Fed to replace its guide for growth Rates could rise within months

July 23, 1993|By New York Times News Service

WASHINGTON -- The Federal Reserve said yesterday that the main yardstick it used in guiding the economy's growth for more than 15 years has become so unreliable that it would largely abandon it.

Chairman Alan Greenspan said the Federal Reserve would stop relying on growth in the money supply -- its traditional tool -- and begin relying on interest rates, an approach more akin to the way it worked before it started relying on the money-supply figures.

In an appearance before the Senate Banking Committee yesterday, Mr. Greenspan said the central bank was jettisoning the money-supply approach because changes in the way Americans invest their money meant it could no longer predict how much economic growth would be produced by a certain amount of growth in the money supply.

"The relationship has completely broken down," Mr. Greenspan said.

Some economists predicted, however, that the new approach could present just as many problems as the one being discarded, and would make it harder for investors, economists and politicians to anticipate the Federal Reserve's actions.

The move comes as the Fed has been criticized for keeping monetary growth low, thus hampering economic growth. It also comes at a time when President Clinton and others are counting on low interest rates to spur the economy to greater growth.

As Senate Democrats badgered Mr. Greenspan to keep interest rates low to speed up job growth, Mr. Greenspan repeated the central bank's concerns about holding down inflation.

"The signal we are endeavoring to send here is at some point, rates are going to have to move up," he said, giving no indication of how soon the central bank might act.

The consensus among economists is that the Federal Reserve may raise rates in two months if inflation news over the next two months is bad, but that it could hold off indefinitely if inflation simmers down, as it seems to be at the moment.

The Federal Reserve has long sought to influence the economy through interest rates, lowering them to encourage growth and raising them to quell inflationary pressures.

How much attention to pay to the money supply in setting policy has long been a matter of disagreement among economists, with some arguing that its slow, steady growth is the key to noninflationary economic growth. Others consider it less important.

Since the late 1970s, the Federal Reserve has made many of its most important decisions by setting a specific target for growth in the money supply -- loosely, the amount of money in circulation plus savings and checking accounts -- and often adjusted interest rates to meet them.

Federal Reserve officials said they were happy with the way money supply targets worked from the late 1970s until last year.

Lower interest rates encourage businesses and individuals to borrow more, putting more money into the economy, some of which comes back to the banks, which then make further loans. In these circumstances, money supply grows faster. Higher rates tend to have the opposite effect.

Federal Reserve officials say the decisions by millions of Americans to move their money from savings accounts into mutual funds, and particularly money market funds that many people use like savings and checking accounts, are the main factor that has damaged the relationship between money supply growth and economic growth.

The reason is that M-2, the Federal Reserve's main measure of the money supply, includes money in savings and checking accounts but does not include money in mutual funds.

"What Greenspan said in effect is he's junking M-2," said David M. Jones, chief economist at Aubrey G. Lanston & Com., a New York brokerage. "That's historic."

The new tool that the central bank is turning to involves real interest rates. These are determined by subtracting the inflation rate from nominal interest rates, which have inflation built into them.

A 5 percent interest rate, for example, effectively amounts to a 2 percent "real" interest rate if inflation is running at 3 percent. The Fed said it would seek to set real interest rates at a level that creates steady growth with minimal inflation.

An unmoored Fed

The plan to end reliance on monetary growth not only leaves the Federal Reserve searching for new guideposts to help steer the nation to a desired level of growth but, critics say, also leaves the Fed steering by the stars, rather than by science, in trying to bring about steady growth with low inflation.

Mr. Greenspan said it now appeared that the Fed could produce satisfactory economic growth with far lower growth in the money supply than was previously believed. In the view of many economists, the Fed's reliance on a new tool -- real interest rates -- indicates that the central bank will raise rates sooner rather than later.

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