Uproar over Interest Rates

By Alexander L Taylor III

Feldstein departs amid new Administration attacks on the Federal Reserve

During his two years as chairman of the Council of Economic Advisers, Martin Feldstein has become known primarily for prickly independence. While President Ronald Reagan and Treasury Secretary Donald Regan have been steadfastly happy-talking the economy and pointing to the high level of growth and low inflation, Feldstein has resolutely warned of the dangers posed by the Administration's huge budget deficits.

Last week Feldstein announced that he would be leaving Washington on July 10 to return to his teaching position at Harvard. Even as he prepared to depart, however, he found himself in a familiar position: at odds once again with Administration policy. Top Reagan officials had just opened a new offensive against the Federal Reserve Board, arguing that it was endangering the recovery by keeping too firm a grip on the money supply. But Feldstein contended, at a meeting with reporters to announce his departure, that the Federal Reserve is "pursuing the right kinds of policy."

The latest White House broadsides against the Federal Reserve were set off by the decision of major U.S. banks, led by New York's Chase Manhattan, to raise the prime rate from 12% to 12 1/2%. It was the third increase in the key lending rate in less than two months and pushed the prime to its highest level since October 1982.

From the viewpoint of the Reagan Administration, the timing could hardly have been worse. White House officials believe that the higher interest rates could clobber key industries like housing and autos just as the President heads toward the November election. Earlier this year, homebuilding appeared to be booming. In February, new housing starts reached an annual rate of 2.2 million. But in March, after interest rates began to take off, housing starts fell to 1.6 million, the sharpest monthly decline in 30 years.

As the Administration sees it, the rise in the prime was the result of the tight monetary policy being pursued by Feder al Reserve Chairman Paul Volcker. The Administration has long been unhappy with Federal Reserve policy, saying in private that the Fed should allow the money supply to grow more rapidly and thus help the recovery. Reagan aides had sharply criticized the Fed earlier in the Administration, but in recent months the attacks had stopped.

Last week they were started anew by White House Press Spokesman Larry Speakes. Immediately after the banks raised the prime rate, he told reporters, "We have been asking the Federal Reserve Board to allow sufficient monetary expansion to assure noninflationary growth. Although the economy has been growing at a healthy pace and inflation remains at a low level, it appears that the money supply is not accommodating real economic growth."

The following day the attack was picked up by Treasury Secretary Regan. In a speech to Massachusetts businessmen and community leaders, he warned that the Federal Reserve's stringent credit policies could begin to hurt. Said he: "If the Fed continues on its tight path now, it will have an effect on November and December. Does that have us worried? You bet your life it has us worried."

President Reagan entered the interest-rate controversy later in the week, although he was careful not to blame the Federal Reserve. Appearing before the National Association of Realtors, he took credit for the earlier recovery in housing. But then he added: "Let me assure you we are not pleased with the recent increases in interest rates, and frankly there is no satisfactory reason for them."

The Administration argues that since prices are rising at a rate of only about 5% annually, the Federal Reserve does not need to step up the attack on inflation by strengthening its already tight grip on the money supply. That position got some support last week when the Government announced that prices at the wholesale level did not increase during the month of April. Said Treasury Secretary Regan after the announcement: "Where's the inflation?" Representative Jack Kemp, an Administration intimate on economic matters, summed up the White House viewpoint when he said, "The Fed is paranoid about inflation, and that paranoia threatens to kill this recovery."

Economists outside the Administration generally do not hold the Federal Reserve primarily responsible for higher interest rates. Most money-market watchers consider them to be the inevitable result of a collision between loan demand from individuals and corporations, and the near record levels of Government borrowing needed to finance the massive budget deficit. Barry Bosworth, a Brookings Institution fellow and former Carter

Administration official, called the attack on the Federal Reserve Board "a cheap shot." Irwin Kellner, chief economist of Manufacturers Hanover Trust in New York, also defended the Fed. Said he: "It is expanding the supply of money and credit enough to allow growth, but not so rapidly as to cause a new round of inflation. The banks are merely responding to the higher cost of money that has been under way for most of the year."

Corporate leaders, who last week were attending the spring meeting of the Business Council, the organization of top U.S. executives, also did not fault the Federal Reserve, even though they expect rates to continue climbing. In presenting the council's report on the economy, IBM Chairman John Opel said of interest rates: "Our consultants forecast a continuing rise this year and next. Several foresee a prime rate of 15% or even more next year."

According to Feldstein, the key to solving the interest-rate conundrum is action on the federal deficit. Unless the Administration and Congress can make major moves to bring down the deficit, interest rates will remain steep and could go higher. That is a position that he has long maintained. Feldstein first broke Administration ranks by proposing that taxes should be raised, if necessary, to bring down the deficit. It was the deficit issue, more than any other, that gave Feldstein his reputation for independence.

His stance resulted in angry and embarrassing confrontations. In February Treasury Secretary Regan told Congressmen that they could take the Council of Economic Advisers' report and "throw it away" because of its warnings about the deficit. Feldstein ignored the criticism and continued to preach the message that earned him the title Dr. Gloom.

While Feldstein had few fans within the Administration, his honesty and forthrightness earned him support on Capitol Hill. On learning of his resignation last week, Daniel Rostenkowski, the chairman of the House Ways and Means Committee, said, "There goes the White House's last link to economic reality."

Not surprising, Feldstein's departure was largely welcomed within the Administration, where he has lately been excluded from key policy discussions. Observed a senior Government official: "Marty outserved his usefulness some time ago." It is considered likely that his post will be left vacant until safely after the November election.

While Feldstein is leaving Government, Federal Reserve Chairman Volcker, the other leading opponent of the deficits, remains. He was reappointed in August 1983 to a new four-year term, and is expected to stay in his job at least until 1985. Volcker is accustomed to seeing the Federal Reserve become a political target in an election year. During the 1980 presidential campaign, Jimmy Carter attacked Fed policies as "ill advised" and grumbled about the "strictly monetary approach to making decisions."

But election-year broadsides have traditionally had little influence on the Fed, and the latest ones will also probably be ineffective. By hewing to a strong anti-inflation line for the past five years, the Federal Reserve tamed the runaway inflation that had plagued the American economy for more than a decade. It is unlikely to change its policies in the face of criticism.

-- By Alexander L Taylor III. Reported by Christopher Redman/Washington and Adam Zagorin/New York

With reporting by Christopher Redman/Washington, Adam Zagorin/New York