Investors are still sorting out the meaning of the latest credit tightening moves by the Federal Reserve. It the Fed follows through on its announced intentions, the long-term implications go well beyond a temporary increase in interest rates and a sharp decline in stock prices on record volume.
Interest rates and stock prices may be more volatile in the future than in the past, a depressing prospect to investors who have endured the volatile markets of the 1970s. The market may be more volatile because the Fed seems to have given up its role in stabilizing interst rates.
The Fed can control either the quantity of money or its price in terms of interest rates, but not both. For decades the Fed chose to keep interest rates as stable as possible while allowing the growth of the money supply to flucuate over a wide range. Now the Fed seems ready to control the money supply tightly while accepting more volatility in interest rates.
The departure from controlling interest rates represents another nail in the coffin of the Keynesian theory that has dominated economics for the past generation. For decades the Fed practiced the Keynesian precept that interest rate are more important than monetary growth, but its latest move aligns it more closely with the monetarist school of economics.
Monetarists such as Milton Friedman have advocated greater control over money supply growth for years, a policy that the Feds seems to have embraced with great reluctance.
Investors face not only greater volatility of interest rates, but greater uncertainty in predicting them as well. The Fed has changed the old rules of the game, while being very vague as to what the new rules are. Investors who carefully watched the federal funds rate as a guide to Fed policy now find themselves with no guide at all. The result is what Fed Chairman Volcker termed a "period of uncertainty."
Normally the Fed maintains an air of uncertainty about its actions to enhance its mystique and to enlarge its freedom of action. In this case, however, the Fed is probably as uncertain as anyone else as to its future actions since it is replacing policies that it knows well with ones that it knows hardly at all.
When a group of bewildered brokers asked the New York Fed's Peter Sternlight for guidance, he responded with the candid, but unnerving reply, "We are in the midst of a learning process ourselves." This is one occasion where the Fed shares part of investors' uncertainty over its future actions and most of investors' uncertainty over the consequence of those actions.
The uncertainty as to level of interest rates extends to their function as well. In past periods of tight credit, potential borrowers were discouraged as much by the lack of credit availability as by the rising level of interest rates. Weak borrowers often found it impossible to borrow at any level of interest. So far the lack of credit availability has not been a major barrier to borrowing but the high level of interst rates is. In theory, the level of interest rates acts as a rationing device to discourage potential borrowers; in practice, this may be one time where interest rates perform that function.
There is no uncertainty as to the effect that high short-term interst rates are having on money market mutual funds. Fund sales are booming because they offer savers more than double the 5 1/2 percent passbook return offered by banks. This strengthens the administration's case for phasing out interest rate ceilings as a way to provide savers with a fair market return on their money. Until now the government chose to subsidize borrowers at the expense of savers, but that policy is increasingly untenable.
Savers now have a positive incentive to save for the first time in years. As long as the Fed kept interest rates below the inflation rate, it made sense to be a borrower who repaid his loan in cheaper dollars. This shift in incentives from borrowing and spending to saving and investing has favorable long-term implications for capital spending and productivity.
While savers face a brighter future, borrowers face a distinctly colder one. It made sense to borrow at 8 percent to buy a house appreciating at 12 percent, but the appeal of that investment changes radically as mortgage rates rise to 13 percent. If the rate of appreciation in home prices flattens as it did in previous periods of tight credit, then the burden of a 13 percent mortgage rate will be crushing.
The same situation comfronts margin buyers in the stock market. When the margin rate was 8-9 percent, many investors borrowed to buy utility stocks yielding at least as much. They hoped that the stocks would go up while their dividends covered the margin interest. Instead, the stocks went down and margin costs rose to 15 percent, far above the yield on virtually any stock.
If the Federal Reserve follows through on it announced intentions, then a major change in the investment climate is inevitable. The real question is whether the Fed means it. There are many skeptics who point to past dramatic announcements by the Fed that were forgotten when the pain of tight moeny and recession became intense. Fed Chairman Paul Volcker has made a good start at rebuilding the Fed's eroded credibility and at coming to grips with inflation. If he succeeds, then a long-term outlook for investors is a very favorable one with low inflation and low interest rates. Getting from here to there, however, may be a long and uncomfortable time.