The Volckernomics Puzzle

By Christopher Byron

High hopes for lower interest rates cause another wild week on Wall Street

Was it the long-awaited end to three years of tight money and high interest rates, or was it a risky short-term maneuver by the Federal Reserve Board to bolster the alarmingly depressed U.S. economy? Would interest rates continue falling or would they soon begin inching up again? Those were some of the questions businessmen, investors and economists asked last week as the stock market leaped then lurched, and interest rates plunged then firmed.

The cause of all the questions was the belief that the Federal Reserve had decided to lower interest rates in an attempt to stimulate economic growth. Discussion about a possible policy change had been building on Wall Street and among economists since midsummer, as analysts looked at the steadily deteriorating economy and worried about a looming depression unless interest rates dropped quickly. Said Steven Einhorn, a vice president and market strategist for the investment banking firm of Goldman, Sachs & Co.: "We reasoned that the Fed would have no choice but to ease up because the consequences of not doing so were simply too serious to contemplate."

Two weeks ago, the Open Market Committee, the Federal Reserve's policy-making group, voted, in effect, to confirm that it was temporarily loosening up on tight-money policy so that the economy could begin growing more rapidly. Said one official somberly: "We could not afford to wait another five or six weeks." Although he insisted that this was only a minor technical change with "zero policy significance," Federal Reserve Board Chairman Paul Volcker confirmed the shift during a weekend meeting of business leaders in Hot Springs, Va.

The effect on Wall Street was stunning. Barton Biggs, chief investment strategist for the Morgan Stanley & Co. investment banking firm, was enthusiastic: "This now raises the chances of a normal recovery, with 6% or 7% real economic growth next year, along with declining interest rates and inflation. In other words, we may end up with the best of both worlds."

As soon as the New York Stock Exchange opened for business last Monday, buy orders poured in by the thousands. At day's end 138.5 million shares had changed hands, driving the Dow Jones industrial average up 25.94 points. For the first time in more than a year, that closely watched index finished above the 1000 level, at 1012.79. As the week progressed, big institutional traders like banks and pension funds were joined by more and more individual investors, who streamed in to catch the action.

But by Thursday, the rally had started to lose steam, sending the Dow Jones index skidding more than 18 points. By week's end the Dow had slipped below the 1000 level, closing at 993. Meanwhile, analysts had begun to warn that little was fueling the buying binge except the fervent hope that lower interest rates would eventually lead to economic growth.

The Reagan Administration welcomed the shoot-the-moon investment frenzy, even if it might turn out to be fleeting. Treasury officials predicted that lower interest rates would clear the way for at least a modest recovery in 1983. Said one top Treasury Department official: "The logjam has been broken. I do not think the Fed has changed course significantly, but if this is the psychological reassurance the market needs, we'll take it."

For Wall Street investors, of course, the easing interest rates were visible proof that there had been a shift in the policy adopted by Volcker three years ago this month. At the time, the Fed chairman had declared that he would henceforth place less importance on regulating the level of interest rates in the economy and attempt more directly to control the growth in money. He argued that such a program was essential for bringing down the runaway inflation that was destroying the value of the dollar abroad and creating chaos in the U.S. economy.

Critics quickly dubbed the policy Volckernomics and accused the Federal Reserve of fostering recession and unemployment through high interest rates. In its primary goal of curbing inflation, the approach has been dramatically successful. The annual rate of inflation as measured by the consumer price index has gone from 15% in the autumn of 1979 to about 5% at present. In September, prices charged by producers actually declined at an annual rate of 1.7%. Market watchers have in fact been noticing a shift in Federal Reserve policy for several weeks. The central bank has chopped the important discount rate, which is what it charges banks to borrow money, from 14% a year ago to 9.5%, the lowest level since June 1979. In addition, the Federal Reserve has allowed the money supply to expand during the past month at an annual rate of 14.5%, which, if permitted to continue, will force average growth rates far above the Fed's own official 5.5% target.

As a result of this loosening of money policy, the cost of funds borrowed from the Federal Reserve by commercial banks has begun to drop, enabling the banks to cut their rates to customers. The prime rate that banks charge corporate clients stood at 16.5% in early July before starting to decline. Last week it fell another percentage point to 12%, its lowest level in more than two years.

The dilemma for the Fed now is just how long the money supply can keep on growing rapidly before inflation begins to heat up. After all, monetarists have long contended that it was excessive money growth during most of the 1970s that fueled the high inflation of that decade. Indeed, if the economy is perking along and prices are beginning to inch up early next year, the Federal Reserve may find that it will have to tighten credit in order to preserve its hard-won gains in the price fight. That, some economists fear, could force interest rates back up and abort a recovery before it really takes hold.

On the other hand, if inflation picks up and the Federal Reserve does not act, investors might see it as a signal that the central bank is no longer concerned about inflation. That, in turn, could lead to a loss of confidence in both stocks and bonds, forcing securities prices down and interest rates back up all over again. Notes H. Erich Heinemann, a monetary analyst for Morgan Stanley & Co.: "I think there is a palpable risk that real interest rates will begin rising again before Thanksgiving, and that if this happens, the nascent economic recovery could quickly dissipate."

A growing number of economists are now beginning to disagree, asserting that the very weakness of the economy leaves plenty of room for the Federal Reserve to expand monetary growth without risking inflation. Some, however, are uncertain just how willing the Fed will be to apply the stimulus necessary. Says David Levine, chief economist for the investment firm of Sanford C. Bernstein & Co.: "It is one thing to ease aggressively when the economy is in the tail end of a recession, and another to maintain an accommodative posture when the economy is in the sixth or ninth month of recovery, and the money supply is far above target."

Federal Reserve officials agree that at least some easing of monetary restraint is possible without refueling inflation because the economy remains so weak. Unemployment stands at 10.1%, U.S. factories are operating at less than 70% of capacity, and last week the Government announced that industrial production in September fell .6%. Those officials argue that even with some easing on rates, business will grow only moderately next year. Said one top policymaker: "We believe that if you do not run an overheated economy, we can continue to make progress on inflation."

While welcoming the lower rates, some Federal Reserve critics were skeptical about the timing, suggesting that the new policy was an election-year ploy. Said Allan Meltzer, a professor at Pittsburgh's Carnegie-Mellon University: "This could be a political move to help the Administration just before the congressional elections." Fed officials bridle at such statements. Said Volcker: "That preelection easing has somehow become part of American folklore."

In private, Federal Reserve staffers insist that it was only .he pressing weakness of the economy and the confusing signals coming from their own statistics that led them to act. The confusion is caused mainly by the maturation of $31 billion in All Savers Certificates beginning this month, which is now distorting the figures for money growth. Meanwhile, Federal Reserve aides had little but disdain for what they regarded as Wall Street's overreaction. Said one top Fed official: "The traders are like sheep. They are afraid of looking silly by being left behind, so they all move together."

Three years ago, Paul Volcker set out to bring about a major decline in inflation without causing a collapse of the economy. The fight against inflation has gone well, but the cost has been high in terms of slumping output and surging unemployment. Now Volcker faces the toughest task of all: to ease interest rates and stimulate growth without firing up inflation all over again.

--By Christopher Byron.

Reported by David Beckwith/Washington and Adam Zagorin/ New York

With reporting by David Beckwith, Adam Zagorin

This file is automatically generated by a robot program, so viewer discretion is required.