itself is generally too little at first and then too much. Just as the Fed can control the federal funds rate only by surrendering control over the base, so it can control the base only by surrendering control over the federal funds rate or any other interest rate. If it did so, and thereby produced steadier growth in the monetary aggregates, interest rates might be more volatile over intervals of days or weeks. Almost certainly, however, interest rates would be far less volatile over periods of months and years, and possibly even weeks. The belief that the Fed can or does control interest rates is a myth that dies hard. But surely if it could, the prime rate would never have hit 21.5%. These are the specific steps that I believe the Fed should take to improve its control of the money supply and to become a major source of stability in economic policy instead of the unguided missile it has so often been: Announce that it will no longer specify a target range for the federal funds rate (or any other interest rate). Specify in advance the amount it proposes to add to, or subtract from, the monetary base week by week over a substantial future period. It should determine these target amounts by estimating as best it can the additions or subtractions necessary to achieve a desired target for a single selected monetary aggregate. (It matters far less whether that aggregate is M1-A or M1-B or M-2 or M-n than that a single aggregate be chosen.) Numerous studies have demonstrated that the necessary additions or subtractions to the base can be calculated fairly accurately. 4
To improve the link between the monetary base and the selected monetary aggregate, the Fed should specify that required reserves are to be calculated from contemporaneous deposits, not from deposits two weeks earlier as at present. There is essential unanimity among experts, including most of those employed by the Fed, that the introduction of lagged reserve accounting in 1968 has made monetary control more difficult with little if any compensating advantage. Only bureaucratic operating problems have prevented a correction of this mistake. The Fed announced its intention to make this change some months ago, but has repeatedly postponed the effective date. To avoid indirectly pegging the federal funds rate, the Fed should convert the discount rate (the rate at which it lends to banks) to a penalty rate and link it to a market rate so that it moves automatically and gradually, not as now at discrete intervals, generally too late. For example, it might set the discount rate each week at two percentage points above the average rate on threemonth Treasury bills during the prior week. In cooperation with other responsible agencies, the Fed should seek to accelerate the elimination of Regulation Q controls on interest rates, as already provided for by current law. I have said nothing about the precise monetary growth targets the Fed should specify because that is not where the problem is. The Fed has known what monetary growth it should aim for. But it has been reluctant to adopt procedures that would enable it to achieve those goals. Improvement in Federal Reserve performance would not by itself enable the Reagan administration to achieve its goals of reduced inflation and healthier economic growth. But failure of the Fed to improve its performance could frustrate achievement of those goals. And, fortunately or unfortunately, moral suasion is the only instrument the new President has to induce the Fed to make changes in its procedures that are so badly needed and so long overdue. Reprinted in Milton Friedman, Bright Promises, Dismal Performance, pp. 241-249. Edited by William R. Allen. New York: Harcourt Brace Jovanovich, 1983. 10/10/12 5