TURMOIL IN THE CAPITAL MARKETS

I DO not look on inflation as a temporary wartime phenomenon," said Irving Rose, president of Detroit's Advance Mortgage Corp., before a convention of mortgage bankers recently. "I regard it as the inevitable price of our national commitment to a full-employment economy. Hence, it is chronic. The fever may abate somewhat from time to time, but it will never end."

Right or wrong, that statement is a classic example of the thinking now creating turmoil in U.S. financial markets. Attention has focused on its impact on the stock market, where traders are increasingly depressed by the fear that inflation, and with it tight money, will continue indefinitely. In the past three weeks the Dow-Jones industrial average has dropped almost 50 points, to last week's close of 812, barely above the year's low. Trouble is much worse in the bond and mortgage markets, the nation's primary channels for funneling savings into the construction of schools, homes, factories, stores and hospitals. Some experts wonder whether, if investors keep expecting endless inflation, these fixed-interest bond and mortgage markets can survive in their present form.

The crisis has been long building. In a current book, The Price of Money, Sidney Homer and Richard Johannesen date the bear market in bonds from 1946, when high-quality corporate debentures sold at interest rates of 2.45%. But the rise in rates and the concurrent drop in bond prices have speeded up enormously since the current inflation began in 1965--and especially this year. Last week, for example, the New Jersey Turnpike Authority sold $137 million worth of bonds at a tax-free interest yield of 7%, compared with a 5 7/8 yield on bonds that it had sold four months earlier. Interest rates on high-grade corporate bonds are threatening to go above 9%. The yield on bellwether U.S. Treasury bonds maturing in 1992 has climbed to 6.72%, and the price of each bond has dropped from $1,000 in 1962 to $714. Even at those interest rates, most bond issues are selling slowly. Mortgage rates on homes have risen to an average 8.12%, and financing for many would-be home buyers is painfully unavailable.

These conditions partly reflect the Federal Reserve's squeeze on credit. Banks are curtailing bond buying and mortgage lending in order to conserve scarce funds for direct loans to business. Insurance companies, which are normally major buyers of bonds and mortgages, are being drained of cash by loans that they must make to policyholders who cannot get credit so cheaply elsewhere. But the bond-mortgage slump reflects even more the ravages of inflation. Corporations, for example, are hurrying to build new plants before construction costs rise even further (see following story), and are selling huge quantities of new bonds to raise the cash. This month U.S. corporations will try to market $1.2 billion worth of new bonds, their heaviest December financing in history.

What Is High? Simultaneously, inflation makes bonds or mortgages unattractive investments. If prices kept on rising during the 20 to 40 years that investors often must wait for full repayment of principal, investors eventually would get back dollars worth much less than those they originally lent. Meanwhile, interest rates would keep on climbing--to levels that might make even today's yields look piddling because lenders would demand even higher returns to keep ahead of prices. (Some mortgage lenders now grumble that they are "stuck" with loans made years ago at interest that seemed high then but is low now.) The end result of this process would be that investors would refuse to supply as much long-term credit as the nation needs to build needed houses, schools and other facilities.

Big corporations have been able to sidestep these problems by selling stock instead of bond issues. Developers of office buildings, apartment houses and shopping centers can arrange mortgages by giving the lender a share in the revenues or profits. These expedients are not available to home buyers or local government units that must sell bonds, and some authorities think that much more radical changes in the markets will be required if they are to raise the cash that they need. Sidney Homer and Economist Henry Wallich, among others, have seriously suggested that mortgage and bond issuers may have to pay variable interest rates tied to movements in consumer prices. Some experts also expect a swing from long to short-term financing. There are signs of that happening already. Executives of Hawaiian Electric Co., for example, last month wanted to-sell $18 million worth of 30-year bonds but, after consulting with underwriters, decided instead to sell an issue maturing in only five years.

Making It Worse. If widely adopted, these makeshift devices could be dangerous. The need to refinance mortgages or bonds every five years or so would create endless headaches for home buyers and builders of schools, roads and factories. Variable interest rates would amount to a recognition that lenders expect continued inflation. That in itself could explosively aggravate the nation's inflationary psychology, which is the basic problem. In the long run, the U.S. simply cannot have healthy long-term capital markets in the midst of inflation. The need to ensure a continued flow of long-term money into houses, schools and other public facilities is thus one of the most important reasons why curbing inflation is the No. 1 U.S. economic priority.

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