"Is the Federal Reserve easing its stance to help the Reagan administration get reelected? Certainly not."
When interest rates start falling shortly before an election, as they have recently, questions naturally arise about whether the Federal Reserve is taking steps to help the incumbent stay on in the White House. There has been recent speculation on Wall Street that the Fed may be relaxing its monetary stringency. And there is no more of the sniping at the Fed that some Treasury officials and White House aids turned to last May when they were frustrated by continuing high interest rates.
Is the Federal Reserve easing its stance to help the Reagan administration get reelected? Certainly not. There has been no departure this year from the Fed's general strategy o trying to keep the increase and the money stock within a pre-specified target range. This policy of targeting the increase in the money stock was first adopted by Paul Volcker in late 1979 to avoid the continuation of the disastrous results of the previous policy of trying to control interest rates. And this policy has been largely responsible for the reduction in inflation since 1981.
The data show no evidence of an easing in monetary policy in recent months. Last fall, the Fed said it would aim to keep M1 -- the basic measure of the money supply that consists of cash and checking accounts -- increasing at a rate of between 4 percent and 8 percent in 1984. During the past several months the actual stock of money has drifted toward the lower end of this range. If anything, money has actually become a bit tighter in the past few months than it was earlier this year.
Although there appears to have been no shift toward an easier monetary policy, several key interest rates, including the prime rate charged by banks and the interest rates paid on Treasury bills and commercial paper, have recently fallen significantly. Why?
Interest rates are falling because the pace of the economy's expansion is slowing down. Real GNP growth has dropped from 7.1 percent in the second quarter of this year to only 2.7 percent in the most recent quarter. With slower growth, there is less demand for money and credit, and interest rates can ease. The reduction in the rate of growth from the frantic pace earlier this year also means that the recovery can be sustained without a return to the kind of double-digit inflation that would send the interest rates soaring again.
While the recent slowdown has been a healthy development for the economy, the Fed will be watchful that its monetary policy doesn't put a further rein on growth that could prove harmful to continued expansion. Just as excessive monetary expansion is inflationary, an inadequate supply of money can put a brake on economic activity. Right now the Fed has the leeway to increase money a bit faster in order to get the money stock back to the midpoint of the target range.
The likelihood that the Fed will expand money a bit faster during the next few weeks also helps to explain the recent drop in interest rates. Financial markets always reflect expectations as well as actual conditions. The expectation of an intentional easing of money in the near future is already reflected in lower interest rates.
But the Fed is unlikely to ease money too much. The painful lesson of the 1970s was that excessive monetary expansion aimed at lowering interest rates only leads to increased inflation. That policy is also self-defeating, because interest rates rise right along with inflation. Paul Volcker is certainly not the man to ignore that lesson. Nor is Ronald Reagan. The president has supported Volcker's policy despite contrary advice from some of his natural allies in Congress and in his own administration. It was the president who called off the administration's Fed-bashers last spring and publicly backed the Fed's strategy.
Even though the president put a quick end to those attacks on the Fed, grumbling has continued from those extreme supply-siders who think naively that more money can generate faster GNP growth and lower interest rates for the remainder of the decade. Why can't these politicians understand the danger of excessive money growth?
Subduing inflation has been one of the chief economic accomplishments of the past four years. If voters do feel better off today than they were four years ago, one sure reason is the reduction in inflation. This achievement mustn't be squandered because of a misunderstanding of the nature of economic growth or of the causes of high interest rates. Faster economic growth can only be achieved through increased supplies of capital and labor and through improvements in technology. And real net- of-inflation interest rates will remain high as long there is an extraordinary pressure of demand for credit to finance the huge federal budget deficit.
The only way to get real interest rates down significantly from their current level without harming the recovery is to deal with the deficit. If the president and Congress get together on a substantial deficit-reduction program next spring, interest rates will fall just in the expectation of greater future credit availability. And interest rates will continue to move back toward their lower historic levels as those expectations become reality. That's the surest path to higher growth and a sounder economic future.