Seasonal Monetary Policy

Introduction and summary It is widely known that economic activity does not evolve smoothly over the course of a year, but that it varies systematically across the different seasons. This is not surprising: Weather is an important factor in many sectors of production. While agriculture is an obvious example, construction is another important activity affected by weather: No doubt, it is much harder to build a house in Chicago during the winter months than during the rest of the year. Institutional arrangements also lead to seasonal fluctuations in economic activity. For instance, a disproportionate fraction of American families take vacations during the summer months partly because they coincide with school recess. Another example is Christmas, which sharply increases retail activity during the last month of the year. While most modern discussion about monetary policy centers on what is the best policy to follow over booms and recessions, very little is said about what is the best policy to follow across different seasons. However, this has not always been the case. The evolution of U.S. monetary institutions and, in particular, the creation of the Federal Reserve System have been partly guided by this discussion. Before the creation of the Federal Reserve System in 1914, the U.S. monetary system was commonly criticized for its alleged "inelasticity" in responding to fluctuations in the demand for credit. While some of these fluctuations were associated with business cycles and bank panics, an important part of them were the result of regular seasonal fluctuations in economic activity. As a matter of fact, in those days it was common for the U.S. economy to go through recurrent periods of monetary tightness during the fall crop-moving and Christmas seasons (September through December). To illustrate this, it suffices to consider the seasonal pattern for short-term interest rates. The reason is that, to the extent that the end-of-year increase in the demand for credit was not matched by a comparable increase in money supply, the short-term interest rates would have to increase. A classic source for the seasonal behavior of interest rates is Kemmerer (1910), who reported the seasonal weekly pattern for average interest rates on call loans in the New York Stock Exchange between 1890 and 1908. Indeed, Kemmerer showed a strong seasonal pattern: He reported that the call rate decreased quite rapidly from 7.38 percent during the last week of the year to 2.50 percent during the last week of January. Moreover, after a long period of relative stability, the call rate increased from 3.04 percent during the first week of September to reach a peak of 7.38 percent during the last week of the year. To use the words of Friedman and Schwartz (1963, p. 292): "That seasonal movement was very much in the minds of the founders of the (Federal Reserve) System and was an important source of their belief in the need for an 'elastic' currency. " In fact, the creation of the Federal Reserve System in 1914 changed the seasonal behavior of interest rates quite dramatically. Figure 1 shows the average call rate in New York City during the periods 1890-1913 (before the creation of the Fed) and 1915-28 (after the creation of the Fed, but before the Great Depression). For the period before the creation of the Fed, we see the same seasonal pattern that Kemmerer reported in weekly data: Interest rates rising steadily between September and December, and dropping sharply in January. During the period after the creation of the Fed, we see interest rates behaving much more smoothly. We still observe a noticeable increase at the end of the year, but it is small compared to the sharp increases that took place before the creation of the Fed. This type of evidence led Friedman and Schwartz (1963, p. 293) to claim that "the System was almost entirely successful in the stated objective of eliminating seasonal strain. " [FIGURE 1 OMITTED] In order to attain such a smooth path for interest rates, the Federal Reserve had to meet the seasonal variations in demand with accommodating expansions and contractions in the supply of high-powered money. …