A weekend ago, the Federal Reserve announced a series of credit-restraining decisions that quickly reverberated through all the credit markets. The Fed announced three measures: The discount rate -- the interest rate commercial banks pay when they borrow from the Federal Reserve -- was raised by one percentage point to 12 percent. Marginal reserve requirements were imposed on four different types of managed commercial bank sources of funds. These are funds that banks can bid for in the open market to finance new loans and investments. The Fed also abandoned the setting of a narrow target for the federal funds rate. This is the interest rate that commercial banks pay generally on day-to-day borrowings -- for the excess reserves of other institutions.
The increase in the discount rate was a traditional move. The imposition of marginal reserve requirements on managed bank liabilities had a few unusual features. But the abandonment of a narrow federal funds rate target in favor of a reserve growth target is an extraordinary and perhaps landmark monetary decision.
The Federal Reserve's decision came against a backdrop of mounting inflation, substantial growth of debt and excessive monetary creation. The fear of inflation was accelerating and encouraging all kinds of speculative investments in gold, commodities, real estate and other tangible assets, contributing to the vulnerability of the dollar in the foreign-exchange markets.
Why in spite of its best intentions had the Fed allowed a very rapid increase in the money supply and failed to arrest loose credit practices and the very rapid expansion of debt?
I believe that the central bank neglected to recognize the changing structure in our financial institutions, which gave institutional lenders the opportunity to take the money risk out of lending. More and more institutions were able to offset high-cost liabilities -- for example, deposits that they attracted by offering high interest rates -- with high-interest loans. As a result, the levels of the interest rates were no longer the powerful regulators of economic activity that they once were. The crucial factor was the interest rate spread between the cost of liabilities to financial institutions and the yield on their assets.
What will the Fed's landmark decision accomplish? It has already narrowed the gap between the rate of inflation and the level of interest rates. The abandonment of a federal funds rate target has introduced a substantial element of uncertainty that should slow the growth of debt. No longer can lenders rely on this financial benchmark in estimating the cost of their liabilities and the rate of return on their assets.
Within the coming weeks certain other events should unfold in the financial markets as a result of the Fed's new initiatives.
The growth of commercial bank lending should slow, although in the near term the demand for bank loans will probably continue to be strong. This demand, however, will at least have to be met partly by the banks through selling securities. This will contribute to additional pressure in the markets for U.S. government securities and especially municipal bonds, where commercial banks play a substantial investing and underwriting role.
Mutual savings banks will be less able to offset the higher cost of the interest that they pay on their deposits, therefore squeezing their declining income even more. Savings and loan associations, many of which have substantial mortgage committments to meet, will find it much more difficult to finance them profitably.
In the secondary market for fixed income securities, like bonds, trading will be accomplished at wider spreads between bid and asked prices. Bonds of medium or lower quality -- those representing less security -- will be under greater pressure and will be less liquid. That is to say that the people holding them will have less assurance that they can sell them whenever they want without taking significant losses.
For the economy, the new monetary approach will dampen speculative excesses, but it cannot prevent the drift into a bisiness recession next year. Nevertheless, the latest tightening actions should not be blamed for the recession next year. There were really no compromise choises available. The wage-price guidlines were making only a very marginal contribution toward the fight against inflation while the slowing fiscal stimulus was insufficient to deal with a dangerous situtation. Monetary hesitancy at this juncture would have contributed to a far more explosive and treacherous situation than just the onset of a business recession.