Reagan administration officials last week sent a message to the Federal Reserve Board policy makers who will meet this week to set their policy goals and money-growth targets for the coming year.
All we want you to provide for 1986, the officials said, is lower interest rates, "sufficient liquidity to sustain a healthy expansion" and slower money growth to restrain inflation.
A "healthy expansion," to the administration, is about an 8 percent increase in current-dollar gross national product, about equally divided between rising real economic activity and higher prices.
Most of the Fed's policy-making group, the Federal Open Market Committee, probably would be quite happy to settle for that kind of economic achievement this year -- so long as it did not lay the groundwork for new problems, particularly on the inflation front, in 1987 and beyond.
On the other hand, some senior Fed officials also say they would not necessarily be troubled by an economy expanding at perhaps a 2 percent or 3 percent rate if such growth appeared likely to continue for some time. And they remain concerned about the inflationary consequences of a possible sharp drop in the value of the dollar on foreign-exchange markets.
With the economy apparently off to a pretty good start for the year, and with long-term interest rates down about a full percentage point since November, there appears to be little likelihood that the FOMC will change its current policy position, according to a number of analysts.
Last week's report that civilian employment rose by about 400,000 jobs in January and the unemployment rate dropped to 6.7 percent, and the continuing declines in world oil prices, probably reinforced the view of a majority of the FOMC that no further moves toward an easier policy are needed right now.
According to projections by several economists, real GNP is rising at about a 4 percent rate this quarter.
The Fed's survey of economic conditions around the country last month indicated "that the economy is growing at a moderate pace on balance," a summary of the report said. The weakest regions were those served by the Federal Reserve banks in Chicago, Dallas and St. Louis.
However, federal spending already has begun to decline as a result of the workings of the new Gramm-Rudman-Hollings deficit reduction law, and more could be on the way as a result of the law's requirements or decisions by Congress and the president.
Some economists say the Fed should respond quickly to this reduction in fiscal policy stimulus to the economy by acting to lower interest rates. Others economists, pointing to the recent declines in long-term interest rates which likely were partly the result of the prospects for smaller deficits, argue that no Fed action is needed now -- particularly with the ultimate size of the deficit reduction so uncertain.
Among the latter group is Alan Greenspan of Townsend-Greenspan & Co., who told a congressional hearing last week: "I think the Federal Reserve is going to have some difficulty over the next few years because of problems at major financial institutions. The Fed would be wise to keep their powder dry."
If the Fed eases substantially, and then has to act later to help ailing large banks by pumping money into the banking system, the nation is "going to end up with more credit expansion than we need," Greenspan said.
A cautious, wait-and-see approach is just what some members of the FOMC have in mind. "In an imperfect world, developments have been reasonably satisfactory, and it would be a mistake to move strongly in one direction or another," said one member. "Various imbalances clearly exist" in the economy, but they are problems that are "not subject to monetary policy," the official said.
Those "imbalances" include the looming problems of possible bankruptcies among smaller oil companies and more trouble for the banks that have lent them money, similar problems in the agricultural sector and growing difficulties in commercial real-estate. At the same time, even with some recent gains, many manufacturers remain hard pressed by foreign imports.
Hovering over all of these situations is the continuing uncertainty about just what policy guide the Fed ought to follow.
A year ago, expecting that a more normal relationship would be established in 1985 between growth of the money and the expansion of economic activity, the FOMC decided to aim for an increase of 4 percent to 7 percent in the money-supply measure M1 between the fourth quarter of 1984 and the fourth quarter of last year. (See chart)
For reasons that no one fully understands, it took a far greater increase, around 12 percent, to eke out even a 6 percent rise in current-dollar GNP over the same four quarters. Prior to the 1980s, a 12 percent increase in M1 would have been associated with about a 15 percent rise in current-dollar GNP.
As the first half of last year progressed, the FOMC understood that that relationship had broken down even more severely than it had earlier in the decade. In July, the committee discussed abandoning M1, which includes currency in circulation and checking deposits at financial institutions. Instead, it chose to widen the target range to 3 percent to 8 percent and to measure M1 growth from its average level in the second quarter of 1985 rather than the final quarter of 1984.
