A theory of the bureaucratic value of Federal Reserve operating procedures

Abstract

Beginning in the mid-1960s and continuing since there has raged a prolonged argument over the proper method, or operating strategy, for carrying out open market operations. This argument has led the Federal Reserve to experiment with and abandon a number of strategies. However, until the most recent experiment, which began in October 1979, all these strategies had one common component: all utilized some money market interest rate as the immediate target of OMO. Undoubtedly the Federal Reserve's reluctance to give up its money market target was founded on economic theoretic grounds. The Keynesian model, which was dominant throughout the 1950s and 1960s and into the 1970s, concentrated on interest rates, not monetary aggregates. Economists trained in this tradition naturally would be slow to discard the received knowledge of the era. This paper sets out another reason for the Fed's tenacity in holding to the money market mode of operation. It analyzes the Federal Reserve System as a bureau, run by individuals who seek to maintain the autonomy of their organization. From this perspective the choice of an operating strategy will be made not only on economic grounds but also on political. Since the political attractiveness of various strategies may differ considerably, the Fed may be substantially influenced by non-economic factors in its choice of methods. Section 1 sets out the theory of bureaucracy used to analyze Federal Reserve behavior. Section 2 describes a model of Federal Reserve information provision developed by B.M. Friedman (1978). The third section briefly reviews the history of Federal Reserve open market operations since the 1950s, paying special attention to the Fed's choice of operating strategies and the criticisms of those strategies by insiders and outsiders. Section 4 presents evidence that the policy followed by the Fed during the 1970s did indeed provide considerable information about future plans, enabling the