The Federal Reserve is usually able to influence the direction of interest rates by controlling the reserves it supplies to the banking system. When reserves are plentiful, banks are able to extend credit by making loans or by purchasing securities. Conversely, when reserves are scarce, banks are either unable to extend credit, or are forced to curtail loans and sell securities to be within their proper reserve ratios.
When reserves are scarce, interest rates usually rise, and we refer to the "tight money" policy of the Fed. Such a policy prevailed from October of 1979 until the summer of 1982. Since then, reserves have become more plentiful and interest rates have fallen sharply. The administration and the Fed feel that rates should fall much further to aid and to sustain the recovery. However, if the reserve aggregates expand for too long a period, we usually end up with price expansion or inflation.
In an effort to avoid another inflationary scene, the administration and the Fed have been resorting to another policy -- "jawboning," or "openmouth" policy, as it is known. Administration officials recently berated the banking community for keeping consumer loan rates so high. Within a week, a couple of major banks lowered their consumer loan rates from 17 1/2 to 15 percent.
Chairman Paul Volcker, in a speech last week, said that inflation was under control and interest rates should decline. For Volcker to make such a statement about the direction of interest rates is in itself highly unusual. Consequently, when Volcker speaks, the market listens and, as if on cue, the government bond market rallied and interest rates fell. In essence, without taking any market action, the Fed was able to talk interest rates lower.
Fears of inflation and concern over international banking problems have recently caused the precious metals market to ascend to levels not seen since 1981. The recent decline in oil prices triggered a re-evaluation of inflation. The more favorable feelings promptly sent the price of gold down 21 percent while silver plummeted 33 percent. Although many customers who owned these commodities on margin were trapped, the market rebounded and stabilized by midweek.