The Federal Reserve Board moved yesterday to tighten monetary policy and raise interest rates again for the third time in less that two weeks, nudging the key federal funds rate up another 1/8 point to 8.25 percent.
The latest move surprised the financial markets and drove bond prices down as much as 1/2 a point while stock prices tumbled.
Unlike the last two increases, which were related to the plight of the sinking dollar, the latest tightening move appears to derive from concern on the part of the Fed that growth in the basic money supply in continuing to outstrip its targets and is thus helping to feed the country's troublesome inflation.
"Domestic considerations have come back into the picture," says David Jones, economist with Aubrey G. Lanston & Co., a government securities firm.
Jones said that the basic money supply, or M-1, which consists of cash and checking deposits, will probably exceed the upper limit of the Fed's 4 to 8 percent target range for the July-August period and that was what caused the Fed to clamp down.
Over the last year, the basic money supply has been growing at nearly 8 percent, a rate that many economists feel is excessive and fuels inflation.
"On a sustained basis, 8 percent money supply growth is too high," said William Gibson, an analyst with Smith Barney, Harris Upham & Co., "It is not consistent with a slowing of inflation and if maintained probably would lead to an acceleration of inflation even from present levels."
To control the growth of the money aggregates at a time when demand for funds is strong - like the present - tends to raise interest rates. And while inflation is worrisome, there is also concern that continued increases in interest rates could sufficiently dampen economic activity to throw the economy into a recession.
However, the rate of economic gain has continued stronger through the summer months than many forecasters had expected and there is therefore less concern that tighter economic policy, for the time begin, threatens a downturn.
But analysts said that, short of another crisis for the dollar, they did not expect the Fed to push interest rates much higher because of concern for the domestic economy.
"We still think short-term rates will peak out pretty soon," said Thomas Bell, an economist with Merrill Lynch Government Securities. "But that depends on the dollar holding steady. If we see renewed weakness in the dollar, rates could go up much higher than anyone now projects."
The Fed signaled the latest tightening move when it allowed the rate on federal funds yesterday to rise above 8.2 percent before it came in to do security repurchases and thus supply reserves to the banking system. The federal funds rate measures what banks charge other banks for overnight loans of excess reserves. The Fed uses this rate to peg its money market operations.
At the beginning of the year Fed funds were trading at just over 6.5 percent. Two weeks ago the rate was 7 7.8 percent when the Fed, in the face of a plummeting dollar, moved the rate up point to 1/8 percent and followed several days later with another 1/8 point increase to 8 1/8.