But that target range proved just as elusive, and the year ended with M1 well above the range's upper limit.
Throughout the year, some monetarist economists, such as Beryl Sprinkel, chairman of the Council of Economic Advisers, urged the Fed to take steps to slow down money growth. If it did not, according to their view, a sharp increase in inflation was sure to follow.
Sprinkel and the other monetarists believe that change in the rate of growth of money has only a passing effect on the level of real economic activity. But with a lag of about two years, changes in money growth push the inflation rate up or down, they say.
The chart on M1 growth and inflation, taken from the CEA's annual report released last week, shows part of the historical link to which this group of economists points. In the latter half of the 1970s, inflation moved well above the lagged measure of money growth as a result of oil and food price shocks, the report says.
Since 1982, this relationship has gone completely awry, as the chart shows. The rising value of the U.S. dollar until last February, which lowered the cost of imports, and greater competition for companies making goods that compete with imports may have been partly responsible.
But the Fed is left with a policy dilemma, which was summed up in an article in the Kansas City Federal Reserve Bank's "Economic Review" in an article by associate research director J. A. Cacy.
"The implications of the recent rapid growth in M1 for current monetary policy are difficult to identify precisely," Cacy wrote. "On the one hand, experience in the 1980s would seem to suggest that, since rapid M1 growth is not inflationary and is needed for economic growth, it should be welcomed rather than feared and avoided.
"On the other hand, experience over a longer period, as well as economic theory, suggests that the potential inflationary implications of rapid M1 growth cannot be ignored by monetary policy makers. Thus, monetary policy actions no doubt will continue to be aimed, in part, toward bringing about moderate M1 growth in order to support balanced noninflationary growth in the economy," he wrote.
CEA Chairman Sprinkel, while wanting slower money growth, also cautioned the Fed to be careful not to slow money growth abruptly. Do that, he said, and the economy will slow down, too. Under repeated questioning by reporters and some members of Congress during the week, Sprinkel would not be more specific about how much of a slowdown he thinks appropriate.
Even though the FOMC disregarded its M1 target for most of last year, the rapid rise in that measure of money worried many of its members, as did the very rapid increase in the economy's total debt. At the same time, two other broader measures of money, M2 and M3, were much more well-behaved. (See chart for M2)
M2 includes M1, most money-market mutual fund balances, savings and small-time deposits at financial institutions and other items. M3 includes M2, large-time deposits and other items.
As the link between M1 and the economy got further and further off track last year, it carried less and less weight in FOMC deliberations. "I haven't got any choice now," said a member. "I have to look at M2 and M3. The longer [the unusual behavior] persists, the less I worry about M1."
Last July, the FOMC set a tentative target for M1 growth this year of 4 percent to 7 percent, the same as last year's original range. A 7 percent upper limit would be consistent with an 8 percent increase in current-dollar GNP only if velocity of M1 -- the ratio of M1 to GNP -- started growing again. Last year, the velocity ratio fell more than 5 percent.
Traditionally, the ratio of M2 to GNP has been more stable than that of M1, showing no upward or downward trend over the years. However, last year the velocity of M2 also fell by 2.6 percent. In addition to that problem, many FOMC members say that the Fed cannot influence changes in M2 as readily as it can in M1.
This week, the FOMC will likely again set money growth targets, though it is possible that it will downgrade M1 from a targeted monetary measure to one that will only be "monitored." The decision will be disclosed at a hearing of the House Banking Committee scheduled for Feb. 19.
And there will be two new members on hand for the discussion and vote. Manuel H. Johnson, former assistant Treasury secretary for economic policy, and Wayne Angell, a Kansas banker, farmer and economics professor, were sworn in Friday as Fed governors.
Johnson replaces governor J. Charles Partee, whose term expired at the end of January, and Angell fills a vacancy created last summer by the resignation of governor Lyle Gramley.
At their recent confirmation hearings, both men indicated they were in general agreement with the Fed's current policy stance. Neither suggested they favor tight adherence to M1 targeting as a policy guide.