The Federal Reserve last week turned its full attention to getting an economic recovery going.
At a meeting Tuesday, the central bank's policy-setting group, the Federal Open Market Committee, at least temporarily abandoned the growth of the money supply as the key guide for Fed policy. Instead, the Fed intends to supply enough money to the economy to push interest rates down and keep them down until there is unmistakable evidence a sustainable recovery has begun.
On Friday, the Federal Reserve reduced the discount rate -- the interest rate the Fed charges on loans made directly to financial institutions -- from 10 percent to 9 1/2 percent. Meanwhile, most major banks lowered their prime lending rate from 13 1/2 percent to 13 percent and one major bank dropped it to 12 1/2 percent.
For all the new emphasis on interest rates, however, there is no indication the Fed has dropped its long-term goal of controlling inflation by restricting growth of the money supply. In the short run, though, the emphasis is on sparking a recovery.
Officials at the central bank acted because they could see no sign a recovery is imminent. At the same time, they have become more and more worried about the devastating cumulative impact the seemingly endless recession is having on American businesses and financial institutions. The risk of some sort of severe economic disruption related to a possible wave of corporate bankruptcies or failures of financial institutions has become too large to allow the recession to continue indefinitely, according to the reasoning behind the policy change.
One Federal Reserve official said last week's meeting may turn out to have been a "momentous" session.
Volcker took the lead at the meeting in urging quick and decisive steps to reduce the array of risks facing the economy and financial institutions. Several other members of the FOMC, however, were prepared to follow his lead. One, Fed Gov. Nancy Teeters, has for some time been urging the committee to raise the money growth target rather than leave markets guessing about how much over-target growth the Fed would tolerate.
Some of the 12 Reserve bank presidents on the committee -- only five are voting members at any one time, along with the seven Fed governors, but all participate in the discussion--have also become increasingly concerned about what is happening in their respective regions of the country.
After the meeting, five of them briefed Martin Feldstein, new chairman of the Council of Economic Advisers, at his request, on their regional conditions. The news they conveyed ran from bad to worse.
Silas Keehn, president of the Federal Reserve Bank of Chicago, said industrialists in the Midwest who are good managers of solid firms have told him "they have reached the bottom of the bag" in terms of cutting costs and reducing employment in response to the recession. If there is no recovery soon, they will have to begin taking actions that "will do great damage to their companies," he said.
Frank Morris, head of the Boston Reserve Bank, said the recession has begun to hit his region -- which includes almost all of New England -- more severely. Even very healthy growth companies in high technology fields are now cutting back in the wake of sharp reductions in business investment spending. Until recently, New England has felt the recession less severely than many other parts of the country.
Neither Keehn nor Morris, who were interviewed at a conference on saving and investment sponsored by Morris's bank, would discuss details of the FOMC meeting.
The Fed had expected that money supply growth near the upper edge of its target range of 5 1/2 percent would be adequate, as inflation came down, to get interest rates low enough to spur a recovery. That has not happened, and recent evidence on new orders for goods and on current production indicate the recession still is worsening slowly but steadily.
These domestic concerns are overlaid by the fear that the worldwide economic slump could lead to so many defaults on loans by both private firms and countries that stability of the entire international system would be endangered.
Against this dismal background, the Fed concluded it had to move.
The stage for last week's decision also was set by the way in which financial markets have responded over the last two months to other Federal Reserve steps in the direction of an easier monetary policy.
Beginning late in July, as it became clearer that the economy was not turning around as expected, interest rates began to fall. The Fed acted aggressively to encourage the decline in rates, but it was able to do so while still hewing to a monetarist approach of targeting money supply growth.
In September, when the level of M1 -- the measure of money that includes currency in circulation and checkable deposits at financial institutions -- moved well above its target rate, interest rates did not go back up to any significant degree.
Financial analysts say rates did not rise because market participants were quite sure the Fed would not tighten credit conditions to bring money growth back in line in the face of such serious widespread economic weakness.
Federal Reserve Chairman Paul A. Volcker had publicly indicated that above-target money growth would be tolerated this fall to some extent.
At the same time, the faster money growth in September did not increase fear of future increases in inflation and thus cause long-term interest rates, which are highly sensitive to inflation expectations, to rise.
These market responses, or, in the case of long-term interest rates, the lack of a response, led Federal Reserve officials to conclude that they finally have established enough credibility as inflation fighters that they could respond more strongly to the recession without having a shift toward greater monetary ease backfire and produce not a recovery but simply higher interest rates.
The length to which the Federal Reserve has gone over the last three years to achieve its goal of lowering inflation -- including acceptance of the worst recession in post-war history and an unemployment rate that in September hit 10.1 percent -- has indeed established that credibility.
The Fed, of course, does not announce its policy decisions except with a lag of a month or more, and several Fed officials expressed surprise at the immediate and massive response of both the stock and bond markets to what market participants assumed happened at the Tuesday meeting. The officials were concerned that details of the FOMC decision may have leaked overnight.
When the minutes of last week's meeting do become available, they are likely to show that the M1 constraint on money policy was dropped for technical reasons rather than simply because it currently was not regarded as consistent with the economy's need for liquidity, as the Fed sees it.
These technical reasons--which include the uncertain ultimate destination of the more than $30 billion of tax-free All Savers certificates maturing shortly, as well as what may happen later this year when banks and thrift institutions are allowed to offer new acccounts paying money market interest rates -- will make M1 an uncertain guide for policy, Fed officials believe.
As a result, they will be working more on M2, a broader measure that also includes money market funds, savings acccounts and small certificates of deposit. But the emphasis is expected to be on getting interest rates down, not in holding M2 within its own target range. While M2 is already above its range, Fed officials anticipate that declining interest rates will cause investors to move large amounts of money out of money market funds and into instruments that are not counted as part of M2.
Albert Wojnilower, the First Boston Corp. economist whose analysis carries great weight on Wall Street, declared, "The Fed has taken a large step and maybe a giant one."
Some Fed officials expressed concern that last week's actions might be seen just as a politically inspired election eve maneuver. Certainly the Fed is aware of the political calendar and of proposals by congressional Democrats to require it to set interest rates in ways that would lower them under current circumstances.
But the motivation of the steps taken last week lay largely with the U.S. economy and the dire straits in which it is today, the officials maintained.
Certainly the economic circumstances are serious enough to warrant some new policy responses, in the opinion of most analysts.