The recent decision by the Federal Reserve Board's Open Market Committee not to apply monetary brakes despite a surge in the money supply since last winter is not only a major shift in monetary strategy but also a daring gamble.
The strategy may provide just the stimulus the economy will need to maintain the recovery in l986. But it carries with it the risk of a sharp increase in inflation, especially if significant deficit reduction is not forthcoming.
In testimony to the House Banking Committee, Fed Chairman Paul Volcker sketched out the background conditions leading to the policy change. During the first half of this year, the basic measure of the money supply, M1 -- or currency and checkable deposits -- has increased much more rapidly than anticipated. An after April that increase became even more pronounced.
The response of the Fed to this increase in the money supply has been unusual, though not unprecedented. The normal Fed reaction to unexpectedly rapid growth in money should be to take counteractive, contractionary measures. Instead, the Fed has said, in effect, let's start all over -- let's keep the same general target range for the money growth rate that was set at the beginning of the year, but start that growth from the new, higher level of the money stock that resulted from the rapid increase of money since the year began.
For the rest of this year, the Fed will aim to keep the annual rate of increase of M1 in a range of 3 to 8 percent. But because that increase is now starting from a higher level, the increase in the money stock for 1985 as a whole will be more than 8 percent, even if the Fed is able to stay at the midpoint of its target range for the remainder of the year.
The element of danger in this new strategy is that such a large and rapid increase of money could lead to a significant rise in inflation. If the historical relation between money and future inflation were to hold in the months ahead, the increase of 8 percent or more in money this year would mean an inflation rate next year of at least 6 or 7 percent This would be a serious setback after three years in which inflaton has been held to 4 percent.
Why is the Fed pursuing such a risky course? The case for rebasing the target rests in part on the belief that there has been a temporary shift in the relation between inflation and money. In his testimony, Chairman Volcker speculated that individuals and businesses have shifted their preferences toward holding more of their assets in cash and checking accounts.
But the case for believing that such a temporary shift has occurred in the demand for M1-type assets is far weaker than it was in l983, when the Fed previously reset the base for monetary growth. At that time there were major changes in banking regulations to explain the shift in the demand for money. The introduction of nationwide NOW accounts and changes in the rules for money market deposit accounts then caused a surge in M1.
This year there have been no such regulatory or institutional changes. The argument for rebasing monetary targets this year is therefore much riskier.
The Fed undoubtedly decided to take this risk because of the current very low rate of inflation and the fact that the economy has grown at an annual rate of only 1 percent in the first half of this year. This is significantly less than was expected when the Fed set its previous monetary targets.
If there has indeed been a shift in the desire to hold assets in currency and checking accounts, then failure on the Fed's part to accommodate that preference change by a more rapid increase in the money supply could act as a drag on the economy, pulling it down to an undesirably slow rate of growth.
Since there are further reasons to worry about a slowdown of the economy in 1986, the Fed has evidently felt that monetary expansion is the best strategy for balancing the risk of inflation on one side and slower growth on the other.
This policy of monetary ease may be just what is needed to forestall the contractionary effects of the hoped-for reduction in the federal deficit. While deficit reduction is essential for the long- term health of the economy, there is no denying that the direct effect of reductions in government and consumer spending is contractionary.
It takes time for the stimulative effects of lower interest rates and increased demand for investment and net exports to be felt. The Fed's action now reduces the risk of a downturn in l986 -- assuming that deficit reduction does occur.
But by the same token, if Congress and the president fail to achieve a substantial deficit reduction program, Paul Volcker will lose his bet. Without a major reduction in the deficit, Volcker's gamble to ease up on money could add increased inflation to the existing woes of a lopsided recovery.