A Clash of Interest

The cost of money--the most influential cost in the U.S. economy--soared last week to a peak not seen since 1929.

Led by Chemical Bank New York Trust Co., the nation's fifth largest, commercial banks from coast to coast boosted their prime rate--the minimum interest charged for loans to their biggest customers-- from 5 1/2% to 5 3/4% . With unusual speed, major banks in such money centers as New York, Chicago, San Francisco, Boston, Atlanta and Houston fell in line with the increase, which was the third since last December. At that time, banks lifted their prime rate from 4 1/2% to 5% ; in March they upped it again to 5 1/2%. Taken together, the rises amount to the swiftest jump in borrowing rates in a generation.

On the Escalator. Because other loan rates are scaled upward from the prime rate, the increase means that the already high cost of borrowing money for everything from autos to homes, from financing business inventories to major industrial expansion will also escalate to new altitudes. While these effects will ripple through the economy slowly--depressing housing starts further and perhaps hurting auto and appliance sales--Wall Street reacted swiftly. Already jittery over Viet Nam, the U.S. balance-of-payments deficit and the cloudy prospects of higher taxes, the stock market staggered through its worst week in seven. The Dow-Jones industrial average of 30 key stocks sank briefly during one day's trading to 859--below the 864 bottom of its spring decline--and even after a rally closed the week with a 20-point loss, at 877.

Raising interest rates is the bankers' way of fighting inflation by rationing funds, the supply of which has been increasing rapidly this year--but not nearly so fast as the demand for money in the exuberant economy. Accordingly, the increase surprised neither bankers, brokers nor Washington. The prime-rate hike caused speculation that the Federal Reserve Board would any day now increase its 4 1/2% discount rate--the amount it charges member banks for borrowing funds. Yet if the board acts, it seems likely to disrupt further the delicate competitive balance between the nation's financial institutions.

That disruption showed clearly last week in the increasingly wild rate war for savings deposits between commercial banks, savings banks, and savings and loan associations. In New York City, about a quarter of the mutual savings banks boosted their rates from 4 1/2% to 5%. Even so, many reported "heavy" withdrawals by savers attracted to 5 1/4% "certificates of deposit--money left to earn interest for a stated time--at commercial banks. In California, at least 40 associations followed the controversial lead of Los Angeles-based Home Savings & Loan in raising rates on passbook accounts from 5% to 5 1/4%, and on longer, 36-month accounts, to 5 3/4%. That move seemed more successful; Home experienced a $2,600,000 savings gain in one day. But it brought angry criticism from other S & L men who cannot afford to match the increase.

"A Laugh at Distress." Responding to industry and congressional pressures to cool the fight, the Federal Reserve last week took a small step to make it unprofitable for commercial banks to pay high rates for certificates of deposit; it raised the reserves that banks must stash away against large time deposits from 4% to 5%. That only infuriated the board's critics. "An invisible crumb from the rich man's table," fumed Chairman Wright Patman of the House Banking Committee, "a horselaugh at people in distress."

Chairman John Home of the Federal Home Loan Bank Board seemed to feel the same way. Calling the Reserve Board's action "minimal," he demanded among other things that action be taken to "reduce the widespread availability of certificates of deposit." With that, the HLBB handed S & Ls more power to fight back. Abandoning its only restraining weapon over S & L interest rates, the board suspended a policy cutting off S & Ls paying more than 4 1/2% in most states (and 5% in California and Nevada) on passbook accounts from borrowing privileges at the twelve Federal Home Loan Banks. "We were simply fighting windmills," explained Home. "Rather than penalize the good people who were holding the line on rates, we decided to discontinue a policy that was no longer effective."

Behind all the squabbling stands the awkward fact that a rapid rise in interest rates--the classic but imperfect monetary weapon against inflation--hurts some segments of the economy (such as savings institutions and housing) but leaves others (such as banks and industry) relatively unscathed. Partly for this reason, there are limits to how much credit can be tightened without so dislocating the economy as to threaten a recession. If Washington reduced its massive domestic spending on top of the cost of Viet Nam, banks and the Federal Reserve could pursue a gentler course.

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