Federal Reserve officials, faced with an economic recovery they believe could speed out of control, will tighten credit conditions next week and let interest rates rise, according to Federal Reserve sources.
Rates already have been going up as financial market participants have anticipated just such a step at a meeting next Tuesday and Wednesday of the Fed's policymaking group, the Federal Open Market Committee.
Some short-term rates are more than a full percentage point higher than they were in mid-May. Long-term rates, including those for home mortgages, also are rising. Any tightening by the Fed would quickly boost all those rates, along with the prime lending rate at banks.
The Federal Reserve moves likely will include soon, if not initially, at least a one-half percentage point increase in the central bank's 8 1/2 percent discount rate, the sources said.
The discount rate is the rate the Federal Reserve charges when it lends reserves directly to financial institutions.
Some senior Reagan administration officials, including Treasury Secretary Donald T. Regan and the chairman of the Council of Economic Advisers, Martin S. Feldstein, also are worried about the pace of the recovery and have encouraged the Fed to act to slow it down, the sources said.
Federal Reserve officials also have all but written off the possibility of any meaningful reduction in the federal budget deficit this year or next--a point underscored in their minds by the 10 percent reduction last week in withholding for personal income taxes.
The greater the deficit, the greater the Treasury's borrowing and the resulting upward pressure on interest rates.
Thus, if the recovery is to be slowed down, it will be up to monetary policy alone to do the job, Fed officials have concluded.
At the May meeting of the open market committee, a number of the 19 members wanted immediate action to slow the rapid growth of the money supply, one measure of which--M1--is far above the target range set for it. But other members were not convinced that the fast expansion of money was primarily due to an unexpectedly strong rebound in the economy.
As a result, it was agreed that the Fed would continue to supply the banking system with the reserves required as a consequence of the rapid money growth. The minutes of that meeting will be released on July 15.
However, since that meeting, all the economic indicators have pointed toward a recovery steadily speeding up.
If credit conditions are not tightened, the Fed staff now expects the economy to expand at a 7 percent annual rate or more during the second half of the year, or roughly as fast as it did in the quarter just ended, the sources said.
Growth that rapid would be faster than any of the open market committee members had expected for 1983. While there are few signs of any significant revival of inflation at the moment, Fed officials are afraid such a speedy recovery could generate new inflationary pressures by next year.
In short, the officials believe a modest tightening of credit conditions at least might avoid more stringent actions, and a potential interest rate spike, next year.
"It may be better to deal with this monetary expansion now, rather than have to do more later," one Fed official said.
While the open market committee makes basic monetary policy decisions and regularly discusses the level of the discount rate, that rate itself is set separately by the seven Fed governors rather than by the larger committee, of which they are part.
The strength of the recovery, according to the officials, both makes necessary some action to slow it and makes taking that action acceptable. If the Reagan administration's recently revised forecast, which shows real gross national product rising at about a 6 1/2 percent rate in the next six months, or the higher Fed staff forecast is correct, then a moderate rise in interest rates would not seriously hurt the recovery in the short run, the officials maintained.
"From the domestic side, this does not have to be dealt with gingerly at this point," one official said.
Several private economists, including Alan Greenspan of Townsend-Greenspan & Co., also have said that they doubt that a moderate increase in rates would damage the recovery this year. "After that is another matter," Greenspan said recently.
Many analysts have assumed that the fragility of the international financial system, burdened as it is by massive debts of hard pressed developing nations, would prevent the Fed from taking steps that would mean higher rates.
Yesterday, in fact, Jack Lavery, Merrill Lynch's chief economist, told the firm's sales force that "international considerations will remain central" in Federal Reserve Chairman Paul A. Volcker's mind at this time and that "he will refrain from dramatic tightening" of credit conditions.
The Fed officials acknowledged that international considerations--including the damage that the high value of the dollar on foreign exchange markets does to the U.S. trade balance--run nearly opposite to the domestic ones. By attracting more foreign capital to the United States, high interest rates help keep the dollar's value higher than it otherwise would be.
"If rates go up noticeably, you affect the atmosphere at the banks and in the countries . . . you affect the confidence that everything will come out well in two years or so," one official said of the developing nations' debt problems.
Nevertheless, that official and others at the central bank are not prepared to ignore problems that could develop in this country for the sake of those international considerations. For one thing, the worsening U.S. merchandise trade deficit itself is helping some of the developing countries increase their own exports and hence their ability to pay their outstanding debts.
Also, most of the financial programs developed for dealing with the international debt problems assumed interest rates levels close to where they are now, officials said. Rates earlier were about three-fourths of a percentage point lower than had been assumed.
During most of the first half of this year, officials at the Fed and most private analysts have been uncertain whether the rapid growth of M1--the money measure that includes currency in circulation, checking deposits at financial institutions and travelers checks--was a serious matter.
Regulations had been changed allowing new types of deposits that distorted some of the money measures, and even the basic relationship between money growth and economic activity had been thrown off track in 1982.
In addition, the broader monetary aggregates, M2 and M3, which include savings deposits and other items, were growing much more in line with Fed intentions.
Now most Fed officials seem convinced that M1 is growing precisely because the economy is growing, although the old link between the two has not been reestablished.
Meanwhile, the broader monetary aggregates also appear to have risen much faster in June, officials said.
"With the budget situation, the faster recovery brings the financial problems sooner," a Fed official said. "We are not jumping up and down about one quarter. You expect to have a big quarter or two. But I don't think you can pass this off as that, and certainly not with the tax cut.
"We are in a zone in which the risks are much more balanced" between a too rapid and a too slow recovery.
"A momentum could develop that would be harmful," the official said.