An uncertain Federal Reserve is being buffeted by rising pressure to change its monetary policy. Everyone who is urging a policy shift has the same objective in mind--a lowering of the high interest rates that are still stifling the economy.
The only problem is, as usual, a total disagreement over whether getting interest rates down requires putting more money into the economy, or less. As a result, the central bank is in its familiar spot: the middle.
So far this year, money growth has run above the target set by the Fed, and a growing chorus of monetarist economists is complaining that the Fed has once again strayed from the path of righteousness. To the monetarists, the Fed's credibility as a devoted inflation fighter is on the line.
At the same time, the central bank is being pressured by some members of Congress, businessmen such as homebuilders, a number of more liberal economists and even a few Wall Street analysts to loosen the monetary reins considerably more than it has.
The Fed so far has chosen to walk a narrow line largely rejecting the importunings of both groups. A large majority of the Fed's policymaking group, the Federal Open Market Committee, voted late in March for growth in the two more closely watched monetary aggregates, M1 and M2, that would leave M1 only about $1 billion above the target range in June and M2 right at the upper limit of the range.
The FOMC will meet next in late June to review its money targets for the remainder of this year and to choose a tentative set of targets for 1983. Its choices will be critical to the economy, and, according to all indications, will be made in an atmosphere of great uncertainty.
Members of the committee readily acknowledge they are uncertain about a number of key elements in the money supply picture, including the likely pace of the economic recovery expected for the second half of the year, whether a recovery might not proceed for some months without causing a jump in the money supply that would have to be countered by policy, and whether the public has for some reason chosen during the recession to hold more of its assets in a highly liquid form that is part of M1, artificially inflating its level.
Observers of the FOMC say that, in this situation, Chairman Paul A. Volcker probably can, if he chooses, swing the committee any way he wants.
Volcker remains strongly opposed to giving any signal that the Fed will accommodate inflation. On the other hand, he is known to believe, as do most other members of the committee, that it is essential that the Fed foster a moderate recovery, during which inflation could continue to fall. In the event the targets turn out to be too restrictive to do that, Volcker is said to favor raising the targets. But that is a judgment far more likely to be made after the fact than before.
The decision in March--taken by a 9-to-2 vote with the dissenters seeking a somewhat tighter policy--essentially was reaffirmed at this month's FOMC meeting, but with the expectation that in June the aggregates will end up somewhat lower than had been thought in March, sources said. In particular, top Fed officials are known to believe M2, the broader measure, could well be back within bounds next month.
The Fed has announced that it is aiming for the upper part of the 2 1/2 to 5 1/2 percent range for M1 because the average for M1 in the fourth quarter of 1981--the starting point for this year's range--was well below its intended level. Growth of 5 1/2 percent this year would be the equivalent of about 4 percent had M1 been at the lower limit of last year's intended range, officials point out. (See chart on page F1.)
(M1 includes currency in circulation, travelers checks and checking deposits at financial institutions. M2 includes M1 plus money market mutual fund share, overnight repurchase agreements, overnight Eurodollar borrowings, and savings and small time deposits.)
Thus, the central bank appears to some observers not to be following precisely a monetary rule that requires keeping M1 within the target range at all times, but nevertheless using the rule as a substantial constraint on how fast money will be allowed to grow.
That is not enough for the monetarist critics. One of them, economist H. Erich Heinemann of Morgan Stanley & Co., New York investment bankers, is disturbed that the money supply, bank reserves and several other measures of credit have expanded much more rapidly this year than they did in 1981.
"These developments are disturbing," Heinemann wrote recently. "They imply that the Federal Reserve System, despite the vigor of its anti-inflationary rhetoric, may be willing to tolerate considerably faster monetary growth than had been the case only a few months ago.
"Should this prove in fact to be correct," Heinemann continued, "it would tend to confirm the worst suspicions of financial market participants, who--during a period of substantial and sustained disinflation--have been seeking to hedge the risk of renewed inflation. It would tend to confirm the widespread fear among managers of financial asset portfolios that Washington cannot realistically be expected to finance a runaway federal deficit in a non-inflationary manner."
Several Fed officials reject the monetarist complaints. It would make no sense at all, they say, to opt for a more restrictive policy at a time when the economy is deeply depressed and unemployment above 9 percent just for the sake of complying with a strict interpretation of a monetarist rule.
