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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