For more than two years, the Federal Reserve - with the active encouragement of the Reagan Administration - has been monetizing the federal debt at progressively more rapid rates. In January, total reserves in the U.S. banking system averaged $56.7-billion, 23.8 percent higher than the same month last year. To put this in context, the average annual growth in bank reserves over the past 25 years was less than 5 percent.

Over time, ripple effects from this rapid expansion of liquidity will spread through the economy. Total debt will continue to increase more rapidly than gross national product. Prices of imported products will rise. The risk of general reflation will mount. Our foreign creditors, who are sensitive to this inflationary potential, will become increasingly reluctant to lend us the $3 billion a week we need to balance our books. They will lend us what we need but not at a price we can afford to pay. The dollar will decline further. Interest rates will rise. Another recession will loom.Monetary growth has already reached such an extreme level that correcting the excess will inevitably involve a significant real economic cost. As usual, those least able to afford it will bear much of the burden. However, further delay in bringing monetary growth under control would only increase those costs. The issue confronting Congress, the administration and the Federal Reserve is not whether interest rates will rise, but when and by how much.

To minimize the damage, the Federal Reserve should do the following:

* Take immediate steps to reduce the rate of growth in the "high- powered " reserve aggregates - the monetary base and total bank reserves - to levels consistent with the Fed's own stated, but generally ignored, guidelines for noninflationary monetary policy.

* Eliminate short-term interest rates as targets for monetary policy. The Fed itself identified interest-rate targeting as an important contributor to creating the inflation of the 1970s. Yet the monetary authorities have drifted back to de facto targeting of rates as their principal means for implementing policy.

* Establish a target for growth in the monetary base and adhere to it over a reasonable period of time, say one year. The Federal Open Market Committee should not publish multiple policy targets and then decide to focus on whichever target appears consistent with the FOMC's preconceived ideas about interest rates. The Fed should not establish targets for money growth and then regularly ignore them.

* Play fair with the U.S. public. Let people know that the current policy of easy money and competitive devaluation has been designed to produce a faster rate of inflation and a decline in the relative real wages of U.S. workers. If inflation does not speed up, and real wages do not decline then the U.S. trade balance will not improve. If the external value of the dollar declines, its internal value will drop too.

Despite the Fed's efforts to flood the economy with money, there seems to be little response. Will the pattern of the recent past continue? Many people believe so. A widespread complacency about monetary policy has developed both among government officials and participants in the financial markets. In popular terms, the Fed can print all the money it likes, but no one will spend it - at least not to purchase goods and services, only to bid up prices of financial assets.

This is a simplistic and dangerous assumption. It is unsupported by empirical analysis. In layman's language, if the Federal Reserve prints money without restraint, inflation will be the inevitable result.

There is cold comfort in the current subdued rate of inflation and in the fact that the broad monetary aggregates - M2 and M3 - have generally been expanding within their assigned target ranges.

The extended disinflation of the past two years chiefly reflects two factors: The lingering after effects of the severe overvaluation of the dollar in 1983 and 198, and the drop in the price of oil. Both these influences have now reversed. As the jump in producer prices during January showed, energy prices have started to climb. Prices of imported products other than oil were up 8.4 percent in the year ended December. These increases will accelerate and have a progressively more important impact on domestic prices during 1987.

As for the comparatively slow rate of growth in the broadly-defined monetary aggregates, remember that most of the components of M2 and M3 are not subject to the Fed's reserve requirements. Thus, for the most part these aggregates do not speed up and slow down in response to policy actions by the central bank. Rather, changes in their growth rates reflect portfolio decisions by the public concerning the form in which financial assets are held.

Repeated assaults on the dollar in the foreign exchange markets in recent weeks represent fair warning that foreign investors are increasingly alarmed at the inflationary implications of current Fed policy. According to the Federal Reserve's flow-of-funds accounts,foreign savers supplied more than 15 percent of total funds borrowed in the United States last year. Overseas investors are the principal marginal suppliers of funds to our credit and capital markets.

Every time a foreign monetary authority intervenes in the exchange markets to support the dollar, this is an indication that investors in that country were reluctant to acquire additional dollar balances at the existing price for the dollar and/or current dollar interest rates. The funds were dumped on the central bank which in turn invested in dollar assets at what amounted to a subsidized rate.

It is especially dangerous to assume - as do both the administration and the Congressional Budget Office - that we can finance our current account deficit at declining real interest rates. If the Fed were to try to force short-term interest rates down at the same time inflation was accelerating, the dollar would decline substantially. The overvaluation of 1984 would be replaced by undervaluation in 1987. Extended disinflation would give way to significant new inflationary pressures, higher interest rates and, ultimately, a recession.

One of government's bedrock responsibilities is to provide its citizens with honest money. Honest money, by any realistic definition, is money with stable and predictable purchasing power.

However, such results are hard to achieve in a world where monetary policy has become increasingly more volatile. In recent years, there have been only two settings for the monetary throttle in the United States: too slow and too fast. Consider the following record:

InSERT table

With the Federal Reserve constantly running from one side of the economic ship to the other, it has become increasingly difficult to predict the impact of monetary policy on the economy. The risk that we may capsize has risen. It is hard to see a strategy of monetary policy that relies on progressively larger oscillations in monetary growth leading to stable macroeconomic performance.

Such uncertainty carries a high cost in excessive real interest rates, misaligned currencies in world financial markets, lost investment, employment and real growth. Economic history carries the unmistakable message that, over time, such costs can be avoided only if the nation's central bank maintains reasonably stable and moderate rates of expansion in relevant monetary aggregates.

The sustained decline in interest rates since 1984 has been systematically associated with accelerated rates of expansion in all of the relevant monetary measures. When, and at what level of growth in high-powered money, will this process come to an end? Fifty percent? Five hundred percent? Unfortunately, there is little guidance from the Fed. Its officials regularly repeat their standard rhetoric against inflation. But their actions belie their words.


Year-over-Year Changes in Changes

Period Ended Change

Third Quarter 1979 8.28 percent

Second Quarter 1980 4.31 percent

Second Quarter 1981 9.90 percent

Fourth Quarter 1981 5.00 percent

Third Quarter 1983 13.04 percent

Fourth Quarter 1984 5.44 percent

First Quarter 1987 *17.30 percent


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