The Fed Crawls To Economy's Rescue

An economic melodrama is underway. The organ music pounds in the financial markets as the scene unfolds. Our heroine, the economy, has been tied to the tracks by a tight monetary policy. The train, a recession, whistles in the distance. Our hero, the Federal Reserve System, starts to untie the fair lady by lowering interest rates and loosening credit.

But will he be in time?

Tune in next year for the conclusion of this episode. But H. Erich Heinemann, chief economist for brokers Ladenburg, Thalmann & Co., says it is too late. He forecasts a flat economy this quarter and a modest recession in the first half of 1990, with the economy declining at a 2.5 percent annual rate.

Leif Olsen, an economic consultant and money manager in New Canaan, Conn., is more hopeful. ``I think they will avoid a recession,'' says the former chief economist for Citibank.

Michael Keran, chief economist for the Prudential Insurance Co. of America, figures national output will be negative in the current quarter but isn't sure whether it will also slip in the first quarter of 1990. Since by definition a recession is at least two quarters of downturn in the gross national product, he's not yet predicting a recession.

The only problem with this story is that the Fed was also the villain. It put the economy in its hazardous position in the first place with a tight, anti-inflationary money policy that lasted more than a year.

``They [Fed policymakers] have for some time overdone this restraint, and put us at the risk of a recession,'' says Beryl Sprinkel. He made the same point directly to the Fed last year when he was chairman of President Reagan's Council of Economic Advisers.

But, as Mr. Heinemann notes, ``The Fed started crawling to the rescue in June.'' That's when the central bank began easing up gradually. It moved again Tuesday, pushing the federal funds rate - the interest commercial banks charge one another on short-term loans - from about 8.75 percent towards 8.5 percent.

``The villain has had a stroke of bad conscience,'' jokes Mr. Keran. He expects the Fed to lower the federal funds rate further.

Some observers are now predicting that the Fed's action will prompt banks soon to lower their prime rate for business customers from 10.5 percent to 10 percent. That would also mean a saving for the millions of Americans with home-equity loans tied to the prime rate.

Mr. Olsen suggests the Fed's action is based partially on its expectation for statistics on the economy to be released next week. He figures industrial production and retail sales will be down, and auto sales will remain weak. He believes the employment increase in October will be revised down next month when the November employment numbers - likely showing weak gains - are released.

``The Fed feels the economy is slipping more rapidly than it had anticipated, and it is appropriate for it to intervene,'' he says.

Notes Heinemann: ``The economy is softening quite substantially and rapidly. It smells of recession.'' He expects businesses to start laying off more people in coming months as the slowdown becomes more obvious and their profits are squeezed.

The monetary aggregates show that the Fed already has had some success in turning around its policy. M2 - one measure of money that includes checking accounts, currency, and some savings - has been growing at a rapid 8.2 percent annual rate in the past three months.

Unfortunately, a shift in monetary policy usually takes six to nine months to have an impact on the economy. ``It is not like instant coffee where you add hot water and get instant results,'' says Heinemann.

The White House will certainly welcome the Fed's action. Though agreeing with the basic anti-inflationary policy of the Fed, it would have preferred a less stern monetary stance. Also, lower interest rates here should weaken the dollar, as the Treasury wants. At times the Treasury has intervened in foreign exchange markets to prevent the dollar from increasing in value. But then the Fed would neutralize the tendency of that intervention to swell the domestic money supply by its action in the money markets. Now it has stopped that ``sterilization'' policy.

There could be more harmony over economic policy in Washington.