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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