FEDERAL RESERVE BANK OF ST.LOUIS overnight interbank rate does not necessarily ensure Editor’s Introduction a restrictive monetary policy.” The high nominal rates in the 1960s and 1970s did not indicate a Daniel L. Thornton restrictive policy because, as Jordan notes, “the infla- tion premium in interest rates was rising faster than IN HONOR OF DARRYL FRANCIS the Committee was raising the overnight policy rate.” Jordan then suggests that, “in the 1999-2000 environ- erry Jordan and Allan Meltzer honor Darryl ment, raising the overnight policy rate did not indi- Francis by chronicling his tenure as president cate that the stance of policy had become more Jof the Federal Reserve Bank of St. Louis, espe- restrictive” because the return to capital was rising cially his role as a member of the Federal Open faster than the policy rate. Real interest rates, Jordan Market Committee (FOMC). Both articles are valu- notes, are often the manifestation of economic able, not only as assessments of past policy errors forces that are independent of Fed policy. If market and what might have occurred had the FOMC forces move real interest rates, and consequently chosen the path that Darryl outlined, but also as a nominal interest rates, faster than policymakers warning for current policy. move the target, Jordan notes that the result will be Jerry Jordan recalls that Darryl Francis was faster money growth and quite likely higher inflation. frank, clear minded, and resolute. He referred to The third parallel is the vital role that “the Francis as a maverick—“an independent individual maverick, the dissenter, the sometimes lonely voice who refuses to conform with his group.” Jordan in the crowd” plays in the continuing evolution of argues that Francis played a key role in the evolu- policythinking and policymaking. And so Jordan tion of monetary policymaking within the Federal reminds us of Darryl Francis’s exceptional courage Reserve. In particular, Jordan notes that Francis was and foresight as he filled this role during a very instrumental in the FOMC’s decision to (i) adopt a important and challenging period of Federal Reserve more strategic operating directive and (ii) include history. monetary aggregates in its operating procedure. Allan Meltzer also praises Darryl Francis’s role He notes, however, that the strategic objectives— in the evolution of monetary policymaking in the reducing inflation and encouraging sustainable late 1960s and early 1970s. During the 1960s and economic growth and balance of payments equi- 1970s, as Meltzer notes, Keynesian economics was librium—sounded a lot like “motherhood and apple the reigning orthodoxy. Fiscal policy was the prin- pie,” and the FOMC’s apparent greater reliance on cipal tool of economic stabilization. Monetary policy monetary aggregates seems now to have been just and, more importantly, money growth were ineffec- a facade. Despite Francis’s courage and leadership, tive in reducing inflation—a policy choice between it was not until 1979, three years after Darryl left the full employment and price stability along a stable Federal Reserve Bank of St. Louis, that the FOMC Phillips curve. finally was “persuaded that inflation was a monetary Meltzer recalls that a furious debate arose phenomenon,” correctable only by slow money over Friedman and Meiselman’s (1963) finding growth. that the money multiplier was more stable that the Jordan suggests that there are three parallels Keynesian investment multiplier and Andersen between Darryl Francis’s FOMC experience and the and Jordan’s (1968) demonstration that changes in FOMC experience today. First is the importance of the money stock had larger and more predictable “maintaining an overriding strategic objective for effects on nominal gross national product than did price stability.” Jordan notes that, in spite of the fact changes in government expenditures. He notes that that the FOMC has made it clear that “the ultimate “at the height of the controversy in the late 1960s objective of monetary policy is to maximize long- and early 1970s, Darryl Francis was the principal, run growth by preserving a stable purchasing power and usually only, spokesman who challenged this of money,” there is a common perception that there orthodoxy at meetings of the Federal Open Market is a trade-off between growth and inflation. Committee.” The second parallel is that “raising a nominal Noting the tendency to associate high and rising interest rates with restrictive monetary policy, Daniel Thornton is a vice president and economist at the Federal Meltzer notes that Darryl Francis stood alone in Reserve Bank of St. Louis. recommending slower money growth to reduce JULY/AUGUST 2001 7 R EVIEW inflation in the late 1960s. Believing that a more for a better understanding of monetary policy and restrictive fiscal policy, not a slower rate of money its effectiveness. Questions addressed include the growth, would reduce inflation, Francis’s