Fed likely to keep its foot lightly on the brake of US economy

While delegates to the Democratic National Convention are busy choosing their party's standard-bearers, the Federal Reserve will be choosing monetary policy options for the coming months.

The 12-member Federal Open Market Committee (FOMC) will meet today and tomorrow to set targets for credit conditions in the next several weeks, and will also establish preliminary money-growth objectives for 1985.

While the Democratic gathering is sure to be more colorful, the FOMC sessions will have a significant impact on the course of the economy in coming months. The monetary policy directions the FOMC sets play a key role in determining how fast the economy grows and whether the growth will be accompanied by inflation.

''It will be a pretty important meeting,'' says Deborah Johnson, economist at Prudential Bache Securities Inc. With the US economy growing faster than many forecasters had expected, the session's outcome will let analysts see if ''the Fed, in an election year, is strict as far as wanting to keep inflation down,'' she says.

At this week's meeting, many forecasters expect the Fed to react to strong economic growth and tighten up on credit conditions a bit in the near term. ''The result would be some upward pressure on short-term interest rates,'' says Harold C. Nathan, a vice-president at Wells Fargo Bank in San Francisco.

But other analysts expect no change in short-term Fed policy. Alan Sinai, chief economist at Shearson Lehman/American Express Inc., lists several factors that point away from the Fed's tightening credit: noninflation-adjusted growth in the gross national product of 8 to 9 percent; M-1 and M-2 (money supply) within Fed targets; and ''bank system fragility.''

A minority of Fed-watchers are recommending - but not predicting - easier credit conditions to avoid a period of deflation, a period when the purchasing power of money would rise. They point to the drop in gold and certain other commodity prices and the soaring value of the dollar on foreign-exchange markets.

While the Fed's plans for the rest of 1984 are a matter of debate, most economists expect the monetary authorities to set somewhat lower targets for money growth in 1985 - perhaps half a percentage point or so on the various money measures - than were in effect this year. The Fed's aim, these analysts say, is to slow economic growth, as excess capacity in the economy diminishes and the economic recovery ages.

The Fed's policy choices are constrained by conflicting goals. Monetary policymakers are expected to try to steer a course between a desire to slow the economy's growth to prevent inflation from reigniting, and the need to keep interest rates from rising so much that Latin American debtor nations plunge into default and drag some US banks down with them.

Signs of the economy's continuing strength came Friday, when the government reported that retail sales rose at a seasonally adjusted 0.8 percent, while industrial production posted a 0.5 percent gain. Inflation, as measured by the producer-price index, was well behaved, with finished-good prices in June unchanged for the third consecutive month.

Those analysts who expect the Fed to tighten money supplies at this week's meeting are not predicting a radical shift in policy.

''Further modest restraint will probably carry the day,'' says Paul W. Boltz, vice-president of T. Rowe Price Associates Inc. He sees the FOMC ratifying an increase of one quarter to one half a percentage point in the upper range for the federal-funds rate, the fee banks charge each other for short-term loans. When the federal funds rate rises, banks typically raise the rates their customers must pay for loans.

FOMC members may have talked by telephone in the last two weeks and agreed to let the federal-funds rate rise. Fed funds averaged 11.25 percent in the week that ended Wednesday. The last ceiling announced by the Fed was 11 percent, Mr. Boltz notes.

''They are not going to tighten overtly (at the FOMC meeting), they already have. They did it in a telephone conversation in the last two to three weeks,'' adds David Berson, a Fed watcher at Wharton Econometric Forecasting Associates. He expects the new Fed fund's ceiling to be set at 12 to 12.5 percent, and he predicts that within the next two months, short-term interest rates will move up by half a percentage point. By year's end, he sees long-term government bonds yielding over 14 percent. Thirty-year Treasury bonds closed last week priced to yield 13.05 percent. Prudential Bache economist Johnson expects long-term government bonds to hit 15 percent by the year's end. She also expects the Fed to lift the discount rate from its current 9 percent level to 9.5 percent. The discount rate is the fee the Fed charges member banks for funds they borrow and is important as a signal of Fed policy intentions.

The slightly tighter monetary policy many observers expect to come from this week's FOMC meeting will follow what most analysts say was earlier tightening action taken at the FOMC's May 22 meeting. The FOMC meets in secret and issues minutes of its meetings only on a delayed basis.

Some clues as to the current direction of Fed policy will come July 25 when Federal Reserve Board chairman Paul Volcker testifies before the Senate Banking Committee.

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