The Federal Reserve quickstep in defining monetary gauge
Harvard University's Benjamin M. Friedman had been having, as he put it, ''a great deal of back and forth'' with Paul A. Volcker about the merits of another significant addition to the tools used by the Federal Reserve System in determining monetary policy.
To his pleasure, Dr. Friedman, an economist, found Nov. 23 that the Federal Reserve Board chairman had been listening. In testimony before the Joint Economic Committee, Mr. Volcker indicated that the Fed would be looking at total net credit as well as money measures in deciding whether to tighten up or loosen its supply of reserves to the nation's banking system.
This decision is both significant and surprising. It took more than a decade for the Fed to switch from basing its monetary policy on interest rates to a money-supply target. The addition of credit as a target has come with amazing rapidity.
''It has been rather quick,'' Dr. Friedman noted in an interview. ''It is a sign of how large the policy vacuum is to be filled.''
What happened was that innovations and other factors in the financial markets had made the basic measure of the nation's money supply, known as M-1, unreliable. At its regular meeting in October, the Fed's policymaking body, the Federal Open Market Committee (FOMC), decided to abandon M-1 (currency plus checking deposits) temporarily and use M-2, which includes some savings, as a target.
But some economists have regarded M-2 as a less reliable guide than M-1. Indeed, Richard Kopcke, an economist with the Federal Reserve Bank of Boston, figures that M-2, even larger M-3, and so-called L (total liquid assets) have all been ''misbehaving'' in this recession. They have been growing faster than usual in relation to total output.
Whatever, some in the Fed wondered if they were trying to guide a huge ship, the US economy, without a rudder or compass. With money measurement problems, the monetary policymakers couldn't be sure whether they were pushing the economy into a deeper recession or creating future inflation problems.
''No one target is reliable enough to follow exclusively,'' Dr. Friedman holds.
For the moment, as he put it, the Fed ''chose to look the other way as the monetary aggregates grew faster than targeted.'' With such a deep slump, the FOMC figured the risks of stimulating the economy too much are minimal at the moment. So money has been growing at rapid rates this fall.
But the Fed can't do that for too long. It must find some technique for deciding how to supply an appropriate amount of money to the nation's economy. So Mr. Volcker took seriously the research by Dr. Friedman on credit, that is the indebtedness of nonfinancial borrowers in the United States.
Dr. Friedman wrote a paper last year showing that persistent changes in credit - in a way that's similar to changes in the pattern of growth of the money supply - preceded moves in the economy as a whole. In other words, if credit grew steadily, the nation's output would also turn up. So if the Fed sees its monetary actions producing an upturn in credit, it can expect the economy to move ahead too after a while. Or vice versa.
Moreover, in this recession, credit, according to Mr. Kopcke, has been behaving. It has grown some 2.5 percent faster than gross national product - its usual pattern during a recession. That's why his boss, Frank Morris, president of the Boston Federal Reserve, has been taking credit seriously as a possible guide to monetary policy.
Some other members of the Federal Open Market Committee are not so convinced. Also, apparently some staff economists in the Fed in Washington are skeptical. They're doing some research aimed at testing the validity of credit as a guide to monetary policy.
The credit number has a prominent advocate on Wall Street in Henry Kaufman, an economist with Salomon Brothers, a brokerage house.
Total net credit involves home mortgages, consumer credit, business loans, corporate bonds, municipal and state bonds, and federal government debt. It follows that if these are growing, the actual production of things and services should also grow.
One problem with total net credit as a guide is that the data are somewhat slower to come out than the money figures. But Mr. Kopcke says that could be easily remedied, that the numbers could come out within six weeks after the end of a month. Since the Fed doesn't try to fine-tune the economy, he believes that should be fast enough.
Dr. Friedman maintains that the ''monetarists have been heavily, if not fatally, damaged'' by the current slump in the economy. These monetarists have mostly been keen advocates of the Fed's setting an M-1 growth target and sticking to it strictly. But to their surprise, the recession has dragged on much longer than their reading of M-1 would indicate likely.
Just lately the upturn in new mortgages and in new underwritings of bonds on Wall Street offer some hope that net credit will turn up - and thus the economy. Growth of net credit through September had been declining somewhat.
If there is this boost in the economy, it will be great news for the Federal Reserve. It has been under severe attack because of the depth of the recession. The Fed didn't want that big a slump. But when the compass and rudder are broken , it's hard to steer a proper course.