When Volcker speaks, Wall Street listens

Normally the government bond desk at Merrill Lynch is full of traders in a cacophonous combination of money and interest rates. Federal Reserve Board chairman Paul Volcker's testimony before the Senate Banking Committee on Thursday, however, stopped the noise.

Mr. Volcker disclosed that the Fed will use the value of the United States dollar as one of its prime factors in deciding monetary policy. At the same time, he said, the Fed officially would demote M-1, the basic money supply, in terms of its status. Until recently many economists viewed M-1 as a good indicator of the nation's monetary growth. Now, however, the slower-growing, broader measures of M-2 and M-3 are considered more significant than M-1.

This major shift in Fed policy will place even more pressure on the US and its four trading partners, which make up the G5 group, when they meet this weekend in Paris (story on meeting, P. 9). There will be considerable pressure on the Japanese to reduce their interest rates because of the threat the US might raise its interest rates and slow the economy, if its trading partners do not stimulate their economies. The result, said one bond trader at Merrill Lynch, is that ``it's introduced more uncertainty into the market.''

When Mr. Volcker speaks, nowhere is his testimony followed more closely than on the bond trading desks. Small movements in interest rates can mean millions of dollars in profits or losses. To follow Volcker's testimony, Merrill Lynch had an economist at the Senate Banking Committee hearing calling in the testimony as Volcker gave it. In this way, they were slightly ahead of the Dow Jones bond wire that reports the testimony only minutes after it is given.

Normally the market would distill and react instantly to Volcker's testimony. In fact, when John Spinello, a senior vice-president at Merrill Lynch Government Securities Inc., came to work yesterday, the bond and currency markets were already reacting to news in Japan of the G5 meeting. The dollar had firmed and interest rates fallen with the expectation the Japanese would lower interest rates, making US securities more attractive to Japanese buyers.

But Volcker's testimony created a void in trading. ``We all have to consult the gurus,'' such as Henry Kaufman of Salomon Brothers, Lawrence Kudlow of Bear, Stearns, and Donald Straszheim of Merrill Lynch, said Mr. Spinello, who is known as one of the brightest traders on Wall Street.

Bond traders are not the only ones who follow Mr. Volcker's remarks. Federal Reserve policy affects interest rates, which have a direct bearing on the economy.

Sen. William Proxmire (D) of Wisconsin, for example, has been concerned that the Fed has ignored the growth of M-1. Since October, M-1 has grown by a 21 percent annual rate, much faster than in the 1970s when inflation was much higher.

Volcker indicated the Fed is concerned about inflationary pressures but feels the general economy remains soft. He pointed out that most commodity prices other than oil are falling, indicating little inflationary pressure.

Volcker said, ``Action to reduce the rate of M-1 growth, promptly and substantially, would be called for in a context of strongly rising economic activity and signs of emerging and potential price pressures, perhaps related to significant weakness of the dollar externally.''

At the same time, Volcker said the Fed was aware of the relationship between strong monetary growth and inflation. In fact, it has been suggested the money the Fed is creating is helping to fuel the stock and bond market bonfires on Wall Street.