Open market operations and monetary policy implementation

Open Market Operations

Monetary policy may involve several facets, including reserve requirements, discount rate and interest rate targeting. The U.S. Federal Reserve's long-time strategy has been to use interest rate targeting through Open Market Operations primarily to keep the economy in its attempts to keep the economy in a state of equilibrium.

Today, open market operations (purchase and sale of U.S. Treasury and other federal agency securities) are the principal tool used by the Federal Reserve in implementing monetary policy (Federal Reserve Web site). The Federal Open Market Committee (FOMC) of the Federal Reserve decides on the short-term objective, an objective that can be either a desired quantity of reserves of a desired price, also called the federal funds rate; this, in turn, will have the effect of making interest rates increase or decrease. "The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight" (Federal Reserve Web site), which allows it to either slow down or heat up the economy, but at a slight remove from the direct action of other actions, such as manipulating the discount rate.

If the FOMC decides it want the funds rate to fall -- the interest rate to decrease -- it buys government securities from a bank, and pays for them by increasing that bank's reserves. "As a result, the bank now has more reserves than it wants. So the bank can lend these unwanted reserves to another bank in the federal funds market. Thus, the Fed's open market purchase increases the supply of reserves to the banking system, and the federal funds rate falls" (Federal Reserve Web site). It the Fed wants the rates to rise, it reverses this, lowering the supply of reserves in the system, making funds rates -- and eventually commercial interest rates -- rise.

It is easy to see that this is a fairly indirect route to ramping up or damping down the economy, dependent not only on what the Fed wants, but what the commercial market -- U.S. industry and consumers -- want. It could be regarded as a more holistic approach, therefore, than others in which the Fed would directly pump money into or siphon it out of the commercial market.

Considering the longevity of Federal Reserve Chairman Alan Greenspan, it is likely that the preference for open market operations as the regulator of the nation's economy via interest rate 'soft manipulation' of this sort has been strengthened during his tenure. However, the United States FOMC preference for an open market operations approach to monetary policy predates Mr. Greenspan. It is equally likely that there are some cogent reasons for the policy having been instituted in the first place, and for its continuing despite calls by some for using reserve requirements or the discount rate instead to perform the same function. Arguably, using the 'invisible' method of Federal Reserve bank internal lending is likely to lead to more stability in financial markets.

Long history of FOMC voting behavior: Personality preference?

Chappell & McGregor (2000) analyzed the voting records of 84 Federal Open Market Committee (FOMC) members who served during a 30-year period, from 1966-1996, longer even than the influence of Mr. Greenspan.

United States monetary policy decisions, despite the influence of the Federal Reserve Chairman, even one as influential as Mr. Greenspan, are made by the Federal Open Market Committee. The FOMC guides monetary policy through directives composed by a committee composed of the seven members of the board of governors and five out of twelve district Federal Reserve Bank presidents. The FOMC is not a single agent, like the chairman, whose preferences might change slowly, if at all. On the contrary, the FOMC can be viewed as a group with an aggregation of preferences, making it all the more astonishing that the preferred policy has held for so long. The directives of this group must be approved by a majority vote at regular meetings, however: whether this works to enhance relative immutability or to diminish it seems fairly clear. In view of the fact that monetary policy has not changed appreciably for more than two decades, the full member vote would seem to be either a rubber stamp, or an indication that the top executives of United States federal banking institutions are remarkably in tune with each other.

There are other reasons for the apparent consistency of the group in continuing to choose open market operations/interest rate targeting to fine-tune the economy. Discussions of monetary policy at the Fed usually begin with a report from the staff covering economic forecasts and outlining alternative policy options to those in place at the time. Members then comment and there is general discussion. The chairman, or a member chosen by the chairman, proposes wording for the policy directive to come out of the meeting. Chappell & McGregor (2000) note that the chairman plays a major role in directing policy in two ways. First, through his influence on the language of the policy, he may be able to shift it in a direction he favors, in a way, subliminally influencing the reaction of the full committee. Second, that may be 'gravy' as the chairman may have already influenced the content of the staff report beforehand. According to Chappell & McGregor (2000), the chairman has both consensus-building and agenda-setting powers; it may be, then, that all that is needed to determine why the FOMC has a long preference for Open Market Operations is to look at the biases and rationales of the chairmen, vis-a-vis the U.S. economy.

