Research & Analysis by Willem Thorbecke
As a result of the buildup of the Old Age, Survivors, and Disability Insurance (OASDI) trust funds, the supply of U.S. securities to the public by the second and third decades of the next century might become extremely limited. While this increase in Federal savings would lower real interest rates and stimulate investment, the buildup would create a difficulty: it would force Federal Reserve open market operations to be conducted in assets other than Treasury securities. It is important to know whether monetary policy would continue to be effective under this new modus operandi. To answer this question it is necessary to have evidence concerning the transmission mechanism through which monetary policy affects the economy. Obtaining such evidence is especially important now since many economists argue that monetary policy works through a black box which we do not understand. Evidence demonstrating one channel though which monetary policy works is presented here. It is demonstrated that news of increases (decreases) in the Federal Reserve's target for the federal funds rate during the 1974–1979 period lowered (raised) stock prices. This period was unique because the Federal Reserve controlled its operating instrument, the federal funds rate, so closely that market participants were able to discern a change in the target on the day the target changed. This evidence supports the arguments of Tobin and Brunner and Meltzer that the stock market is an important link in the monetary transmission mechanism. The results indicate that if the OASDI trust funds purchased most or all Treasury securities, open market operations conducted using other assets would still be efficacious through this channel. By affecting bank reserves and thus the federal funds rate, these operations would influence stock prices and economic activity.