The Squeeze of '79

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Bonds took an especially bad beating, since they usually pay fixed rates of return to investors and have values that fluctuate in accordance with overall interest rates in the economy. When interest rates rise, bond prices go down, and last week they fell through the floor. IBM had an offering of some $1 billion worth of notes and debentures, but many remained unsold when bond prices collapsed last week, leaving the underwriters with a loss of as much as $25 million.

There was a message in the weeklong madness in the markets. Says Democratic Economist Walter Heller: "I think Wall Street was saying, Sure, we think you ought to fight inflation, you ought to strengthen the dollar, you ought to tighten money, but holy smokes, not necessarily to the extent of knocking the props out from under profits." Still, the chaos in the markets deflected attention from the more fundamental significance of the Federal Reserve's moves, particularly its shift toward management of the money supply through direct controls instead of manipulation of interest rates. Conservative Economist Alan Greenspan describes this development as "by far the most important and significant change in U.S. monetary policy in a generation," and others concur. Says Carter's chief economic adviser, Charles Schultze: "Whether you like it or lump it, this is one of the most interesting things that's happened to monetary policy in years."

Strictly speaking, the Federal Reserve's action is less a shift in policy than a change in procedure. Successive Fed chairmen, beginning with William McChesney Martin in 1951, have remained committed to holding down inflation by preventing the rapid growth of money and credit. But the economy of the 1970s has grown so bloated and distorted with spiraling prices that the traditional techniques of money management have become increasingly useless and even counterproductive. Indeed, at certain critical moments, well-intentioned efforts by the Fed either to tighten up or to relax the reins on monetary growth have boomeranged. The result has been periods of money drying up when it should have been plentiful, or pouring in torrents into an economy already very much awash in it.

In fact, a surprise surge in money growth was precisely what happened last spring. This is a big reason why inflation shows no signs of abating. Ironically, even as then Fed Chairman and now Treasury Secretary G. William Miller was proclaiming a clampdown on monetary growth and pointing proudly to double-digit nationwide interest rates as evidence that the Fed was making it costly to borrow funds, the money supply itself was about to explode.

Miller's mistake had been to assume that the Fed's orchestration of the highest interest rates in five years would alone be sufficient to discourage borrowing and spending. Through the first half of 1979, business was actually slowing somewhat as a result of bad winter weather and the gasoline squeeze, which together put a crimp in consumer purchasing. The Fed even began to fear that its seemingly draconian interest rates were pushing the economy headlong into recession.