When asked about complaints such as Heinemann's, Nancy Teeters, the one Fed governor who is on record as favoring raising the money growth targets for the remainder of this year, exploded, "With 9 1/2 percent unemployment and 14 percent interest rates, what do they want? Should we go to 15 percent unemployment for the sake of somebody's rule?"
Despite all the grumbling, the Fed's dilemma now is nowhere near as great as it would be later this year if a recovery gets underway and the money supply begins to expand more rapidly than it has been. A number of analysts believe that is exactly what will happen since they expect a recovery to cause a renewed rise in business demand for short-term credit.
When business loan demand rises, and banks accommodate it, typically a large part of the proceeds end up as deposits against which the banks must set aside reserves.
The process of lending and creating additional deposits is the mechanism though which additions to the money supply come into being. To limit it, the Fed can sell government securities in return for cash. Taking the cash out of the banking system reduces the level of reserves available to banks, which normally results in higher interest rates, less bank lending and less money creation. Of course, the system works in the opposite direction, too, when faster money growth is desired.
Unfortunately for the Federal Reserve, many of the links in this chain are quite loose and the entire process works with a lag that can vary. For instance, in the first quarter of this year, M1 and M2 both rose strongly while the economy was declining. Monetarists say last year's very slow growth of M1 caused the drop in economic activity.
Ironically, Heinemann and some other monetarists, such as Jerry Jordan, a member of President Reagan's Council of Economic Advisers, point to the faster money growth so far this year as one reason they expect a recovery in the second half of the year. At the same time, they argue that slower money growth will bring down interest rates, which will foster a recovery.
The question raised by critics of the monetarists is whether a tighter money policy would lead to lower interest rates without first also clamping down again on economic growth. The experience of the last 18 months strongly suggests to the critics that slowing money growth will, at least in the short run, restrain real economic activity, not just inflation and interest rates.
The monetarists generally had claimed that once the Federal Reserve had persuaded financial markets that it would, as promised, continue to slow money growth to hold down inflation, expectations of future inflation would fall. That would enable the nation to adjust quickly to a lower inflation rate without a large loss of output and jobs.
For whatever reason, that prediction turned out to be wrong, as Federal Reserve officials are fully aware. That fact only worsens their dilemma. If the demand for credit does rise this fall as a recovery takes hold and money growth accelerates, should the central bank hew closely to the monetarist rule and seek slower money growth even if it entails a rebound in interest rates and the risk of aborting the recovery?
At least one member of the FOMC, Robert Black, president of the Federal Reserve Bank of Richmond, believes the Fed should stick to its targets. Black dissented in March on the grounds that allowing M1 to remain above the upper limit of the range would raise inflationary expectations and therefore tend to boost long-term interest rates. "I thought we should have moved strongly against the bulge in money in April," Black said last week. "That would have increased our credibility . . . . Markets do seem to pay attention to those things."
Several members of the FOMC, including Volcker, were not prepared to try to bring M1 back within bounds more quickly, partly because they were and still are puzzled by the rapid growth of the so-called NOW accounts--interest bearing checking accounts--component of M1. Most of the expansion of M1 this year has come in that form.
"We have to consider the possibility that people have increased their liquidity preference to a degree," Fed Governor Lyle Gramley noted. "The generalized uncertainty about interest rates, the economy, fiscal policy and monetary policy" may have caused people to want to hold more of their savings in a highly liquid form, he explained. If that is what has been going on, then the nation's transactions balances, which M1 is supposed to measure, have not been rising faster than targeted, and therefore growth of M1 should not be slowed.
Heinemann and some other monetarists dismiss this sort of argument as just a rationalization to allow faster expansion of the money supply than for which the targets call.
Meanwhile, the inability of Congress to find ways to reduce the huge budget deficits in coming years has kept financial markets jittery and interest rates at least somewhat higher than they probably otherwise would be, most analysts agree.
If Congress does get its act together, however, and moves to trim the deficits substantially, it will remove some prospective pressure in financial markets. At the same time, it will put the Fed more in the middle than ever. Virtually everyone on Capitol Hill is going through the agonies of trying to cut the budget to bring down interest rates. If the cuts are made and rates still do not fall appreciably--and a number of people, including former Treasury Secretary W. Michael Blumenthal, have warned they will not--then the spotlight will be on the Fed.
For now, Federal Reserve officials have their fingers crossed hoping for the best of all worlds this fall. In that world, a recovery gets underway, inflation does not rebound sharply, interest rates continue to drift downward, and all this happens while the money supply stays within its target ranges. All that conceivably is possible, given the situation today. But it will help to be lucky, too.