Some pointed remarks by Federal Reserve Chairman Paul A. Volcker and a Labor Department report indicating that the economy still is growing sluggishly, at best, combined last week to halt a six-week rise in interest rates.
Even though there had been few signs that economic growth was picking up, financial markets apparently had taken to heart the consensus forecast that the economy would accelerate significantly in the second half of the year.
As a result, many market participants have given up their earlier expectation that the Fed soon would take further steps to lower interest rates.
Short-term interest rates had risen about one-half a percentage point, and some longer-term rates had jumped nearly a full point.
The cap came early last week when some remarks about the persistence of inflation made by Volcker at a meeting of international bankers in Boston were interpreted by market participants as a signal that the Fed was about to tighten monetary policy.
During a congressional hearing the next day, Volcker cautioned market participants not to read more into his comments than was really there. He had not intended to send any signal that the Fed was about to tighten, he declared. That set the stage for a dramatic turnaround.
It came Friday when the Labor Department reported that civilian unemployment rose from 7.1 percent to 7.3 percent in May and that other employment data indicated that the economy remained sluggish last month. Employment continued to rise steadily in the service sector, the report said, but it fell once again in manufacturing and dropped very sharply in mining, particularly in the oil and gas industry.
Analysts took the report to mean the economy was weaker than they had been thinking and that no economic surge is just around the corner. The report, coming on the heels of Volcker's comments, helped spark a bond market rally that for a while raised the price of some long-term U.S. Treasury securities by as much as $30 for each $1,000 face amount, or 3 percent.
"The market's psychology had gotten extremely poor," said Charles Lieberman, director of financial markets research at Manufacturers Hanover Trust Co. in New York. "It was ignoring everything that didn't show the economy getting stronger . . . and Volcker shook everyone up when he talked about inflation.
"Then he retracted and the unemployment numbers came on the heels of that," Lieberman continued. "The employment report was extremely weak. . . . What people are realizing is that in the immediate term, the economy is soft. For the first time in some weeks, the market is being forced to recognize that economic weakness and that more growth is not assured."
Convinced that the long-predicted increase in growth was at hand, market participants were expecting that the Fed's next move would be to boost, rather than lower, interest rates. The market also has been concerned that the central bank might decide to make reserves less readily available to the nation's banking system -- a move that would boost interest rates -- in order to slow growth of the money supply.
The Fed reported later Thursday that M1, the measure of money that includes currency in circulation and checking account deposits, rose another $1.7 billion in the week ended May 26 to reach a seasonally adjusted level of $660.5 billion. That is well above the upper limit of the target range set by the Fed for M1, but neither Volcker nor other Federal Reserve officials have given any indication that they would tighten policy solely on the basis of rapid money-supply growth.
Moreover, some senior Fed officials have indicated that, unless both the economy and inflation moved into much higher gear, they would be reluctant to take specific steps that would mean higher interest rates. After two years of relatively sluggish growth, the officials said that a period of more rapid expansion would be appropriate unless prices also started to rise sharply, too.
In any event, the market shrugged off the money-supply report and staged its rally on Friday. Even if the Fed makes no change in its policy stance, financial market participants can change their mind, and that can change interest rates.
Back in April, when the Fed last cut its discount rate -- the interest rate it charges on loans it makes to financial institutions -- from 7 percent to 6.5 percent, many analysts expected another cut would come within a few weeks or a couple of months at most. Many short-term interest rates that are set by market forces, such as that on three-month Treasury bills, fell to levels that were more consistent with a 6 percent discount rate than one at 6.5 percent.
Long-term rates, which are heavily influenced by both the level of short-term rates and expectations of future inflation, also fell in the wake of declining crude oil prices, analysts said.
Then the expectations of further easing by the Fed began to disappear and short-term rates began to climb. When both short rates and oil prices began rising at the end of April, so did long-term interest rates. For instance, yields on five-year U.S. Treasury securities rose by a full percentage point from 6.8 percent in mid-April to 7.8 percent in mid-May. Some yields on 20-year and 30-year Treasury securities also rose sharply.
Lieberman said he now thinks that much of the run-up in rates that occurred during late April and May will unwind. If the pace of the economy improves as slowly as he expects, "there is an even chance for another discount rate cut," he said.