The Squeeze of '79

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The then Treasury Secretary, W. Michael Blumenthal, strongly disagreed. He argued that the slowdown was only momentary and that demand for money and credit would soon be rocketing all over again. That is precisely what happened. With people increasingly following an impulse to "buy now before the price goes up," spending began to roar anew in midsummer. Consumers once again crowded into supermarkets and stores while businesses began to borrow at a breakneck clip.

Left to itself, the accelerating demand for credit would have quickly pushed interest rates far beyond the target that the Federal Reserve had set. For instance, interest on six-month Treasury bills, which is used as a guide for regulating interest on certain bank deposits, would have leaped alarmingly. To keep money markets stable, the Fed's so-called Open Market Desk in New York was forced to begin making more and more money available to banks in order to satisfy demand for funds. Indeed, though the Fed's own inflation-cooling monetary growth target was 4.5%, which is just about right, the Open Market Desk's operations after March were actually expanding the money supply at an annual rate of close to 11%.

Demand for credit ballooned. In the past four weeks alone, loans to business jumped at a rate of 23%, while the commercial paper market, which is where big corporations trade megabuck lOUs back and forth among themselves, leaped by an astonishing 96%.

The truth was that when Miller left the Fed in August to become Carter's Treasury chief after the summary axing of Blumenthal, the Fed's monetary policy was in disarray. So strong has been the resulting expansionary momentum that even as investors and financial markets were reeling last week from Volcker's abrupt shift in Fed tactics, the central bank itself glumly announced that money growth for the previous week had been a too robust $2 billion. That was anywhere from two to four times what had been expected.

Clearly, the Fed's efforts to get a grip on the money supply have come not a moment too soon. Liberal Economist Arthur Okun, who was chief economic adviser to Lyndon Johnson, is a consistent critic of fighting inflation with tight money, which inevitably slows economic growth and raises unemployment. Yet Okun says. "The Fed had to do something. It simply could not let those huge credit flows continue."

The Fed's change of strategy had been in the works since Sept. 29. On that date, Volcker and Treasury Secretary Miller met with their West German counterparts and Chancellor Helmut Schmidt in Hamburg as part of a series of continuing huddles that grew out of the now faltering dollar-rescue package of November 1978. The West Germans told the new Fed chief that any sort of Son of Rescue plan would now be simply unacceptable. If Washington wanted anything more than disdainful sympathy for its economic malaise, the Germans indicated, it would have to stage a sustained assault on inflation itself. The U.S. could not just go on blabbering about exchange-rate instability, as if all the dollar's woes boiled down to foreigners not wanting to own the crumbling currency.