MORE than a million people had to lose their jobs, but the Federal Reserve System finally figured out that economy is in trouble. In mid-November, the Federal Open Market Committee (FOMC), the Fed's key policy group, voted for ``a slight reduction'' in ``pressure'' on bank reserves. ``A limited degree of easing at this juncture,'' the FOMC said in statement released late last month, ``would provide some insurance against a deep and prolonged recession without incurring a substantial risk in current circumstances of fostering intensified inflationary pressures.''
Actually, instead of easing, the Fed tightened. True, short-term rates have declined, but they are a misleading, inaccurate indicator of policy. As the recession has deepened, the Fed has lagged in allowing rates to go down. As a result, the monetary policymakers have drained reserves out of the banks (or allowed them to grow very slowly) to prevent rates from declining. In the wake of November's decision to ``ease,'' for example, the FOMC pulled more than $800-million out of the banks.
Fed officials may intend to change policy. To date they have not done so. This is bad news for the economy. Business activity should recover from the recession within six to nine months. However, Fed officials could put that outlook in jeopardy if they hesitate. Tight money started the recession. Only easy money can end it.
By contrast, this is great news for bond traders. The deeper the hole the Fed digs for the economy, the higher bond prices will eventually soar. While prices won't move in a straight line, the bond rally last fall was likely only an hors d'oeuvre in what promises to be a lengthy feast. By late winter or early spring, yields on long-term Treasuries should decline to a range between 7 and 7.5 percent.
Ironically, the monetary base (a proxy for the Fed's balance sheet) grew rapidly during 1990. However, practically all of this acceleration reflected increased demand for United States currency overseas, particularly in Eastern Europe. In effect, the Fed has used fallout from inflation in Eastern Europe as a tool in its drive to slow the economy.
In political terms, the Fed is at a critical juncture. In the three and one-half years Alan Greenspan has been Fed chairman, the Fed has provoked one of the sharpest drops in monetary growth since World War II. Whether this gambit will succeed in conquering inflation is still in doubt.
How Mr. Greenspan manages policy in the months ahead (if he remains Fed chairman) will determine how he is remembered. He and his allies on the FOMC emphasize long-run linkages between turnover of the money supply and the rate of inflation.
However, the actual conduct of policy has had short time horizons. The Fed slammed on the brakes so hard that the economy has skidded into recession. The risk is that the Fed will do what it has always done in a recession - print a lot of money.
This fall, activity dropped further and faster than Fed strategists anticipated. Tight money brought growth in the corporate sector to a halt months ago. Demand for credit crashed. Total debt owed by individuals, nonfinancial corporations, state and local borrowers, and foreigners rose only 5.8 percent in the 12 months ended October. That was the slowest increase since 1955, save a brief period at the bottom of the 1975 recession.
In this setting, policy actually tightened when business prospects were darkening day by day. At some point the Fed will reverse direction and put money into the banks. The critical issue is whether Greenspan will be able to keep the rebound in money growth within noninflationary bounds.
Of course, inflation cannot continue without an accommodative policy. As Milton Friedman, a Nobel laureate economist, put it many years ago, ``inflation is always and everywhere a monetary phenomenon.''
The longer the central bank procrastinates, the more likely it will eventually be forced to flood the economy with funds. Interest rates are likely to decline in any event, but they will only stay down if the Fed keeps monetary expansion under reasonable control. In his zeal to whip inflation now, Mr. Greenspan could bring it roaring back to life.