With interest rates at near-record levels, money supply growth running below target, and the economy at a virtual standstill, the stage was set last week for the Federal Reserve to ease its tight grip on credit, most Fed watchers thought. They were wrong.
Instead, it has been learned, the Fed's policymaking group in effect decided at a two-day meeting last week to lower a keymoney growth target as another anti-inflation move.
The action probably will mean continued high interest rates in the short run, but it does not necessarily mean rates in coming months will not be somewhat lower than today.
After hours of discussion, the Federal Open Market Committee, or FOMC as the group is know, decided not to change the formal target range for growth of M1-B, the most closely watched measure of money, sources said. However, as Federal Reserve Chairman Paul A. Volcker is expected to tell the House Banking Committee next week, the Fed will implicitly have a lower target because it intends to aim not for the middle of the 3 1/2 percent to 6 percent range but the lower edge.
Federal Reserve officials acknowledge that their policy stance runs the risk of a slower, weaker economy for the rest of 1980 and into 1981, with homebuilding particularly mired in recession. They also agree the policy will mean a continued threat to the survival of some hard-pressed thrift institutions that are in the red because of the high cost of money.
The officials expect interest rates to ease "only if we get real softness in the economy." Even if that happens, most of the decline will come in short-term rates, with long-term rates moving down less quickly and not as far, the say.
While there are strong indications the economy at the moment is more or less marking time, there are still some signs of strength, the officials believe. High on the list is a heady level of demand for business and commercial loans at banks, which jumped $2.83 billion in the week ended July 1. And if long-term interest rates were to drop a bit, some analysis expect corporations to flood the bond markets with up to $5 billion of new securities a month, partly in an effort to pay down expensive short-term bank loans.
Most and perhaps all of the 12 FOMC members are determined to accept the risk of a weaker economy in order not to lose what progress has been made this year in the fight against inflation, a fight they regard as by no means won. The recent drop in reported inflation rates has encouraged the Fed policymakers that they are on the right course, the sources explained.
Increasingly, Fed officials are concerned about what may happen in a series of major wage negotiations during 1982 covering the steel, trucking and automobile industries, among others. Without a "real break" on the wage front next year, control of inflation in the longer term will be far more difficult, they say. Thus, they are determined not to do anything that would send the wrong signals about future inflation to either labor or management negotiators.
Evidence of this increasingly tough stand can be found in FOMC records, such as the minutes of the May 18 meeting published last week. Beginning in April, the committee sought to counter quickly a surge in money growth with ever more restrictive policies. As of May, there was as yet not "clear relaxation of underlying inflationary pressures, and emphasis was placed on the importance of conveying a clear sense of restraint at a critical time with respect to inflation and inflationary expectations," the minutes said.
The FOMC decided at the May meeting to provide reserves to the banking system consistent with a growth of M1-B from April to June at an annual rate of 3 percent or lower. M1-B includes currency in circulation and checking deposits at financial institutions. The Fed targets are for M1-B after an adjustment for money being shifted from regular checking accounts into interest-bearing accounts such as NOW accounts.
Another reason for the FOMC decision implicitly to lower its target for M1-B for the remainder of 1981 is that the committee is paying more and more attention to growth of a broader money measure, M-2. M-2, which also includes savings deposits at commercial banks, shares in money market mutual funds and some other types of deposits, has shown stronger growth than M1-B. It consistently has been close to or above the upper edge of the Fed's 1981 target range.