Inflation, Interest Rates, and Monetary Growth

On October 6, 1979, the Federal Reserve System changed its operating procedures for monetary policy. The period following that change has been one of turbulence in the money and capital markets. Not only have interest rates risen to unprecedented heights, but both interest rates and money supply growth have been unusually volatile. During this period, the objectives of the Federal Reserve have remained constant-to reduce inflationary pressures and eventually the level of interest rates by gradually lowering the growth of the money stock. In principle, the growth of the money stock could be constrained by controlling either interest rates or bank reserves. Under the former operating procedure, the Federal Reserve estimated the relationship between interest rates and the money supply, then “targeted” the interest rate on federal funds in a narrow range that was estimated to be consistent with desired monetary growth. This procedure proved to be unsatisfactory, because the relationship between interest rates and the money supply changed as inflation accelerated and because changes in interest rates were often not large enough to control money supply growth. In this environment adherence to interest-rate targets caused money growth to deviate further and further from desired targets.