counter- following: How does the Fed move the federal funds parts on the FOMC favored what Meltzer terms rate? Is the effect of monetary policy completely “a fiscal solution to a monetary problem.” Specifi- reflected in the behavior of the overnight federal cally, they recommended a policy of reducing inter- funds rate, or does money have separate effects est rates to offset the effect of the then proposed on economic activity and inflation? Is systematic temporary 10 percent surtax on incomes. monetary policy effective, or must the monetary Noting that history suggests the neglect of authority surprise the market to have an effect? money was a “major mistake,” Meltzer uses the Could the practice of monetary policy be improved FOMC meeting transcripts at the time to offer this by having the central bank commit to a time path prediction: “If Darryl’s advice had been taken, we for the interbank rate? would have avoided the great inflation.” According Each paper or discussant comment is interesting to Meltzer, the failure to heed Darryl’s advice had in its own right. Nevertheless, I found reading them wide-ranging implications. He argues that, together a rewarding experience. Despite their very If the FOMC had acted on Francis’s recom- different themes, the papers overlap and interact mendations, the U.S. and much of the rest in a variety of interesting and, occasionally, unex- of the world would have avoided the worst pected ways. I highlight some of the most important of the Great Inflation. The Bretton Woods discussions and findings here. I encourage the System may not have survived, but it would reader to read all of the papers. My short summary have lasted longer. The relative price of oil does none of them justice. would not have fallen precipitately after the U.S. devaluation, so the oil shock might have The Central Bank’s Influence on been avoided, with positive consequences Interest Rates for productivity growth in the developed The first two conference papers deal with the countries. With greater certainty, inflation, issue of how the Fed influences the federal funds disinflation, and regulation would not have rate. According to convention, the Fed controls the destroyed the thrift industry. Perhaps, also, there would have been fewer petrodollars to funds rate through open market operations. Specif- recycle, less bank lending to Latin America, ically, the Trading Desk of the Federal Reserve Bank and no debt crisis in the 1980s. of New York (Desk) sells securities when the Fed desires to raise the funds rate and purchases securi- The important lesson to be learned from ties to reduce the rate. In recent years, however, the Darryl Francis and the period of monetary history Desk acknowledges doing nothing different when over which he served is that it is a mistake to the FOMC changes the funds rate target. ignore money growth when conducting monetary John Taylor begins his analysis with a detailed policy. Meltzer agues that this period and others discussion of the federal funds market and two serve as reminders that “it is impossible to have important changes that affect the demand for high and sustained inflation without monetary reserves—the virtual elimination of reserve require- accommodation.” ments as a consequence of banks “sweeping” reserv- He concludes that economic theory and expe- able deposits and the 1998 move to lagged reserve rience have shown that there have been times accounting. In addition, Taylor notes that, since when interest rates mislead policymakers when 1994, target changes have been announced imme- money growth did not: “Darryl Francis’s tenure diately upon making the decision, but after the Fed was one of those times. Fortunately, he recognized has carried out that day’s open market operations. the error. Unfortunately for us, and much of the Consequently, since 1994 it has been impossible rest of the world, his colleagues did not.” for the Fed to implement open market operations MONETARY POLICY IN THEORY AND to change the funds rate until the day following the PRACTICE announcement. After discussing these changes, Taylor presents The conference papers and discussants’ com- a simple model of the reserve market to illustrate ments cover a wide range of issues that are important how the funds rate can move when the FOMC 8 JULY/AUGUST 2001 FEDERAL RESERVE BANK OF ST.LOUIS announces a target change without the Desk carrying in advance of the announcement and others occur- out open market operations. Given the declining ring with a delay. importance of reserve requirements as a reason for Taylor also notes that the theoretical response holding deposit balances at the Fed, Taylor’s specifi- of the funds rate to a simulated shock to the demand cation for the demand for balances at the Fed is for balances at the Fed exhibits persistence that is motivated by Furfine’s (2000) model of a typical very similar to that of actual deviations of the funds optimizing bank.