'Tight money' could pinch US recovery

Will the Federal Reserve Board cut off the fragile economic recovery? This is the question economists began asking as the Fed, fearful of a resurgence of inflation, recently started to tighten the screws again. If the Fed continues to tighten credit by raising the cost of borrowing, economists expect that whoever is elected president in November will have to cope with high unemployment in 1981.

Economist Monte Gordon of the Dreyfus Fund noted that the Fed's action "runs the risk of halting the fragile recovery." But he added, "Look at the trade-off: There may be a significant recovery later with skyrocketing inflation if the Fed doesn't act."

Senior Economist Sandra Shaber of Chase Econometrics agrees that the Fedhs actions may choke off the recovery. In fact, she says, "it's still too early to say the recession is over. I think we [will] have some further dips in the months ahead and at best have a modest recovery early next year."

Even the government's report Sept. 24 that for the third consecutive month the Leading Indicator Index for August was up, this time by 1.9 percent, did not impress Dr. Shaber. "The main reason for the increase," she notes, "was the increase in the money supply."

Also, stock prices were very strong in August, a factor that won't be present in the index for September.

Furthermore, weakness in the housing sector could spill over to other areas of consumer spending, further weakening the economy, notes Richard Hoey, an economist for the brokerage house of Bache Halsey Stuart Shields.

The Fed's specific actions so far have included raising the discount rate -- the rate at which it lends to member banks -- from 10 to 11 percent and allowing interest rates on the open market to rise sharply. As a result, most banks have raised their prime interest rates to 13 percent. Further hikes are expected later this week.

Mortgage rates likewise have spurted, hitting 14 1/4 percent in California.

Dr. Shaber says this rise in mortgage rates will probably cut short the recovery in the housing market. "Lumber prices have softened," she notes, "and this is often an excellent advance indicator of what will happen in the housing sector."

The Fed's actions are the result of a faster-than-expected growth in the nation's money supply -- the total amount of money available in checking accounts and cash. Thus, in order to avoid inflating the economy again, it has tried to adopt some "fine tuning."

With the economy just showing a tentative upward trend, many economists question the Fed's tactics.

One who does is Lawrence Kudlow of Bear, Stearns & Co., a brokerage house. He says, "Efforts to fine-tune the money supply over short-term periods are bound to fail." Mr. Kudlow says he believes the Fed must act decisively to control the money supply if it is to avoid another explosion in short-term interest rates and another run on the dolar.

But economist Kudlow acknowledges that "an election-year recession also tends to narrow the Fed's short-run policy options."

The prospect of the Fed tightening interest rates further has not gone over well with investors. In the week prior to Sept. 30 the Dow Jones industrial average plunged more than 50 points. The conflict in the Middle East added impetus to the selling.

However, Steven Hess, economist and vice-president of Security Pacific Bank in Los Angeles, says the cutoff in oil from Iraq should not have a substantial impact on the US recovery. First, he notes, the US doesn't use that much Iraqi oil and thus there won't be any shortages caused by the cutoff. Second, he doesn't expect the war to continue much longer.

Security Pacific, Mr. Hess Says, is still projecting negative growth for the economy through the end of the year, although there will be some improvement over the second quarter. Rising interest rates will keep the final year's figures from being positive.

Dr. Shaber of Chase believes the Fed's actions might even push the economy next year into a steeper slide.