Federal Reserve shift generates more money, and brightens outlook
PHEW! The sighs of relief on Wall Street were almost audible late last week. Given economic uncertainty, there could still be something of a business slump next year. But it became clear that there is enough government action, as economist Erich Heinemann put it, ``to mitigate the extent of a decline and give us a more rapid recovery.''
Most important, new monetary statistics show a dramatic switch in Federal Reserve System policy.
``The superficial impression is correct - they [the Fed] did put a great deal of money in the system in the last 10 days of October,'' says Mr. Heinemann, who is with Moseley Securities Corporation.
The Fed conducted an extraordinarily tight monetary policy from April to mid-October. There was no growth in commercial bank reserves. It was, says Heinemann, the ``most abrupt'' monetary squeeze in the post-World War II years. He believes it was a major factor in the stock market plunge of Oct. 19.
As a result of the Fed's policy reversal after that, bank reserves grew at a 16 percent annual rate in October.
``This is very rapid indeed,'' says Heinemann. Those reserves are turned into money - the fuel for economic activity - through the banking system. The market's drop means a loss of nearly $800 billion in wealth. The extra money counters damage to consumer spending from that ``hit.''
Whether the independent Fed continues its easy-money policy remains to be seen. Certainly United States Treasury Secretary James Baker III wants ease to prevail. He told the Wall Street Journal last week he wants to ``make sure'' the Fed keeps ``sufficient liquidity in the system.''
The Fed hasn't always been generous in past financial crises. Jerry L. Jordan, chief economist of First Interstate Bancorp, says the Fed drained reserves from the banking system following the Penn Central collapse, the troubles of Continental Illinois, the Suez crisis, the Bay of Pigs, the Franklin National affair, the imposition of price controls by President Nixon, and the introduction of credit controls by President Carter.
During each of these disturbances, short-term interest rates fell, giving an impression of ease. Actually, investors seeking security piled into liquid investments and drove down their prices. But the Fed wasn't pushing much to create more money.
The Fed rescued Continental Illinois with $7 billion at the discount window. It took more than that out of the system in the summer of 1984 through the sale of Treasury paper.
In this current crisis, interest rates also tumbled dramatically as investors sought safety in money and its near-equivalents, such as Treasury bills. The Fed also has so far passed the litmus test of adding reserves to the banking system, easing, by the way, concerns of presidential adviser Beryl Sprinkel.
Because of past Fed tightness, Heinemann still expects a mild recession next year, with a maximum 2 percent drop in national output. But he admits that the Fed's action makes this less certain.
Most economists forecast a slowdown, not a recession. They count on the fall of the dollar - about 10 percent since mid-October - to boost exports and maintain US output.
More good news was the West German decision to roll back short-term interest rates and the steadiness in sales of US-built cars.
It was no wonder stock prices held their own.