It should not be suggested, however, that there is never any dissent within the FOMC. "In the past, differences among the governors and the bank presidents have led to widely publicized conflicts within the FOMC over whether to respond more actively to a sluggish U.S. economy" (Chappell & McGregor 2000, 407ff), that is, whether to return to a more activist stance than the open market operations approach allows.

In fact, during 1992, during the term of office of the first Mr. Bush as president, three of the governors were prepared to manipulate the discount rate in order to mitigate some of the effects of the economic slowdown. Two others, at the time, were worried that the Fed had already lowered rates too much and eased monetary policy too far (Chappell & McGregor 2000, 407ff). It did not happen, however, because by requiring directives be the result of committee consensus, such changes are also slow in coming unless pushed forward by the chairman through his considerable influence, as noted above.

Despite all these factors indicating that consensus would be the likely outcome in almost all cases, Chappell & McGregor (2000) also documented "the considerable diversity in policy preferences of FOMC members over the 1966-1996 time period" (Chappell & McGregor 2000, 407ff). Despite this, Chappell & McGregor concluded that accurately describing the forces underlying policy choices by the FOMC would, eventually, be useful to ensure high ethical behavior by politicians. They noted, however, that despite the dissent, the policy did not change.

By 2004, Chappell, writing with McGregor and Vermilyea, was ready to claim that although decisions are "formally majoritarian" at the Federal Reserve FOMC, "the Board Chairman has often been portrayed by the media as a monetary policy dictator" (Chappell et al. 2004, 906).

In May, 1982, U.S. News and World Report listed Fed Chairman at the time Paul Volcker as the second most powerful person in the United States. In addition, the academic literature on monetary policy making suggested a very prominent role for the chairman. Woolley, noted Chappell et al., made the connection between the person and power of the chairman of the Federal Reserve, and monetary policy decisions, noting that "the Chairman's roles as liaison with external clients and resource allocator within the Fed give him leverage over the FOMC, and other research has documented both the influence of various Chairmen on monetary policy decisions and the factors that have shaped their policy positions" (Chappell et al. 2004, 906).

In their earlier study, Chappell and McGregor (2000) suggested that there was internal dissent in the FOMC. However, by 2004, they note that internal consensus -- or at least, the consensus arrived at in the process of issuing policy directives -- gives the Fed "power and credibility in dealing with external clients, including the President, the Congress, and the public" (Chappell et al. 2004, 906). In setting the policy favoring Open Market Operations, however, the Chairman's preference still dominates. Chappell et al. note:

Although the need to garner majority support and achieve consensus may sometimes limit the power of the Chairman, the presence of an ethic favoring consensus might accentuate it. For example, if members are reluctant to challenge proposals offered by an agenda-setting Chairman, then he may be able to tilt outcomes toward his favored positions (Chappell et al. 2004, 906).

It would appear that while the preferences of any given set of Fed governors and Reserve Bank presidents can have an effect on monetary policy and the continuing preference for Open Markets Operations, it has been, at least since the Reagan administration, primarily the desire of the Chairman that causes that policy to remain in effect.

Shrinking government debt and the wisdom of the Open Market Operations policy

Shreft & Smith (2002) noted that for several decades, the Federal Reserved had relied "almost exclusively: on open market operations in Treasury securities in order to supply liquidity." During the Clinton administration, however, there were significant surpluses, leading some commentators to wonder what the implications on the Open Market Operations policy would be. The conclusion of that model was that "As long as the supply of government debt exceeds the demand for reserves at the desired target, monetary policy with the desired inflation target can be implemented through open market operations with no difficulty" (Schreft & Smith 2002).

On the other hand, with declining debt, the model holds that the supply of reserves will become so limited that the central bank will not be able to provide the desired degree of liquidity any longer to support its inflation objective (Schreft & Smith 2002 848ff). This would be less problematical if the Federal Reserve Bank was more willing to use reserve requirements as part of its monetary policy. However, as long as reserves must be supplied from open market operations, problems arise, and the "central bank must resign to the fact that it cannot supply enough liquidity to meet the demand associated with its original inflation objective. Instead, it must operate with a higher inflation objective, where the limited supply for reserves can satisfy the reduced demand corresponding to the higher opportunity cost associated with the higher inflation rate" (Shreft & Smith 2002 848ff). Should debt sink further and further, policy would need to keep adjusting by accepting higher rates of inflation; the ultimate problem would be, of course, that equilibrium would cease to exist, and the open market operations system would be more chaotic than "open."

So, again, what impels the Federal Reserve Bank to cling steadfastly to the open market operations preference, especially in light of the currently worsening federal deficit?

Possibly it is the knowledge that if the situation became really frightful, the Federal Reserve could simply resolved the difficulty by uncoupling the supply of reserves from the government debt, or, in other words, move away from open market operations in Treasury securities as the main vehicle by which liquidity is supplied. In turn, this could be accomplished by relying on the discount window to provide liquidity, "which in principle diffuses the problem altogether" (Schreft & Smith 2002 848ff). It is possible to view the open market operations paradigm as one that, by experience, the FOMC has found works best except, perhaps, at the extremes of the possible economic conditions. Therefore, until they feel those extremes have been reached -- which they arguably had in the 'stagflation' of the 1970s -- use of the open market operations approach will continue.

Another possible tactic, in the event of economic distress, would be replacing Treasury securities with other assets, or, alternatively, expanding the use of repurchase agreements.

One must assume throughout that the macroeconomic objective of the Federal Reserve is to maintain long-term price stability and foster maximum sustainable GDP growth. Because of what he sees as the ease of carrying out the adjustments to a strict open market operations stance mentioned above, Orphanides does not see shrinking government debt as a severe problem for an open market operations policy. Of course, at the current time, government debt is not shrinking but rather expanding at an enormous rate, especially in comparison to the quite substantial shrinkage of the debt under Mr. Clinton. It has apparently not yet reached that critical point at which the FOMC would consider a more activist approach, similar to the pre-stagflation manipulations of the money supply.

It is likely, in fact, that Schreft & Smith and others who think the open market operations rubric can be easily adjusted, and is therefore work keeping, have been influenced by the past. In its first decade, the Federal Reserve System did rely primarily on discounting for extending credit; it has, however, been a very long time since that was the case, open market operations having become the norm for more than the past two decades.

In addition, it seems almost as if the Federal Reserve is holding onto the open market operations policy so that, should it become necessary, it can create a mirror image of the first decades of the Federal Reserve system. Schreft & Smith believe that, should a move out of Treasury securities become necessary over the next two decades, it would be no more than a mirror image of the "gradual increase in Federal Reserve holdings of government securities during the System's first two decades of operations" (Schreft & Smith 2002 848ff).

Looking for a 'fail safe' maneuver

With various possibilities on the horizon, not the least of which, arguably, was the intent of the administration to engage in at least one war in addition to that in Afghanistan, at the end of January, 2001, the FOMC required the staff of the Federal Reserve to begin a study of alternative approaches to managing the system's portfolio. However, their contingency policy was predicated not on increasing debt, as should have been apparent from the defense expenditures, but on the "contingency of rapid declines in Treasury debt outstanding" (Schreft & Smith 2002 848ff).

Again, the possibility of the influence of the Chairman and possibly the senior members may be operative in continuing the open market operations policy regardless of economic conditions (pending a quantum leap to one of the other policies should that become necessary under the extreme conditions scenario mentioned above) is regarded as causative. Chappell et al. (2004) "investigated how collective choices made by the Committee are related to the stated preferences of its members. The formal operating procedures of the FOMC require that adopted policy directives be approved by a majority vote of its members, so the median voter model provided a starting point for our analysis" (Chappell et al. 2004, 906). They reiterated, as well, the importance of the Chairman's desires and his desire for consensus, as long as that consensus upholds his bias. "Our empirical results substantiate the claim that the Chairman carries greater policymaking weight than rank-and-file Committee members," according to Chappell et al. (2004). Those researchers estimated the voting weight of the Chairman at approximately 40 to 50% of all influence wielded in the FOMC. However, the FOMC does not respond to pressure from elsewhere within its own ranks, with Chappell et al. finding that non-voting Federal Reserve Bank presidents had no influence over policy directives.

