Federal Reserve Chairman Paul A. Volcker said yesterday that the central bank stopped easing its monetary policy last month, a step that means the five-month slide in short-term interest rates probably is over.
With both the money supply and the economy growing more rapidly than they were last fall, Volcker told the Senate Banking Committee that the easing of policy, which began last August and helped foster a 3-percentage point drop in some rates, was ended to prevent "overshoots" in money growth and possible inflation problems later.
But Volcker also stressed that the Fed has not begun to tighten policy and that it intends to supply enough money and credit in 1985 for the economy to grow at about a 3 1/2 percent to 4 percent pace. That should be fast enough for the civilian unemployment rate -- 7.4 percent last month -- to fall below 7 percent by the fourth quarter of this year, he said.
Nevertheless, some of the technical details in the Fed's semi-annual report to Congress on monetary policy indicated that it anticipates that short-term interest rates probably will rise later this year as the economic expansion continues, analysts said.
Financial market participants took a bearish reading of Volcker's remarks, and both short-term and long-term rates rose moderately during the day.
The Federal Reserve's policymaking group, the Federal Open Market Committee, which met last week to review the economic outlook and set official targets for money supply growth for this year, expects the inflation rate also to be in the 3 1/2 percent to 4 percent range, Volcker said. The Fed's inflation projection is slightly more optimistic than that of the Reagan administration and the Congressional Budget Office.
The Fed's forecast of 3 1/2 percent to 4 percent growth in the gross national product, adjusted for inflation, falls between the administration's 4 percent forecast and the CBO's 3.4 percent.
"Economic growth is expected to remain strong enough in 1985 to produce some further decline in unemployment, with little, if any, pickup in inflation," Volcker told the Banking Committee. "But we must not be beguiled by those tranquil forecasts into any false sense of comfort that all is well. If the enormous potential of the American economy for growth and stability -- not just for 1985 but for the years beyond -- is to become reality, we need a sense of urgency, not of relaxation."
The Fed chairman noted that inflation is still "in the neighborhood of 4 percent" and that some sectors of the economy, such as farming, are still in deep trouble. Meanwhile, the nation's trade deficit has risen, and only a large net inflow of foreign capital is keeping some interest rate-sensitive sectors from being "crowded out" of financial markets by borrowing to finance the federal budget deficit.
"Looking ahead," he declared, "the stability of our capital and money markets is now dependent as never before on the willingness of foreigners to continue to place growing amounts of money in our markets. . . . But we are in a real sense living on borrowed money and time."
Volcker urged Congress to use that time to find ways to reduce prospective federal budget deficits, raising taxes to do so if enough spending cuts cannot be found.
In his report on monetary policy, Volcker said that the Federal Open Market Committee, or FOMC, reaffirmed the tentative target set last July for 1985 growth of the money measure M1 of 4 percent to 7 percent. The target ranges for growth of the broader money measures M2 and M3, both tentatively set at 6 percent to 9 percent, were expanded to 6 percent to 9 1/2 percent, primarily for technical reasons, Volcker testified.
The policy group also decided that, given the recent slower pace of the economic expansion, it would be better to have money growth somewhat faster than that early this year and slower later in the year. In addition, the FOMC concluded that if the relationship between money growth and economic growth behaves as expected this year, it would be appropriate for M1 to remain above the midpoint of the 4 percent to 7 percent range for the entire year.
Some administration officials, such as William A. Niskanen Jr. of the Council of Economic Advisers, have been urging that the Fed adopt precisely that approach for 1985.
Furthermore, Volcker explicitly said that the sharp rise over the last three months in M1 -- which includes currency in circulation and checking deposits at financial institutions -- and M2 -- a broader measure that also includes savings deposits, most money market mutual fund shares and other items -- has not left them too high relative to the Fed's targets.
"As a matter of economics and policy, rather than graphics, the FOMC is not disturbed by the present level of M1 and M2 relative to its intentions for the year," he told the Banking Committee. "It contemplates that, as the year progresses, growth will slow consistent with the target ranges."
The "graphics" to which Volcker referred is the practice of both the Fed itself and many financial market analysts of depicting the target range for money growth month-by-month as a cone with its point placed at the money level for the fourth quarter of the previous year, the base from which the growth is calculated. Showing the range this way implies the Fed regards it as much narrower early in the year than later when the cone is much wider.
Volcker said that the Fed did not regard itself as constrained in the fashion implied by these graphics and that the target range could as well be illustrated by a set of parallel lines instead of a cone. His testimony included a chart showing both approaches, as was done at least once in similar testimony several years ago.
Some analysts have regarded the Fed as, in fact, feeling constrained to keep money growth within the implied narrow band early each year. Currently, some of these analysts have been arguing that with money growth above the upper limit of the target range, as depicted by the cone, the Fed would have to reduce the flow of reserves to financial institutions to slow down money growth. Any such action would be accompanied by rising interest rates.