HISTORY OF MONETARY TARGETING READING ADAPTED FROM LINDA KOLE

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History of Monetary Targeting

History of Monetary Targeting


Reading adapted from: Linda Kole and Meade, Ellen E. (Federal Reserve Bulletin, 1995, October 1, PP. 917-931), “German Monetary Targeting: a Retrospective View.”


Note: The term G7 in this article refers to the 7 most industrial countries; these are the United States, Japan, Germany, the United Kingdom, France, Canada, and Italy.



Throughout the 1950s and most of the 1960s, the industrial world experienced rapid growth with low inflation. Under the Bretton Woods system of fixed exchange rates, instituted in the mid-1940s, the central banks of the major industrial countries were limited in their ability to pursue independent monetary policies. Occasionally, they were obliged to intervene in the foreign exchange market to maintain exchange rate parities, directly affecting their reserves and the supply of money. When exchange markets were tranquil, central banks attempted to influence liquidity in the banking system; some regulated interest rates, some imposed controls on the growth of particular credit aggregates such as bank loans, and some did both.

The practice of targeting rates of growth of key monetary aggregates had its roots in the late 1960s when monetary authorities in several major industrial countries reduced their emphasis on short-term interest rates and began to pay more attention to monetary aggregates. Around that time, economic conditions raised awareness of the influence of the money stock on economic activity over the short to medium run and on prices over the longer run. The U.S. credit crunches in 1966 and 1969 and the German recession in 1966-67, for example, were seen as having been caused in part by monetary contractions that, at least in retrospect, seemed excessive. And the U.S. fiscal expansion associated with the Vietnam War, along with an increase in the pace of money growth in 1967 and 1968, clearly precipitated a substantial rise in U.S. inflation in the late 1960s, which was transmitted to the other G-7 countries through the fixed exchange rate system. From 1970 to 1973, frequent exchange market interventions during the terminal stages of the Bretton Woods system led to a worldwide expansion in liquidity and a rise in inflation in all the G-7 countries in 1972-73.

Announcement of Targets in the 1970s

The orientation of monetary policy in the G-7 countries changed significantly during the 1970s. The breakdown of the Bretton Woods system gave monetary authorities greater latitude to pursue independent policies. In the early 1970s, rising inflation pressures, together with the move to flexible exchange rates, led some G-7 central banks to set objectives for the pace of monetary expansion. For instance, the Federal Reserve adopted monetary targets in 1970 with the intention of using them to gradually reduce inflation. As a result, the Federal Open Market Committee (FOMC) began to set targets for M1 and M2 growth over the period between its bimonthly meetings. These objectives were initially used to guide internal policy discussions and were not released publicly.

The rise in inflation in the early 1970s was exacerbated by the outbreak of the Arab-Israeli war in autumn 1973 and the OPEC oil embargo, which caused the international price of oil to quadruple in January 1974. The negative supply shock associated with the rise of oil prices in 1973-74 contributed to recessions in the G-7 nations, which were worsened by the monetary contraction that accompanied it. High levels of inflation, interest rates, and unemployment prevailed in the G-7 countries by the mid-1970s and led to growing public concern about monetary policy.

It was in this atmosphere of stagflation that monetary authorities took a new approach to implementing monetary policy: publicly announcing targets for the growth of the supply of money. Monetary authorities in most G-7 countries adopted explicit targets for the growth of one or more money or credit aggregates in the mid-1970s, and during the second half of the 1970s these targets became a major focus of monetary policy in Canada, Germany, the United Kingdom, and the United States. By the end of the decade, all the G-7 countries except Japan and Italy had official objectives for the rate of monetary expansion.

Experience with Targets

In the early years of monetary targeting - the second half of the 1970s - the targets often were exceeded; only Canada was able to meet its targets consistently. At the same time, monetary authorities were trying to reduce the variability of interest rates and exchange rates, actions that were sometimes at odds with meeting the monetary targets. Nevertheless; rates of monetary growth eventually slowed somewhat, and target ranges were reduced. Then global oil prices more than doubled during the course of 1979, contributing to a worldwide rise in inflation that peaked near the turn of the decade.

The appointment of Paul Volcker as Chairman of the Federal Reserve Board in August 1979 marked a turning point in the implementation of monetary targeting. In October 1979, the Federal Reserve announced a major change in its conduct of monetary policy - adoption of an operating target for nonborrowed reserves to improve its control over M1. Interest rates shot up, and M1 growth declined from an annual rate of 8 1/2 percent over the first three quarters of 1979 to 5 1/2 percent during the four quarters of 1981. The change in operating procedure was largely successful at reducing inflation, which peaked at around 13 percent in early 1980 and fell below 5 percent during 1982. The shift toward tighter monetary policy and lower rates of inflation eventually occurred in all G-7 countries over the course of the 1980s and generally has continued in the 1990s.

Decreased Emphasis in the 1980s

Financial liberalization and innovation over the 1970s and 1980s changed the relationship between money stocks and other economic variables in most G-7 countries. Structural changes in these countries' banking systems altered the role of banks in the monetary transmission mechanism, and technological changes, particularly the advance of computer technology, fundamentally revolutionized financial markets and increased the speed with which financial transactions could occur.

In many countries, previously stable money demand relationships broke down during the 1980s. Financial innovation and deregulation altered the elasticity of money demand with respect to income and to interest rates, making monetary aggregates less reliable as intermediate targets. For example, by late 1981 the velocity of M1 in the United States had begun to deviate significantly from its trend and the linkages between money, income, interest rates, and prices had become less stable and predictable.


In some countries, monetary aggregates were deemphasized through a change in targeting procedure. For example, as the demand for the broad U.K. aggregate M3 became less stable, the British government shifted to the much narrower aggregate M0. Canada abandoned monetary targeting altogether in 1982. By the end of the 1980s, the problems with monetary targeting were widely recognized and most G-7 nations had ceased to rely on monetary targets as a consistent guide for policy.


Update: Eventually all of the G7 countries abandoned the use of money supply targets in favor of short term interest rate targets.



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