Deductive reasoning: the policy works because it works

Orphanides (2004) examined the reasons underlying a long period of stability in the economy between 1966 and 1995. Orphanides used the periods before Paul Volcker was appointed Chairman of the Federal Reserve in 1979 to suggest that there are, between those times and the present, "broad similarities in policy" (Orphanides 2004, 151ff). Particularly, Orphanides disputes the idea that the Great Inflation was the result of weak FOMC response to expected inflation. Orphanides suggests that before Volcker's appointment, monetary policy was too activist, reacting continually to perceived gaps in output affecting GDP and was also overambitious in what it thought it could achieve, and doing so my the more rapidly felt manipulation of discount rates or reserve requirements. Since the Great Inflation, however, Orphanides suggests that has been a vast improvement in macroeconomic stability, ostensibly owing to the preferred open market operations policy, the effects of which creep more slowly into the economy than do direct manipulations.

Orphanides is something of an apologist for the open market operations approach, regardless of conditions of inflation or deflation or stagflation, arguing that there is some other factor operative at such times of relative economic disequilibrium. To make his point, Orphanides provides a history lesson.

Analysis of a period of prosperity as supportive of the open market operations policy

Orphanides points out that the U.S. economy performed impressively from the early 1980s through the end of the 1990s, with steady expansion interrupted only briefly in 19990. Inflation throughout the period remained "fairly stable and subdued" (Orphanides 2004, 151ff). He notes that the 1980s saw the longest peacetime expansion ever in the U.S. economy, and that was followed by the longest expansionary period in history regardless of conditions of peace or war. Often called the "Long Boom," the period, according to Orphanides, was one of exceptional stability and growth, a nice contrast to the decade and a half before that which was marked by a new descriptive term, "stagflation." However, Orphanides points out, starting in the mid-1960s, the Great Inflation (of which the stagflation was a part) became more virulent during the 1970s.

Orphanides looked for an explanation of the transformation from the unstable and unsettling Great Inflation to the steadily expanding Long Boom. Naturally, he looked to policy for a cause. He proposed that the easiest way to find the cause of the good times would be to assess what errors of the bad times had been corrected, and how. That having been done, it would not be necessary to have any more bad times because the mistakes would be known and could be avoided.

It was mentioned above that the Volcker chairmanship was hallmarked with an end to excessive meddling in the economy. Orphanides cites two other researchers who argue that "the difference in performance from the Great Inflation to the Long Boom can be squarely traced to a shift in this response associated with Paul Volcker's appointment as Chairman of the Federal Reserve in 1979" (Orphanides 2004, 151ff). The argument is that during the Great Inflation, the Federal Reserve "pursued a policy that accommodated inflation and induced instability in the economy by lowering real interest rates when expected inflation increased and vice versa" (Orphanides 2004, 151ff). Volcker ended this cycle and restored monetary stability.

Orphanides offers an alternative view on how policy might have improved since the Great Inflation; simply put, he suggests that economic activity, as opposed to expected inflation, has been at the basis of economic policy. In short, the use of the open market operations policy is proactive, as opposed to reactive as raising and lowering the discount rate or reserve demands would be (Orphanides 2004, 151ff).

In addition, the rationale for an open market operations policy is that it offers fewer opportunities for errors of commission. Even more simply, it offers fewer opportunities for errors in assessment of conditions to snowball into an out-of-control economy. Orphanides has noted that "if policymakers mistakenly adopt policies that are optimal under the presumption that their understanding of the state of the economy is accurate when, in fact, such accuracy is lacking, they inadvertently induce instability in both inflation and economic activity" (Orphanides 2004, 151ff). Therefore, the instability of the Great Inflation was caused by too much, and overambitious, activist monetary policies in the face of erroneous assessment of the conditions that obtained.

Another point Orphanides makes is that not only were the Fed's assessments wrong, they also "adjusted real interest rates in a perverse manner prior to Volcker's appointment but not after" (Orphanides 2004, 151ff).

Orphanides steadfastly blames activism for economic problems before the Volcker period, in which, arguably, open market operations policies rose to prominence.

Orphanides points out that "policy after 1979 did not exhibit the same degree of activism, resulting in a reduction of emphasis to the output gap relative to inflation in setting policy. Contemporaneous accounts provide additional support for the view that an intentional reduction in policy activism along these lines followed Paul Volcker's appointment as Federal Reserve Chairman" (Orphanides 2004, 151ff) and continued into the Greenspan era.