Kenneth R. Szulczyk
economy returns to the full-employment level, the Fed’s policy kicks in, expanding the economy
and creating inflation.
The Fed uses operating targets and intermediate targets to reduce the problems with time
lags. The Fed uses its tools to influence the intermediate targets, and the intermediate targets
directly affect the price level, unemployment rate, and economic growth rate. Moreover, the Fed
has more control over the intermediate targets, and the time lags are shorter. Intermediate
targets include the M1, M2, and M3 definitions of the money supply and short-term interest
rates.
Fed has more control over operating targets than intermediate targets. Operating targets are
the federal funds rate and non-borrowed reserves. Federal funds rate is the interest rate that
banks charge for lending their excess reserves to other banks. When the Fed uses open-market
operations, changes discount policy, or alters reserve requirement, the Fed’s monetary policy
has an immediate impact on the federal funds rate and non-borrowed reserves. When the Fed
implements monetary policy, such as a creating a greater GDP growth rate, the Fed’s policy
immediately affects the operating targets, and, in turn, influence the intermediate targets, such as
GDP growth rate. Accordingly, the Fed monitors changes in the intermediate and operating
targets, determining whether monetary policy is affecting the economy correctly.
The Fed uses three criteria to select an intermediate target. First, the Fed must easily
measure the intermediate target in order to overcome information lags. Second, the Fed must
have control over the intermediate target to overcome the impact lag. For example, the Fed can
influence the money supply, but not the GDP growth rate. Many factors influence the GDP
growth rate, and the Fed cannot influence all of them. Thus, the Fed would never select GDP as
an intermediate target. Finally, the Fed selects intermediate targets that influence the policy
goals predictably. For example, the Fed influences the M1 definition of the money supply, and
M1 sometimes influences the unemployment rate, while at other times, it does not. Therefore,
M1 would not be a good intermediate target.
Before the 1990s, the Fed alternated back and forth between interest rate and money supply
targets. This strategy was not successful because the Fed’s monetary policy caused more
instability in the economy. Economists refer this to procyclical monetary policy, which means
the Fed amplifies the business cycle. Monetary policy further expands a growing economy
creating inflation, or it strengthens a severe recession. For example, the Fed selected interest
rates as its intermediate target. A growing economy causes interest rates to rise. For the Fed to
lower the interest rates, it must buy more U.S. government securities. Consequently, the bond's
prices increase, causing the interest rates to drop. Nevertheless, the bank reserves expand the
money supply, expanding the economy faster. On the other hand, as an economy enters a
recession, then interest rates fall. If the Fed wants to boost the interest rates, subsequently, the
Fed must sell U.S. government securities. Thus, the price of the securities decreases, increasing
the interest rates. However, bank reserves falls, contracting the money supply and worsening a
recession. Since the 1990s, the Fed has emphasized a low inflation goal, and this policy has been
successful. Europe and Japan also emphasize price stability and low inflation rates.
Economists suggested the Fed use other intermediate targets, such as the following: