Volcker: deficits remain key threat

Recent economic news has been almost entirely favorable, but Federal Reserve Board chairman Paul A. Volcker warned Congress Wednesday that a bout of national euphoria should be avoided.

''Far from basking in the warmth of past and present progress, the strongest kind of effort will be necessary to convert potential success into sustained growth and stability,'' he said.

Large federal deficits remain the key threat to the economy, he argued, adding that their impact on interest rates and exports is putting some sectors of the economy, like agriculture, ''under heavy pressure.'' As a result, various parts of the economy are growing at sharply different rates.

Without action on the deficits the nation could suffer ''a relapse into inflationary economic malaise,'' Mr. Volcker told the Senate Banking Committee as part of a semiannual report to Congress on monetary policy mandated by law.

During the session the 6-foot, 6-inch-tall central banker:

* Unveiled a forecast for sharply lower economic growth in 1985 than in 1984. The Fed expects inflation to speed slightly next year and foresees little additional progress against unemployment in '85.

* Emphasized that the Fed had decided not to tighten credit conditions this year. The Fed announced slightly lower tentative money growth targts for 1985. The targets were a bit more stringent than some private forecasters had expected. All other things being equal, the less money the Fed provides, the slower the economy grows.

* Disagreed with President Reagan's assertion during a Tuesday evening press conference that economic growth would make further reductions in the deficit. ''Little or no further decline now seems probable for 1985 and beyond,'' Volcker said.

He also disagreed with administration economists, who argue that there is no link between rising interest rates and the deficit.

* Agreed with the President that deficit reduction should begin with spending cuts. ''The more spending can be reduced to close the gap the better. If it can't be done on the spending side, as a practical matter you've got to look at the revenue (tax) side.''

* Noted ''encouraging'' signs of progress in resolving the debt problems of certain Latin American nations like Mexico, Venezuela, and Brazil. But ''the challenge for all remains substantial,'' he said.

The economic forecast Volcker unveiled shows real economic growth slowing in 1985. The Fed expects inflation-adjusted economic output to grow in the 3-to-3. 25 range next year. That is down sharply from the 6.25-to-6.75 percent pace of economic growth the Fed expects between the fourth quarter of 1983 and the final quarter of '84.

The Fed also expects prices, as measured by a gross national product-related index, to rise 5.25 to 5.5 percent between the fourth quarter of 1984 and the final quarter of '85. This year the Fed expects inflation to range from 4 to 4.5 percent.

Volcker warned the senators that unless action is taken on the deficit, there are ''substantial risks of less satisfactory results'' with respect to economic activity, or prices, or both.

Two of the Fed's three principal money measures, M-1 and M-2, remain within target ranges set for 1984 at the beginning of the year. M-3, the broadest of the three measures, has grown faster than the Fed wanted.

With two of the Fed's three main money growth measures behaving well, and considering other factors, ''stronger restraining actions on money and credit growth generally have not appeared appropriate,'' Volcker said.

He explained that interest rates could rise - as they recently have - even when the Fed does not clamp down on the money supply. For instance, as businesses seek loans to expand, banks lend them money. The banks then get deposits to cover the loans ''by bidding aggressively in the market for money,'' thus forcing interest rates up, he said.

Next year's M-1, which includes cash and checks, is targeted to grow 4 to 7 percent, vs. a 4 to 8 percent growth range for 1984. M-2, which includes M-1, as well as money in savings accounts, is slated to grow 6 to 8.5 percent in 1985, vs. a 6 to 9 percent growth range for '84. The growth range for M-3, which adds large time deposits to M-2 and M-1, was left unchanged at 6 to 9 percent.

The full percentage-point reduction in the upper target for M-1 is a signal from the Fed, says David Berson, an economist at Wharton Econometric Forecasting Associates. ''They are using it send a signal to both Congress and the financial markets that the Fed really wants'' noninflationary growth, he said.