Fed treads cautiously in crafting '85 monetary policy. One analyst says central bank's next step is likely to be more restrictive

The Federal Reserve Board is generally pleased with the economic outlook for 1985, Fed chairman Paul A. Volcker told Congress Wednesday. In light of this, the Fed has stopped easing credit conditions and is being slightly more cautious in its policy actions to avoid overstimulating the United States' economy, Mr. Volcker said in his semi-annual report to Congress.

``Economic growth is expected to remain strong enough in 1985 to produce some further decline in unemployment, with little if any pickup in inflation,'' Mr. Volcker told the Senate Banking Committee.

The central bank has adopted a monetary policy course of ``steady as you go, for the near term,'' says David Jones, chief economist at Aubrey G. Lanston Company Inc., a major dealer in government securies. For the next month or two that means the Fed is not seeking a major change in credit-market conditions or interest rates.

But the move away from actively trying to ease credit-market conditions means the next policy step is more likely to be ``restraint rather than further ease,'' Mr. Jones notes.

Volcker disclosed that the Fed has ended a move, started in the latter part of 1984, to provide banks with more lendable funds and thus to lower interest rates. The main way the Fed affects banks' reserves is by buying or selling government securities.

``The progressive process of easing [banks'] reserve positions, undertaken in the latter part of 1984, has ended,'' Volcker said. He asserted that this did not mean the Federal Reserve necessarily was moving to tighten credit.

The Federal Reserve has ``been a bit more cautious in providing reserves'' to the banking system, he said. The goal is to ``guard against inadvertent `overshoots' in supplying reserves'' to banks, Volcker said. ``I would not call that a tightening at this point, but a little more cautious.''

But if the economy continues to grow as expected and the Fed's current stance remains unchanged, interest rates would tend to rise slightly as demand for credit increases, notes David Berson, senior economist at Wharton Econometric Forecasting Associates.

At a meeting of its policy-setting Federal Open Market Committee (FOMC) last week, the Fed adopted only minor changes in its targets for money growth in 1985, Volcker said. ``Some small changes'' were made, he said, in response to certain technical considerations concerning the speed with which money changes hands, among other things.

The changes ``do not represent any change in policy intentions,'' Volcker said.

The Fed reaffirmed the tentative 1985 target range it adopted for M1 last July of 4 to 7 percent. M1, which is the money supply measure analysts say the Fed is paying closest attention to at the moment, consists of checking and NOW-account deposits plus cash held by the public. The Fed's target for M1 growth in 1984 was was 4 to 8 percent.

M2, a broader money measure, is targeted to grow between 6 and 9 percent in 1985. That is the same range as in 1984, but the upper end was increased 1/2 a percentage point from the tentative range for 1985 set in July. M2 includes everything in M1 plus some types of savings accounts.

The new range for M3 of 6 to 91/2 percent also was set 1/2 percent higher than agreed to in July, Volcker said. The M3 range for 1984 was 6 to 9 percent. M3 adds to M2 several kinds of investments, including bank certificates of deposit.

In the last two months all of the ``Ms'' have been growing faster than called for in the Fed's preliminary targets for 1985, Fed figures show. Volcker said the FOMC ``is not disturbed by the present level of M1 and M2 relative to its intentions for the year. It does contemplate that as the year progresses, growth will slow consistent with the target ranges.''

The Fed's economic projections, which call for slower economic growth in 1985 than in '84, are generally in line with those issued earlier by the Reagan administration and the Congressional Budget Office (CBO).

Mr. Volcker stressed that the Fed projections are not targets toward which the Fed ``fine tunes'' its policy actions.

The FOMC expects US economic output, or gross national product (GNP), to rise 7.5 to 8 percent before adjustment for inflation in 1985; the CBO predicts an increase of 7.7 percent. Last year, this ``nominal'' GNP rose 9.3 percent on a fourth-quarter-to-fourth-quarter basis.

The Fed expects inflation-adjusted, or real, GNP to rise 3.5 to 4 percent in 1985, vs. a CBO forecast of 3.4 percent. In 1984, real GNP rose 5.6 percent on a fourth-quarter-to-fourth-quarter basis.

Inflation, as measured by the GNP deflator, is seen rising 3.5 to 4 percent in 1985 by the Fed, vs. a 4.2 percent forecast by the CBO. Last year the deflator rose 3.5 percent on a fourth-quarter-to-fourth-quarter basis.

The Fed projects an average unemployment rate in the fourth quarter of 1985 of 6.75 to 7 percent, while CBO predicts a 6.9 percent rate.

Volcker warned of being ``beguiled by those tranquil forecasts into any false sense of comfort that all is well.''

While the US inflation rate has been reduced, the general price level still is rising about 4 percent a year. Good inflation prospects ``could prove fragile -- highly vulnerable'' to signs that public policy is prepared to accommodate inflationary forces, he said.

He repeated his frequent plea to Congress to reduce the federal deficit.

Foreign investors are helping to finance that deficit. The result, Volcker said, is that ``the stability of our capital and money markets is now dependent as never before on the willingness of foreigners to continue to place growing amounts of money in our markets. . . .

``In a real sense,'' he said, ``we are living on borrowed money and time.''