Volcker Is on the Spot Again

Will stronger growth force the Federal Reserve to raise interest rates?

Ever since the recovery began in December 1982, economists have been scanning the horizon for shoals that could endanger or wreck growth. Last week a couple appeared, and it will require some expert seamanship by policymakers to keep the economy on course. Early in the week, big U.S. banks boosted the bench-mark prime rate from 11% to 11½%, the first such increase in seven months. The very next day, the Commerce Department weighed in with a “flash estimate” showing that the gross national product in the first quarter is rising at the unexpectedly brisk annual rate of 7.2%.

The G.N.P. announcement touched off fears of an overheated economy that could bubble over into higher prices—fears that were not stilled by the report at week’s end that the consumer price index rose only a modest .4% in February, a smaller increase than in January. If rapid growth continues and prices climb, the Federal Reserve can be expected to push up interest rates. They might eventually go high enough to cause a repetition of the spiral of 1980-81, when the record cost of borrowing brought on the 1981-82 recession.

The interest-rate hike and fears about more to come sent the Dow Jones industrial average down nearly 30 points during the week, after a 44.60-point rise the week before. It finished at 1154.84. Shaky for months, bond prices weakened again. As the markets fluttered, analysts and investors turned once more to their favorite sport: watching the Federal Reserve Board’s every move. The policymaking Open Market Committee is due to meet early this week to review the state of the economy and set interest-rate guidelines, and many moneymen fear that it will tighten up rates because of the first quarter’s strong growth. Federal Reserve Chairman Paul Volcker conceded last week that the economy is facing a “critical period.”

The 7.2% leap in the first-quarter G.N.P. took virtually all economists by surprise. Only two weeks ago, a survey of 48 forecasters by Blue Chip Economic Indicators, a Sedona, Ariz., newsletter, produced a consensus prediction that growth would be only 5.7% during the period. Observed Charles Schultze, a chief economist under President Carter: “In hindsight, it is surprising to see the continued strength of housing, the auto industry and business investment in the face of such high interest rates.”

Still, the first-quarter surge is viewed as an aberration. In part, it was fueled by high levels of construction and retail sales in January, caused by extremely cold weather in December that pushed some of the usual business from that month into the next. Government economists also note that automotive assembly plants have advanced production from late spring into the first quarter in anticipation of shutdowns for new-model retooling. In addition, farmers got a one-shot boost during the quarter from the payment-in-kind program, which will not be repeated. Economists generally expect that the first quarter will be the year’s strongest, and that growth during the second quarter will run around 4.4%.

Reagan Administration officials insisted that the sudden growth was not worrisome. Commerce Secretary Malcolm Baldrige called it “a temporary acceleration in the expansion.” Concurred Martin Feldstein, the President’s chief economic adviser: “I’m not worried about overheating at this time.”

Private economists agree. As Irwin Kellner, chief economist of New York City’s Manufacturers Hanover Trust, points out, unemployment remains at 7.8%, well above the 6% at which labor shortages might begin to push up prices. Factories are operating at only 80.7% of capacity, so there is room before production bottlenecks occur that might create inflationary pressures.

Unlike the G.N.P. figures, the upward move in the prime rate was expected. In fact, it was overdue. Most other short-term interest rates have gone up over the past few months. Three-month Treasury bills, for example, have risen .75%, to 9.65%, since the beginning of the year.

Nobody knows whether the prime-rate hike signals the start of a new run-up in the cost of borrowing. Manufacturers Hanover’s Kellner insists, “There is plenty of money out there. Loan demand only recently began to rise.” Others see the prime rate continuing to climb, perhaps reaching 13% by year’s end.

The course of interest rates and the economy depends on two imponderables. One is action by Congress on the federal deficit. Two weeks ago, President Reagan and Senate Republican leaders agreed on a threeyear, $150 billion deficit-reduction package. Democrats are working on a plan for slightly deeper cuts. Nonetheless, the deficits will remain huge. The Congressional Budget Office reported last week that even if the $150 billion project is adopted, the deficit will be $198 billion in fiscal year 1987. Such heavy federal borrowing will keep pressure on interest rates. Economist Robert Gough of Data Resources, a Lexington, Mass., economic-analysis firm, warns, “The business community is beginning to be crowded out of the credit markets, and I think we will see some slowdown in business spending in the months ahead.”

Once again the Federal Reserve faces a dilemma. Explains Washington Econo mist Michael Evans: “If the Federal Reserve tightens now, it runs the risk of stop ping the recovery. If it waits and tightens later, it may be closing the barn door after the horse of inflation has left.”

Some conservative economists are urging the Federal Reserve to keep down the money supply with higher interest rates to prevent more inflation. They fear that signs like last week’s $4 billion jump in the basic money supply point toward sharp price increases later in the year. In deed, Salomon Bros. Economist Henry Kaufman expects the discount rate, the price the Federal Reserve charges mem ber banks for loans, to rise a full percent age point in the next two months. Others contend that since the money supply has been growing within its announced target range of 4% to 8%, there is no need to clamp down.

One top Federal Reserve official maintains that the central bank will raise rates if the money supply rises significantly above its targets. But he seems unperturbed about the sudden growth in the G.N.P., saying, “I’m somewhat surprised at the strength of the economy but will be terribly concerned only if growth reaches 10%.” This week moneymen and the financial markets will be peering at the Federal Reserve meeting in the hope of getting a hint about future interest-rate trends.

—By Alexander L. Taylor III. Reported by Jay Branegan/Washington and Adam Zagorln/New York