Cost of money slipping - but supply is too

Interest rates are down. Monetary policy has eased. Right? Wrong!

In fact, some monetarist economists are concerned that the Federal Reserve System may be overdoing its tight-money policy right now.

The view that interest rates are the measure of monetary policy stems from decades of dominance of the Keynesian or neo-Keynesian school of economics in this country. Interest rates, such economists hold, are the dominant factor in determining the business cycle. For instance, high interest rates will discourage business borrowing and spending, prompting an economic slowdown.

However, another school of economists, the monetarists, maintains that it is primarily the supply of money -- rather than its cost -- that is the main factor in the business cycle. Thus a shortage of money, not so much high interest rates, will prompt a recession. Late last year, for example, business was still borrowing at a rapid pace despite record-high interest rates. This theory of economics has become much more influential over the last decade or so.

In any case, what bothers the monetarists today is that the supply of money to the economy has been declining for the last two months. And this at a time when the economy is plunging faster than many expected into a sharp recession.

If such a tight-money policy were to continue, says Jerry L. Jordan, chief economist with Pittsburgh National Bank, the Fed would once more be acting in a pro-cyclical manner, deepening and lengthening the recession, despite the drop in interest rates.

In past recessions, the nation's central bank has worsened recessions by watching interest rates rather than money supply. Once business activity drops, the demand for loans soon shrinks rapidly and interest rates also decline. If the Federal Reserve tries to prevent rates from going down too rapidly, it will also lower the supply of money to the economy. This will deepen the recession.

Mr. Jordan charges that the Fed did this in late 1974 and '75. It's officials were concerned about clobbering domestic expectations for continuing high inflation. A fast decline in interest rates, they thought, would be misinterpreted as an easing of their determination to fight inflation. The result was the worst recession since the Great Depression of the 1930s.

Some monetarists are concerned that the Federal Reserve might make the same mistake today. This time its officials may also be concerned that declining interest rates here may be regarded abroad as a reversal in monetary policy. This could hit the dollar on foreign-exchange markets. Henry C. Wallich, one of the Federal Reserve governors, expressed that view in a dissent at a March meeting of the policy making Federal Open Market Committee.

Last Oct. 6, however, the Fed made a major change in its procedures when it announced it would determine policy on the basis of friends in monetary aggregates directly, rather than indirectly by watching interest-rate changes. This switch meant that the it allowed the historic rise in interrest rates this past winter.

If the system sticks to this policy, it should allow interest rates to plunge extremely rapidly now if that is necessary to maintain growth in the money supply. The Fed, said Mr. Jordan, must be "symmetrical" in its monetary policy.

He sees some possible statistical problems in money-supply measures.

The apparent trend in money supply, however, is such that it has set warning bells ringing among the monetarist economists.

Mr. Jordan says that maybe the Federal Reserve chairman, Paul A. Volcker, could convince foreign financial communities that declining interest rates are not a signal of easy money. Rather, they should watch the money supply. The Swiss and West Germans know this. Then he could tell some of his colleagues at the Fed and many federal politicians what they want to hear -- that money is easier, as shown by declining interest rates.

But this would be a two-faced position. Better, Mr. Jordan admits, would be a fuller understanding of how monetary policy really works.