A cloud of confusion drifted over the financial markets and the press last week. The source? Federal Reserve Board chairman Paul A. Volcker in appearances before Congress and the press. He blew cigar smoke over them, charges Lawrence A. Kudlow, a former top economist at the Office of Management and Budget.
The headlines of one paper read: ``Fed sets new monetary targets aimed at fostering sustained economic growth, lowers GNP estimate.'' The story noted accurately enough that the Fed had decided to ignore the bulge in the nation's basic money supply that has occurred so far this year by ``rebasing'' its new, higher target for money growth on the average level in the second quarter.
This, the article continued, would ``allow the central bank leeway to continue its recent easy credit policy in an effort to invigorate the sluggish economy.''
Bond prices rose as investors figured money would be easy, that interest rates would fall.
By the end of the week, however, the smoke had cleared and the press and the money markets began to realize that the Fed will be tightening monetary policy -- not keeping it loose. Bond prices fell.
What prompted the confusion was the difference between changing monetary targets and changing actual monetary policy. The Fed boosted its target range for M-1 (currency plus checkable accounts) from between 4 and 7 percent to between 3 and 8 percent (on the new base). That looked, deceivingly, like easier money.
M-1 grew at a huge 12.2 percent annual rate, however, from the average of four weeks ending Dec. 31, 1984, to the average of four weeks ending July 1. That's printing money like a counterfeiter.
To get the money supply within the new target -- the Fed will forget this past printing spree -- the central bank will have to slow money growth substantially. In other words, tighter money.
Michael W. Keran, chief economist of the Prudential Insurance Company of America and a former high Fed economist, comments: ``I can't imagine that Volcker would have established a new target for M-1 without some intention of staying within it, because it would start to undermine his credibility.''
Rather than rebasing M-1, the lanky Fed chairman could have scorned this basic measure of money supply as being out of line for technical reasons. Instead, Mr. Volcker could have adopted M-2 -- which is a larger monetary aggregate which includes cash and checking, plus some savings deposits and similar accounts. The M-2 numbers have been behaving better from the standpoint of the Fed's targets. After all, the Fed did abandon M-1 in favor of M-2 in October 1982.
In other words, the new target means the Fed is serious about getting better control of M-1.
``I don't think the Fed has much elbowroom,'' said Mr. Kudlow, now president of Rodman & Renshaw Economics Inc. in Washington, D.C. ``Volcker had no choice.''
He calculates that for the Fed to trim money growth down to the lower end of the new target (the 3 percent mark), it could create new money at only a 0.1 percent annual rate for the rest of the year. If the Fed aimed for midway in the target (5.5 percent), it could create money at only a 3 percent rate. Even at the top of the new range, 8 percent, the Fed can let money grow at only a 6 percent annual rate for the rest of the year -- half the recent rate.
Since last September the Fed has bought some $12 billion in government securities on the open market, that is, from the public. When the Fed does that, it writes a check to the seller, who deposits it in a bank, and, behold, the banking system creates new money out of nothing. The Treasury still pays the interest on the bills, notes, and bonds held by the Fed, but the Fed turns over any profits (after expenses) to the Treasury. In reality, the Treasury no longer has to pay any interest on that extra $1 2 billion held by the Fed.
In a growing economy, the Fed must always supply some new money to the financial system. Fortunately for the politicians in Washington, the government gets the first free use of that new money.
If the Fed creates too much new money, however, it could in time kick off a boom and higher inflation. That's the risk the Fed now runs.
Volcker talks of the nation's output of goods and services jumping from the second quarter's 1.7 percent real annual rate to a 4 percent rate in the second half.
But Washington economist Kudlow thinks gross national product (GNP) will grow at a real 5 percent rate between now and New Year's. He figures inflation could soon be rising at a 6 percent rate. And he expects a rise in interest rates.
Prudential's Mr. Keran also forecasts more-rapid GNP growth (4 to 4.5 percent) and faster inflation (6 percent, second half of 1986). He sees the dollar weakening against foreign currencies, boosting import prices.
One difficulty for such forecasts is velocity -- how fast money turns over. It fell 4 or 5 percent in the first half of this year, whereas it usually increases. Both Keran and Kudlow expect the turnover of money to move toward normal now. The Fed will create fewer new dollars. But these will be used more often, and thus help meet demands for credit. Keran thinks this may keep interest rates from rising sharply.
In justifying recent money supply surges, Paul Volcker noted that money grew rapidly for part of 1982-83 but did not kick off inflation. ``We see some plausible reasons to think this recent burst has some of the characteristics of that earlier burst,'' he told Congress.
But Kudlow responds that at the time, industry was using less of its capacity and unemployment was higher. He doubts Volcker -- and the nation -- will be as fortunate this time. If Kudlow is right, expect a mini-boom and more inflation.