The first two days of this week produced an upward surge in interest rates as nervous traders reacted to speculation that the Federal Reserve, in a shift in policy, had begun to tighten the supply of cash and credit in the economy again.
Since the Oct. 19 stock market plunge, the Fed has been supplying virtually all the cash the nation's banking system wanted, and financial market participants have been watching for the first sign that the central bank was becoming less generous. On Monday some thought they had seen that sign in a report in the Wall Street Journal saying the government had changed its policy subtly to lend more support to the dollar, which has plummeted in recent weeks.
In fact, there has been no change in Fed policy, either to support the value of the dollar or for any other reason, Federal Reserve sources said yesterday.
But the flurry underscored the tense atmosphere pervading the highly volatile bond and stock markets after Oct. 19. Long-term interest rates began rising Friday and spurted on Monday, as did short-term rates. Yesterday, long-term rates rose again, while stock prices -- defying the most common pattern -- also rose sharply. Analysts said the stock market may be reacting to new evidence that the economy has not been as damaged by the October market plunge as initially feared.
As evidence that the Fed has not shifted policy, the closely watched federal funds rate -- the interest rate financial institutions charge when they lend reserves to one another -- dropped below 6.75 percent yesterday after jumping above 7 percent after Thanksgiving. Many financial analysts had assumed 6.75 percent was the level the Fed was seeking to maintain as it made reserves available to the banking system.
At the same time, long-term rates, which are much less directly affected by Fed policy, remained above the lows reached in late October. For instance, the yield on 30-year U.S. government bonds yesterday was about 9.2 percent, up from around 8.9 percent but still well below the 10.4 percent level reached in mid-October. Yesterday's rates were little changed from the previous day.
The value of the dollar is affected by the spread in interest rates between those in the United States on, say, 10-year government bonds and similar securities issued by the Japanese and West German governments. Higher rates in the United States relative to those abroad make investments in this country more attractive, and as foreigners sell their own currency to buy dollars in order to make such investments, the value of the dollar goes up.
Other government officials yesterday stressed that what really had changed recently was policy in West Germany, where a number of key interest rates have been cut in response to pressure from the United States and other industrial nations to stimulate the lagging German economy. Some fiscal policy changes have been made, too.
"It's fair to say that we're in a generally conciliatory mode" toward the West German and Japanese governments, given the policy moves in the former and the strong economic growth in the latter, one official said.
Treasury Secretary James A. Baker III and other officials have been seeking faster growth in West Germany and Japan to create larger markets there for goods from the United States and other countries, particularly developing nations. Such a shift could help reduce the U.S. trade deficit, improve growth prospects in debt-burdened developing countries and reduce trade surpluses in Japan and West Germany.
Meanwhile, the administration and congressional leaders agreed to spending cuts and tax increases to reduce the federal budget deficit in fiscal 1988 and 1989.
Taken together, these U.S. and foreign actions should provide more support for the dollar, whose value has plummeted nearly 10 percent in recent weeks, the government officials said.
With fundamental economic policies better aligned, U.S. authorities apparently are more likely now to intervene in currency markets to support the dollar directly by buying dollars and selling Japanese yen or German marks.
One reason that some financial market analysts were quick to believe that the Fed might be tightening monetary policy to support the dollar was that recent reports increasingly indicate that the October stock market plunge has not damaged the American economy in any significant way -- at least so far.
The National Association of Purchasing Management yesterday released an economic forecast based on a survey of its members made in mid-November showing continued strong growth through 1988.
By a ratio of more than 4 to 1, the association's members predicted that 1988 would be a better year than 1987, and that the current quarter would turn out to be stronger than the third quarter, during which the gross national product expanded at an annual rate of 4.1 percent after adjustment for inflation and seasonal variations.
However, nearly 60 percent of the survey respondents also expressed concern about the outlook over the next 12 months, partly as a consequence of new uncertainties flowing from the stock market's troubles.
A similar feeling of uncertainty was reflected in the latest summary of economic conditions around the country prepared by the 12 district Federal Reserve banks for a meeting of the Fed's top policymaking group, the Federal Open Market Committee, next Tuesday and Wednesday.
Most of the Fed districts reported continued economic expansion, with particular strength in the Boston, Chicago, Minneapolis and San Francisco districts, the report said. But it added, "Despite general optimism among surveyed firms, there was also widespread evidence of increased uncertainty about future growth in demand. Furthermore, while the majority of survey respondents said that the stock market crash had not materially altered their capital spending plans, reports of at least some deferrals of plans appeared in a number of district discussions."
With such uncertainty about the economic outlook, some Fed officials have said they would be reluctant to tighten monetary policy and boost interest rates unless there are strong signs of increasing inflation, or rising inflationary expectations among financial market participants.
For one thing, the central bank policymakers are also looking at some forecasts from private economists, such as those at Data Resources Inc., which predict a significant slowdown in growth in the first half of 1988. The latest DRI forecast predicts an increase in real GNP this quarter at a 2.6 percent rate, down from 4.1 percent in the third quarter, and a further drop to about a 0.5 percent rate in the first half of next year.
DRI predicts that consumer spending will rise only about 1 percent in 1988 while housing construction falls. Continued business investment in equipment and rising export demand will be the major factors keeping the economy growing early next year, DRI said. Staff writer Paul Blustein contributed to this report.