The US economy's fragile recovery may be put to the test later this year if interest rates continue ticking back up. This is how economists are reading the most recent round of interest rate hikes, which has pushed the prime rate back up to 11.5 percent from a low of 10. 75 percent on July 24.
Some experts say another rise -- to 11.75 -- could come soon.
The most vulnerable segments of the economy are the housing and auto markets. Both have seen their fortunes improve slightly in the last few months. But they usually suffer when loan money becomes more expensive.
William V. Sullivan Jr., senior vice-president at the Bank of New York, terms the trend of rising interest rates "a potentially negative development," especially for the housing and consumer spending markets. For the economy as a whole, the banker says, it could lead to a weaker fourth quarter than is generally expected.
Behind the interest rate rise are concerns about the rate of growth of the nation's money supply. Since June, the money supply -- roughly defined as the total private checking account deposits plus cash in the public's hands -- has surged ahead at a 13.8 percent rate, way above the Federal Reserve Board's 7 percent target. Although Fed officials decline to comment on rates, bankers say the rise in the money supply has been due to technical factors -- not rising demand.
For instance, Henry Kaufman, a senior partner at Salomon Brothers, says such "technical factors" as the increases in social security payments have been responsible for the fast-paced growth of the nation's money supply. Although Mr. Kaufman says he expects these conditions to correct themselves in August, there are still concerns that these increases in the money supply could act to give the economy another inflationary spurt.
Accentuating the rise in rates are other factors as well. Corporations continue to borrow large sums of money in the bond markets as corporate treasurers expect interest rates to keep rising. Furthermore, the federal deficit keeps ballooning as Congress adds new programs during the election year and tax receipts fall because of the recession. In the month of July, for example, the deficit swelled by $15.06 billion, compared with $7 billion last year.
Interest rates continue to rise, the crunch could hurt the housing industry the most. Rising interest rates make home mortgages more expensive and reduce the availability of funds for home purchases.
Michael Sumichrast, chief economist of the National Association of Homebuilders, located in Washington, says the most recent nine-week rise in mortgage rates, from 11.97 percent to a current 13.73 percent, now means that some 30,000 units will not be built this year and another 160,000 next year, if rates stay high. Not only are builders unable to get loans, he notes, but consumers are unable to obtain mortgages.
The nine-week rise has already disqualified some 1 million potential homeowners from qualifying for mortgages. In addition, the Federal Housing Administration now is adding 10 points onto loans it makes. Thus, if a house is sold for $60,000 the seller must pay $5,400 and the buyer $600 to the FHA at the settlement date. "That takes all the profit out of selling a house," Mr. Sumichrast complains.
The rate rise may also have an adverse impact on auto companies. Mr. Sullivan of the Bank of New York says the higher rates reduce the availability of installment credit and thus "may limit the extent of any pickup in consumer durables spending."
However, Ray Nelson, executive vice-president of General Motors Acceptance Corporation (GMAC), says he doubts the "uptick in interest rates will chill car sales. . . .
"I think a great majority of financial institutions got out of the auto financing business when interest rates hit 20 percent," he explains, "and they are just now getting back into the business." He notes that usury ceilings were an inhibiting factor earlier this year. In New York State, for example, banks are allowed to charge only 12.68 percent.
Any sustained rate rise might also halt the 4 1/2-month-old stock market rally. "If rates are going up because we have a booming inflationary economy," says analyst Larry Wachtel of Bache Halsey Stuart Shields Inc., a brokerage house, "then the market will be hurt." However, Mr. Wachtel contends, "right now we have a sluggish economy and we see no support for an interest rate spiral." Instead, he predicts, rates will be lower by year-end.
Milton J. Ezrati, senior economist for Lionel D. Edie & Co. Inc., a financial consulting firm, likewise is predicting rates will fall back again later this year by 1.5 to 2 percentage points. Mr. Ezrati believes the recession is only just beginning; thus, rates have not yet bottomed out.