Why interest rates are resisting all overtures to come down to earth
Interest rates are refusing to come down from their tree. Their stubborn predilection for heights may reflect a change in how markets figure the cost of borrowing money.
On Jan. 21, when President Reagan took the oath of office, the prime rate was 20 percent. Since then, inflation has moderated. The Federal Reserve appears to have finally gotten a grip on the money supply. Mr. Reagan's budget cuts have progressed far through Congress.
By July 14, despite coaxing from this relatively good economic news, the prime rate had crept up a bit further, to 20 1/2 percent.
"Interest rates are unhooked from their past relationships with inflation and money growth," says Dr. Ben Laden, chief economist at T.Rowe Price, a mutual fund group.
Back in simpler times, when cars were huge and bonds were a conservative investment, interest rates went up and down with the inflation rate. "Real" interest -- the difference between interest rates and the inflation rate -- stayed fairly constant. (If inflation were 2 percent, and you had a 3 percent mortgage, you would be paying 1 percent real interest. You would also be very happy.)
Real interest rates have historically averaged 3 percent. But now they have skyrocketed to record highs. Using the prime as a benchmark, on Jan. 21 real interest rates were around 8 1/2 percent. Today they are closer to 11 percent.
The real yields on government bonds are at record levels in virtually all major countries, according to a Salomon Brothers study.
"Many traditional interest rate yardsticks have been altered substantially, or have lost their validity altogether," the report says.
The market, that amorphous entity with such power over our economic life, has decided that real rates are to be permanently higher, economists say.It believes it needs a thicker profit margin to cushion the risk of lending money. Experts point to two major contributing factors:
1. Strong demand for loans.
"Demand-side pressure is giving a strong upward push," says Alan Sinai, vice-president of Data Resources Inc.
Business and government are elbowing each other to get at the credit window. Corporations, still uncertain about the economy, are putting off long-term borrowing and snapping up short-term cash, at high rates. And the trend toward mega-mergers is tying up huge amounts of capital. If you think dinner and a movie is expensive, consider this: Conoco's suitors have lines up more than $20 billion in credit lines to impress their intended.
2. Everybody's favorite bad guy, the Federal Reserve.
In 1979 the Fed changed its strategy in controlling the nation's money supply. Instead of managing certain interest rates, it decided to pay closer attention to monetary aggregates by playing with nonborrowed bank reserves.
"The policy of pegging interest rates never made any sense," says Dr. Laden.
The new operating procedures have worked better, though not perfectly, and the Fed has hung tough on its promise to slow the growth of money. So interest rates may climb a tree, but Paul Volcker and his fellow Federal Open Market Committee members have refused to extend a helping ladder, claiming that looser monetary policy would only result in still higher rates in the long run.
"Even as the economy has softened, the reduction in the growth of the money supply is not yet low enough for the Fed to ease up on policy," Mr. Sinai says.
The Fed has done its job efficiently that the growth of M-1B, one of the basic measures of the money supply, has fallen below the midpoint of its target. The federal funds rate -- the rate banks charge one an other for overnight loans , made to satisfy Fed reserve requirements -- has stayed high, but seems to have peaked. After reaching the rarefied 20 percent heights, it clambered down to 18 1/4 percent by July 14.
Some economists see the decline in the federal-funds charge as a first glimmer of good news. Tim Howard, senior economist at Wells Fargo Bank, argues that the market has set the funds rate at least 100 basis points higher than it should be.
"The Fed has probably waited long enough for some relaxation in policy," he says.
Mr. Howard and other economists say technical factors lead them to believe the Fed has eased up slightly in the past few weeks -- though that may be the result of one-shot events such as the Iranian assets exchange.
But any relaxation of monetary policy would probably be temporary. The Federal Open Market Committee met last week to set money growth targets for 1982 . Though not yet official, reports indicate that next year's targets will be even lower than this year's.