JACKSON HOLE, Wyo. -- Federal Reserve officials believe they remain well equipped to fight inflation and guide economic growth despite massive changes in financial markets that have reduced the role of banks as suppliers of credit.
Speaking at a two-day conference on monetary policy sponsored by the Federal Reserve Bank of Kansas City that ended Saturday, Fed officials also signaled that they intend to continue to take a wide variety of total and economic indicators into account when setting short-term interest rates.
Conference participants, who included central bank officials, academic economists, and Wall Street fund managers, generally agreed that the Fed can implement monetary policy without major problems despite the increased complexity of financial markets.
"The bottom line is the Fed can still tighten and ease by changing short-term interest rates," said Mickey D. Levy, chief economist for NationsBank. "What has changed because of financial innovations is the Fed's ability to use intermediate targets to achieve its inflation objectives. That has become more difficult."
Federal Reserve Board Chairman Alan Greenspan, in opening comments, said the increased competition for deposits from money market mutual funds and higher-yielding stock and bond funds has made banks and thrifts "far less special than they once were."
On the lending side, Greenspan said, rapid growth in commercial paper markets and increased competition from finance companies have cut banks' share of short-term and intermediate-term credit to businesses "to little more than half."
Banks remain the primary source of credit for small business, but even that role could be scaled back if Congress succeeds in passing legislation to securitize small-business loans. Greenspan said.
Given such changes, Greenspan said. "the fairly direct effect that open market operations once had on the credit flows for businesses and home construction is largely dissipated."
Still, he said, the Fed's ability to influence short-term rates remains intact, although achieving a desired effect on U.S. goods and services "may take longer, and require larger movements in rates."
The stampede by investors from bank certificates of deposit to stock and bond funds led Greenspan to announce last month that the Fed is no longer targeting growth in the M2 measure of money. M2 includes currency, savings and checking accounts, and certificates of deposit under $100,000.
M2 "may well become more useful again over time" to policymakers, Greenspan said, but in the meantime they will have to rely more heavily on economic and financial indicators in setting rates. Members of the FOMC who met on July 6 and 7 voted to maintain the Fed's bias toward raising short-term rates, according to minutes of the meeting released Friday.
The Fed's direct leverage over consumer rates has diminished sharply as banks have given up their lead role as financial intermediaries over the last decade, according to Franklin Edwards, a professor at Columbia University, who presented a paper at the conference.
Edwards said the share of household financial assets held by commercial banks plunged to 26.8% from 37.2% in 1980, while thrifts saw their share drop to 16% from 23.3%.
Over the same period, pension and trust funds, investment companies, and insurance firms boosted their combined share of household assets from 34.1% -- less than what banks had at the time -- to 49.3%, or nearly half.
Edwards and other conference participants agreed that the diminished role of banks in financial markets, globalization of trading in securities, computerized communications, and growth of new products such as derivatives, all create a challenge for central bankers in executing monetary policy.
Several warned that the Fed may find problems that could prove nettlesome to Greenspan and his colleagues. "Households in the U.S. are becoming much greater risk takers," said Henry Kaufman, president of Henry Kaufman & Co.
Kaufman said consumer spending may prove to be much more volatile now that households are putting more of their savings in stock and bond funds instead of federally insured deposits. In the event of a big market drop, that could put a brake on spending and the economy that "poses a significant problem" for the Fed in executing monetary policy, he suggested.
Leonard Santow, managing director of Griggs & Santow Inc., said he has seen more and more investors reaching for yield and going for junk bonds. These funds do not have much cash and will have to sell if the bonds are called in a market downturn, he warned. "The world doesn't go one way forever," he said.
Conference participants Were less interested in discussing the changed financial environment and more interested in discussing the fine art of Fed watching, which involves second-guessing how the central bank views the economy and prospects for inflation.
In his July testimony, Greenspan said the Fed will be placing new emphasis on real interest rates, or rates adjusted for inflation.
But Donald Kohn, director of the Fed's monetary affairs division, told the conference that tracking real interest rates "is no panacea." One problem is measuring inflation expectations in order to calculate any equilibrium level for rates, said Kohn. Moreover, he said, the most relevant rates for spending by consumers and business are in the intermediate and long-term maturities, where the Fed's influence is weakest.
Benjamin Friedman, a professor of economics at Harvard University, endorsed the Fed's multi-indicator approach to setting monetary policy but suggested it would be useful to monitor the spread between Treasury bill rates and commercial paper rates, which are typically higher. Economic research has shown that a widening gap between rates on commercial paper and Treasury bills typically precedes a recession, the same way a flattening Treasury yield curve does.
But even the paper-bill method can sometimes send "false signals," said Friedman. For example, the spread narrowed before the recession began in July 1990, and then widened during the downturn.
Allan Meltzer, an economics professor at Carnegie-Mellon University, argued that the Fed would be better served in setting monetary policy if it used a rule based on growth of the monetary base. The monetary base consists of currency in circulation plus bank reserves and is a long-standing favorite of monetarists who oppose the Fed's more discretionary approach to policy.
Greenspan at one point asked Meltzer whether reliance on a complicated rule would not essentially be the same as what the Fed does now, drawing a startling "you're wrong" from Meltzer and a charge that policymakers are trying "to fool markets." Greenspan politely responded that he "would love to continue the debate" but was unable to do so.
Conference participants listened keenly to the exchange, but for the most part seemed to side with Greenspan. Jacob Frankel, governor of the Bank of Israel, said the chief rule now guiding the Fed is the need to cope with the pace of change. "In this rapidly changing world, formulas that are done by 30 mathematicians cannot really substitute for good judgment and solid analysis of fundamentals," Frankel said.
"There was a pretty broad endorsement of a policy based on a spectrum of indicators," said Roger E. Brinner, executive research director for DRI/McGraw Hill. "M1 or M2 is not going to be replaced by real interest rates but by inflation, GDP growth, employment growth, and anything else the Fed feels is relevant to gauging future inflation potential."