The Federal Reserve, seeing no recovery ahead for a desperately weak economy, has decided to ease credit conditions and force interest rates down in a significant shift of policy, sources said yesterday.
The Fed's decision, at a private meeting of its policy group on Tuesday, came just ahead of today's unemployment report, which is expected to show the jobless rate at 10 percent or higher for the first time since World War II.
Based on an extraordinarily gloomy assessment of the economy for the next three to six months, the Federal Reserve decided it must administer a shot in the arm to end the recession -- with lower interest rates and more cash at least for the immediate future.
The Fed is also increasingly worried about dangers to the banking system if the economy stays weak and interest rates stay high.
Despite the dismal outlook for the economy, stocks and bonds soared yesterday amid record-breaking volume, on hopes that the Fed will back off from strict monetarism and let interest rates fall further.
The Dow Jones Industrial Average climbed 21.71 points in the day to end at 965.97, with 147.07 million shares changing hands. Interest rates on long-term bonds plummeted, pushing up the value of long-term Treasury bonds by more than $25 for each $1,000 in face value, while major banks lowered their key prime lending rate to 13 percent from 13.5 percent.
Stock market volume was so heavy that the New York Stock Exchange tape fell behind as soon as the market opened yesterday, and by midday it was nearly 30 minutes behind trading. The market's close was the highest since July 1, 1981.
The Fed's action comes a month before the congressional midterm elections, which have become a referendum on President Reagan's economic policies. Many members of Congress and private economists have been pushing for a policy shift by the Fed which, they say, could revive the battered economy. Although the Reagan administration will likely claim credit if interest rates do fall and spark a recovery, the president has generally supported the Fed's tight money policy.
The Fed believes that its M1 money measure, which includes cash and all checking accounts, is going to be heavily distorted in coming weeks with a flood of money into people's accounts as the popular All Savers Certificates expire and banking changes in the wake of a new law just passed by Congress.
It has thus decided effectively to abandon its M1 money targets for the next few weeks and concentrate policy on interest rates and the broader M2 measure, which includes passbook savings accounts and money market funds, sources said.
The Federal Reserve was faced this week with deciding whether to tighten credit conditions in order to bring money supply growth back on target or whether to allow money to continue to overshoot its targets and attempt to bring interest rates down to aid the economy. The central bank's adherence to tight control of the money supply has been blamed for the persistent high interest rates that have pushed the economy into recession and kept it there.
Fed Chairman Paul A. Volcker announced earlier this summer that the Fed would "tolerate" above-target money growth for a short time if it believed that the money numbers were reflecting a change in people's banking habits rather than in the amount of spending money available. Earlier this year, when the money supply has been above target, the Federal Open Market Committee has always aimed at bringing it back into the target range over the period immediately ahead.
This week, however, Volcker argued strongly at the meeting of the Fed's policy making FOMC that the economy and the financial system needed lower interest rates and easier credit, regardless of the M1 figures, sources said. The FOMC decided not to try to bring M1 back into target in the next three months, sources said. Another source said that the federal funds rate, which influences all short-term market rates, may come down to about 7 percent from its present level of between 9 1/2 percent and 10 percent.
There was a feeling on the FOMC that the central bank now has sufficient credibility in the financial markets to ease up for a while without setting off new fears of inflation. Some monetarists have argued that any loosening of money would drive interest rates up rather than down, by increasing fears of future inflation. However, the recent above-target money growth has been accompanied by declining rates, and yesterday's market rumors of a Fed easing sent rates tumbling further.
Last night, economist Albert Wojnilower of the First Boston Corp., one of Wall Street's most respected analysts, said, "The Fed has taken a large step and maybe a giant one. I'm very pleased, even though it makes my own forecast wrong . . . . If the Fed had played the money supply game as they did in January, February and April, there would have been a disaster. Too many corporations are at the brink, and too many lenders were about ready to give up."
Wojnilower said financial markets have been assuming since mid-August that the Federal Reserve would not react to increases in money growth, or would react only in token fashion. But until this week, the market had expected the Fed would continue on the basic path of keeping money growth close to the target ranges rather than aggressively seeking to lower interest rates.
Volcker is to talk at a meeting of top businessmen on Saturday and the FOMC reviewed his speech at the meeting, indicating that he will talk about the Fed's policy shift, sources said.
The stock and bond rally has come this summer as economists have grown more and more pessimistic about the prospects for recovery. Markets have rallied on the hope that the weakness of the economy would lead to lower interest rates.
Further evidence that recession continued last month came yesterday with a Labor Department report showing new claims for state unemployment insurance close to record levels in mid-September. The 697,000 figure for new claims in the week ending Sept. 25 was higher than analysts had expected.
As the recession has gone on and unemployment climbed steadily to new peaks, the Fed has come under increasing fire from Congress for keeping interest rates too high and money too tight. There are bills in both the House and the Senate that would force the Fed to pay more attention to the level of interest rates when setting policy.
Volcker is known to have been disappointed that rates have stayed so high, despite declining inflation, and that the economy has remained so weak. He had expected a pickup in demand to begin before now. Instead, the Fed is now predicting a further decline in final demand. Firms will also likely start to work off a new bulge of unwanted inventories that were built up in hopes of a recovery this summer, the Fed economists believe.
President Reagan had predicted that the income tax cut of 10 percent on July 1 would spur consumer spending and recovery, but that has not happened.
The Fed has tried to control the money supply in an attempt to control total spending in the economy. But a new banking bill just passed by Congress will upset the money supply figures and may change their relationship to spending.
Treasury Secretary Donald T. Regan warned this week that the money numbers would be virtually meaningless for a while because of the new banking bill. This will allow banks and thrift institutions to set up a new deposit account to compete with the popular money market funds. While the new account will pay high interest and attract funds from savings deposits, it will also be readily convertible into cash.
Consumers may decide to shift money out of both checking and savings accounts into the new accounts, thus obscuring the underlying changes in deposits that show up in the different money measures. It is not yet clear how the new accounts will be classified by the Federal Reserve, whether they will count as part of M1, or just be included in M2.