The Federal Reserve Board has set a monetary policy course for 1986 that it expects will help to produce economic growth of about 3 to 4 percent and keep inflation within the same range during the year, Fed Chairman Paul A. Volcker said yesterday.
Testifying before the House Banking Committee, Volcker expressed concern several times that the recent decline of the dollar on foreign exchange markets could get out of hand, adding to inflationary pressures by increasing the cost of imported goods and making it more difficult for the United States to borrow money from abroad with which to finance its trade deficit.
Some financial analysts took Volcker's comments about the dollar as a strong indication that the Fed is not likely to take steps soon to reduce short-term interest rates. A number of financial market participants had thought that Fed policy makers decided at a meeting last week to move in that direction.
Volcker disclosed that Fed policy makers have made no "significant" changes in accommodating the banking system's need for cash that could lead to lower short-term interest rates.
Volcker told the committee that the Federal Reserve expects healthy growth this year with moderate inflation, but with some continuing serious problems.
"In my judgment, the present expansion -- already longer than the postwar average for peacetime years -- is not about to die from old age or sheer exhaustion," he said. "We don't have the pressures on capacity, the excess inventories, the accelerating costs and prices, or the rising interest rates that have typically presaged cyclical downturns in the past.
"Yet . . . there are evident points of economic pressure and financial strain, some of them aggravated by the sharp decline in oil prices," Volcker continued.
He said it will take years to correct the nation's trade and budget deficit problems, and that there is no way to insulate the United States from difficulties in other countries, such as how Mexico can pay interest on its large foreign debt while oil prices drop sharply.
Several committee members pressed Volcker on whether he expects a loan default by Mexico or other developing countries that could precipitate a serious financial crisis in the United States.
The Fed chairman replied that he does not anticipate such a crisis, but that, if one did develop, the central bank would contain it.
Volcker also noted in his testimony that several parts of the American economy, including agriculture and energy, are under severe strains, and that they, too, could pose difficulties for U.S. banks.
"These sectoral strains and imbalances point up the crucial importance of maintaining the essential safety and soundness of our financial system, and, in particular, our depository institutions," he said.
To help ensure that soundness, Volcker urged Congress to make some urgently needed changes in present banking laws, including adopting a more up-to-date definition of what, in fact, constitutes a bank or a thrift institution and closing of a number of legal loopholes that institutions have exploited.
Volcker said that the central bank's policy-making group, the Federal Open Market Committee, is still very uncertain about the current relationship between changes in the money measure M1 and changes in economic activity. As a result, the FOMC decided to widen to a 3 to 8 percent range its M1 target for 1986. That range was set tentatively last July as 4 to 7 percent.
M1 includes currency in circulation and checking deposits at financial institutions. The tentative targets for the broader monetary aggregates, M2 and M3, and the "monitoring range" for total debt were left unchanged.