Question

An article in the New York Times in 1993 stated the following about Fed Chair Alan Greenspan's decision to no longer announce targets for the money supply: "Since the late 1970 's, the Federal Reserve has made many of its most important decisions by setting a specific target for growth in the money supply \(\ldots\) and often adjusted interest rates to meet them." If the Fed would no longer have a specific target for the money supply, what was it targeting? Why did the Fed give up targeting the money supply?

Short answer

In lieu of targeting the money supply, the Federal Reserve shifted its focus to targeting the federal funds rate. This shift was likely due to the less predictable relationship between the money supply and the country's overall economic health, and changes in the financial environment.

Step-by-step solution

Identifying the New Target

When the Federal Reserve gave up on targeting the money supply, it turned its focus towards targeting the Federal funds rate, an interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight. The Federal funds rate is used as a benchmark to set interest rates for various types of loans in the United States.

Reason for the Change

Many factors likely contributed to the Federal Reserve's shift away from direct money supply targeting. The relationship between money supply and the country's overall economic health had become less predictable over the years. Changes in the financial environment, such as the development of new financial products and changes in spending habits, may have also made the money supply a less useful predictor of inflation or economic activity. By targeting the federal funds rate, the Federal Reserve could exert more direct control over the interest rate environment and, in turn, influence spending and investment decisions.

Key concepts

Federal Funds Rate

When discussing the Federal Reserve and its impact on the economy, one term often comes to the forefront: the Federal Funds Rate. This pivotal interest rate is the rate at which banks lend money to each other overnight, using their reserve balances held at the Federal Reserve. Since banks need to meet reserve requirements, this rate influences how easily they can obtain the funds to meet these requirements without experiencing significant costs.

The primary reason the Federal funds rate is so important is that it serves as a benchmark for many other interest rates, including mortgages, loans, and savings accounts. Simply put, when the Federal funds rate is altered, it impacts the borrowing and lending behavior of banks and, consequently, the spending and saving actions of consumers and businesses. Changes in this rate can have broad effects on the economy, making it a central tool in the Federal Reserve's monetary policy arsenal.

Understanding the Reserve's Rate Objective

Previously, the Fed's strategy focused on setting targets for the growth of the money supply. However, in the 1990s, the Federal Reserve shifted its approach to target the Federal funds rate instead. By managing this rate, the Fed could exert more direct influence over the economy, addressing issues like inflation or recession by encouraging or discouraging spending and borrowing through the cost of credit.

Monetary Policy

Monetary policy refers to the strategies and actions taken by a country's central bank—such as the Federal Reserve in the United States—to control the supply of money and interest rates in its economy. The main objectives of monetary policy typically include regulating inflation, maintaining employment at a healthy level, and ensuring economic stability.

To achieve these goals, the Federal Reserve uses several tools, including the Federal funds rate, as discussed earlier. When the Fed lowers the Federal funds rate, it essentially makes borrowing cheaper, encouraging banks to lend more. This increase in lending activity can stimulate economic growth by making it easier for individuals and businesses to invest and spend.

The Shift from Money Supply to Interest Rates

Adopting interest rate targeting marked a significant change in the Federal Reserve's approach to monetary policy. By placing the Federal funds rate at the heart of its strategy, the Fed could respond more flexibly to changing economic conditions. For example, in times of economic downturn, the Fed might lower the rate to stimulate borrowing and spending, while in times of high inflation, it might increase the rate to cool down the economy.

Economic Indicators

Economic indicators are vital to understanding the health and direction of an economy. These are statistics that provide insight into the economic performance and trends, helping policymakers, investors, and businesses make informed decisions. Common examples of economic indicators include gross domestic product (GDP), unemployment rates, inflation rates, and consumer spending.

For the Federal Reserve, which aims to manage the monetary aspects of the economy, indicators such as inflation and unemployment provide valuable signals on when to adjust the Federal funds rate or other monetary tools. In the case of Alan Greenspan's tenure, the decision to move away from money supply targeting toward interest rate targeting was likely based on the understanding that indicators like the Federal funds rate provide more immediate and manageable insight into the economy's state.

Why Economic Indicators Matter

While direct money supply metrics may offer one perspective, broader indicators can offer a more comprehensive view of the economy's strength and weaknesses. By monitoring a mix of various economic indicators, the Federal Reserve can fine-tune its monetary policy moves to address specific concerns like inflation or unemployment, thus steering the economy toward its desired trajectory.