Paul Volcker Superstar

The Fed chairman must cool off money growth without halting the recovery

The cameras rolled beneath the television lights, and nearly 200 standing onlookers strained to get a view. The object of all the attention was towering (6ft. 7½-in.) Paul Volcker, who was discussing the outlook for money growth and interest rates before a congressional committee that held hearings on his reappointment as Federal Reserve Board chairman. The rumpled, cigar-puffing Volcker has become the staid financial community’s first superstar. So great was the interest in his remarks that the 3½-hour session had to be moved from the Senate Banking Committee Hearing Room to the cavernous Caucus Room, the scene of the Watergate hearings and the Senate’s most ornate special chamber. Declared Republican John Heinz of Pennsylvania at one point in the hearing: “We’re lucky to have you as chairman.”

Volcker’s appearance had aspects of high drama, even though his reappointment is certain, because he now faces what may be his toughest test as head of the Federal Reserve. The task: to slow down the growth of money without killing the economy’s recovery. The money-supply measure known as M1, which consists of cash and bank checking accounts, has been growing recently at a blistering pace. The key indicator rose at an annual rate of 14.1% to $512 billion during the first half of the year, far above the Federal Reserve’s target range of 4% to 8%.

That runaway expansion is forcing the Fed to make delicate decisions. Volcker could push interest rates up sharply to slow money growth, but that would risk aborting the seven-month-old recovery. A big jump in credit costs could also cripple the ability of such borrowers as Brazil and Mexico to repay their U.S. bank loans. “We’re going through the moment of truth,” says Republican Congressman Jack Kemp of New York, a leading critic of tight-money policies. “What the Fed does now will determine the fate of the economy for the rest of the year, perhaps longer.” Kemp said that President Reagan should withdraw Volcker’s name from renomination if the Fed squeezes too hard.

Some economists, on the other hand, fear that the Federal Reserve will reignite inflation, which now is running at less than 5%, if it does not halt the M1 expansion. The Government reported last week that producer prices rose at an annual rate of 5.6% in June. A renewed outbreak of rising prices would boost interest rates and eventually slow the recovery. Asserts former Treasury Secretary William Simon: “Unless somebody bites the monetary bullet, we’re destined to pay the inflation penalty.”

In his testimony, Volcker sought to reassure both those who worry lest the Fed overreact to the monetary growth and those who fear that it will do too little. He acknowledged that the Federal Reserve has been tightening over the past six weeks, and hinted that it will continue to do so. But he denied that the Federal Open Market Committee, the central bank’s policymaking arm, had decided last week to clamp down hard on money. The day before Volcker testified, the twelve-member group completed a two-day meeting at which it determined guidelines for the next 18 months. “We haven’t taken any strong action recently,” Volcker insisted. “Anything I’d characterize as drastic isn’t going on at the moment.”

Minutes of the previous Open Market Committee meeting in May, released the day after Volcker’s testimony, revealed that the group has turned into a battleground in recent months. The committee voted 7 to 5 during the May session to curb money growth moderately. Volcker had led the majority.

Little can be known for certain about last week’s Open Market Committee meeting until the minutes are published at the end of August. Volcker, however, may reveal some policy guidelines this week when he testifies to congressional committees about the group’s money targets for the year.

Volcker told the Senators at his reappointment hearing that the Federal Reserve is not overly concerned about the speedup in M1 growth, because it believes the rate of expansion is largely due to technical factors. Since June 1982, more than $34 billion has poured into interest-paying checking accounts, the so-called NOW and super-NOW accounts. The Federal Reserve argues that this development has distorted the M1 numbers and that money is really not growing as fast as statistics suggest. Some economists now consider M1 to be virtually meaningless. “It’s a rubber yardstick,” says Anthony Frank, president of First Nationwide Savings in California.

Other experts say the entire subject of money growth is filled with confusion. “Put half a dozen economists together in a room, and they couldn’t tell you what M1 really is,” says John Paulus, chief economist for the securities firm of Morgan Stanley. While Paulus estimates the true gain in M1 is smaller than the numbers suggest, he believes that moderate tightening is still needed.

