Money-policy makers gather at Fed as rising interest rates hit at home, abroad
Policymakers from the Federal Reserve Board will meet tomorrow in a cavernous second-floor conference room at the Fed's marble headquarters to set the course of monetary policy in the weeks ahead.
The decisions arrived at in secrecy by the Federal Open Market Committee (FOMC) will play a key role in influencing US interest rates. And the meeting comes as interest rates have moved to center stage in United States and world economic events.
For instance, rising rates have fueled a bond-market plunge, have made it surprisingly difficult for the federal government to sell long-term securities to finance its deficit, have helped push a major US bank to the edge of collapse , and have prompted calls for radical new forms of aid for debtor nations.
The main culprit in rising rates has been the collision between surging private borrowing, which has followed rapid economic growth, and heavy federal borrowing to cover the massive US government budget deficit.
''It is this competition for funds - in the face of a moderately restrictive monetary policy - that is the main cause of the recent climb in interest rates, '' says Andrew F. Brimmer, an economic consultant and a former member of the Federal Reserve Board.
The battle for funds has led to a sharp spike in interest rates. For example, last week the yield on bellwether 30-year Treasury bonds was 13.58 percent, up from 10.82 percent a year ago.
The impact of rising rates has been startling. For instance, rising interest rates have fueled a more than 12 percent drop in the bond market since January. Because bonds carry a fixed rate of interest, the price of existing bonds drops when interest rates rise. Rising rates were also behind the highly unusual reluctance of investors to purchase US securities after the May 11 government bond auction, until dealers slashed prices. Treasury obligations have long been viewed as the safest investment available.
The higher US rates also pinch overseas by contributing to lower growth and higher inflation, major European trading partners charged at last week's meeting in Paris of the Organization for Economic Cooperation and Development.
The reasons for the charges are complex but, in brief, high US interest rates make it more attractive for foreign investors to park their money in dollar-denominated investments. That pushes up the value of the dollar. It also pushes up the price of goods other nations purchase - like oil, which is valued in dollars. That feeds their inflation rates. And if other nations push up their interest rates - either to slow the economy to reduce inflationary pressures or to stem the flow of funds to the US - that reduces their economic growth.
The climbing US rates are an especially heavy burden on third-world debtor nations, like those in Latin America, where higher US interest rates are a double sword. By slowing growth in the industrialized world, rising rates cut the demand for third-world exports and thus slash the income available to pay those countries' massive international debts.
And since the bulk of the debts carry interest costs pegged to market rates, high US interest rates have raised serious questions about the Latin nations' ability to repay the loans or even meet the interest payments on them.
During his visit to Washington last week Mexican President Miguel de la Madrid Hurtado warned President Reagan that in the short term, ''it is necessary to take effective action on the cost of money.'' The recent 1.5 percent rise in the US prime or benchmark lending rate added $900 million to Mexico's debt bill. New York Fed president Anthony Solomon has proposed capping the interest rate on third-world debt at 10 percent and adding any excess interest fees onto the loan principal.
Doubts about the soundness of loans to developing countries were a contributing factor in the negative rumors that pushed Continental Illinois National Bank & Trust Company, a major Chicago bank, to the brink of failure last week. Only a federal bailout plan of unprecedented scope kept the bank from failing and perhaps setting off shock waves that could have triggered problems at other major banks. Other money-center banks have much heavier exposure to developing-nation loans.
The announcement by the Federal Deposit Insurance Corporation that it would protect all of Continental's creditors and the Fed's statement that it would meet any of the bank's cash needs seemed to stem the outflow of funds which started with foreign borrowers.
With the federal aid package in place, ''this is a one-bank problem,'' says Robert R. Davis, senior economist for the Congressional Joint Economic Committee. Pumping funds into Continental could lead to a more expansive monetary policy unless the Fed took corrective actions. ''In fact the Fed has taken steps to drain reserves or provide fewer from other sources,'' he says. As a result, the impact on the nation's money supply should be minor and temporary.
Fed-watchers are split between those who expect the FOMC to tighten credit conditions just a bit more and those who expect the Fed to wait and see how recent steps to tighten the credit supply have affected the economy.
The latest signs are that the expanding economy will continue to keep pressure on interest rates. Revised government data show that gross national product, the value of goods and services produced in the economy, rose at a rapid 8.8 percent rate in the first three months of the year.