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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.