Volcker did manage to startle some members of the Senate Banking Committee with one brief reference to his own future. Asked whether he would serve a full four-year term if reappointed, he replied, “I do not feel committed to do so.” Democratic Senator William Proxmire of Wisconsin said he was “somewhat shaken” by that admission. Volcker indicated, however, that he would stay on for at least two years. Volcker believes that the four-year terms of the Federal Reserve chairman and the President should roughly coincide. By leaving in two years, he would allow the next President to name his own man to the Fed near the beginning of the term.

Whatever happens to interest rates will have an impact on Wall Street. The stock market’s bull market of 1982 was set off when the Open Market Committee voted last August to ease Committee policy, and the market has been reacting nervously to rumors of higher rates. Investor fears that Fed tightening would boost interest levels caused the Dow Jones industrial average to drop 14.92 points last week, to close at 1192. The Reagan Adminstration, which fears that tight money could brake the recovery, has been making some clumsy attempts to influence the Federal Reserve’s policy on interest rates. White House Spokesman Larry Speakes said last week that the Administration opposes any increase in the discount rate, which is the interest the Fed charges on loans to its member banks. A boost in the rate, which has been at 8½% since January, is unlikely, however, because it would indicate a strong shift in policy. Concedes a Fed official: “Nobody wants to send a signal of a tough new policy. At least not at this time.”

Some key interest rates have started moving up in recent weeks (see chart). The level of three-month Treasury bills has climbed from 8.2% to more than 9% since May. The average cost of a home mortgage has risen from 12.6% to 13.3% over the same period. Asserts Harry Pryde, president of the National Association of Home Builders: “The housing-led recovery is in imminent danger of collapsing.”

Interest rates are actually being pushed up mainly by heavy Government borrowing to finance huge budget deficits, which could reach $220 billion this year, rather than by the Federal Reserve’s attempt to slow economic growth. The Treasury tapped credit markets for $41.5 billion during the second quarter, an unprecedented amount in a normally slack period. The Treasury borrowed just $11.7 billion in the second quarter of 1982.

The deficit will remain a stubborn obstacle to holding down interest rates. “You can’t talk of monetary policy in a vacuum without reference to the enormous debt level and to the responsibility of Congress and the President,” says Harry Freeman, a senior vice president of Shearson/American Express. “Volcker is being asked to keep interest rates down when he only has part of the action.” Congress continues to fail to cut the fiscal 1984 budget deficit below the projected $180 billion. The Senate last week approved funds for the B-1 bomber and chemical-weapons systems. The House passed a new $15.6 billion housing authorization that will maintain the spending level of existing programs. Meanwhile John Chapoton, Assistant Treasury Secretary for tax policy, predicted that Congress will be unable to pass any substantial tax increases in the next two years.

Despite the prospect of moderately higher interest rates in the near future, economists are hopeful that the recovery will stay on course. “We have an economy that is bursting with energy,” says Allen Sinai, a senior vice president of Data Resources, an economic forecasting firm. A new crop of 3 Government reports indicated last week that the strong upturn is continuing. U.S. industrial production rose 1.1% in June, the seventh monthly increase in a row, while June retail sales gained .7%. Says Walter Heller, chairman of the Council of Economic Advisers under Presidents Kennedy and Johnson: “A percentage point increase on the interest rate would not abort the expansion because it’s got a lot of speed—but then it needs a lot of speed.” He added, however, that “it would be dangerous to tighten too much.” Observes Alan Greenspan, who was President Ford’s chief economic adviser: “Higher interest rates now will have very little effect on the short-term economic recovery.”

If interest rates continue to rise, Volcker will probably be blamed, even though the cause may be fiscal rather than monetary policy. Senator Proxmire told the Federal Reserve chairman last week that in his new term he would face “condemnation, denunciation, criticism.” Said Proxmire: “You start off with the warm approval of almost everyone, and with the blind high hopes from everyone that somehow you can keep interest rates down.” But Proxmire added that this was impossible in view of federal budget deficits. Even superstars cannot do the impossible. Said Proxmire: “You just won’t do it. You can’t. No one could.”

—By John Greenwald.

Reported by David Beckwith/Washington and Bruce van Voorst/New York