The Loan-Charge Mystery

"Is there any point to which you would wish to draw my attention ?"

"To the curious incident of the dog in the night-time."

"The dog did nothing in the nighttime. "

"That was the curious incident," remarked Sherlock Holmes.

--Sir Arthur Conan Doyle, in Silver Blaze

Economists these days are applying a kind of Sherlock Holmes logic to the strange case of interest rates. Like the watchdog who did not bark (thus signifying to Holmes that the crime he was investigating must have been an inside job, perpetrated by someone the dog knew), loan charges have been doing the opposite of what might be expected. They have been lying low throughout a period when all past experience indicates they should have been rising. Like Holmes, economists think that this curious behavior must provide an important clue--in this case to what is really happening in the U.S. economy. Their main conclusion: inflation is subsiding during this recovery, rather than speeding up as it did in earlier ones, and that has changed all the rules of the game.

The upturn that began just about a year ago seems to be picking up speed. For example, the Government reported last week that real gross national product--output of goods and services, discounted for inflation--rose 8.5% in the first quarter, rather than 7.5% as first estimated. Corporate profits before taxes jumped 45% over the first quarter of 1975, to a near-record annual rate of $140.8 billion.

By this stage of all previous recoveries, interest rates were rising as businessmen gobbled up loans to finance expansion and build inventories. But this time interest rates throughout the recovery's first year have continued the slide that began during the recession. The prime rate charged by banks to their most credit-worthy customers has dropped from a sky-high 12% in mid-1974 to 6 3/4% now. Yields on high-quality corporate bonds have held almost unchanged, and those on "federal funds" --money that banks lend overnight to each other--are less than half the almost 13% of two years ago.

A few rates, it is true, have begun to edge up again; the federal funds' rate last week eased up from 5.02% to 5.28% --a signal to some economists that the money supply is tightening. Wall Street has been displaying an almost panicky fear of a further rise: worry about the possibility of higher interest rates is a major reason the Dow Jones industrial average keeps dropping back below 1000 every time it reaches that mark (it closed last week at 990.75). But even the rise in those rates that have turned around is barely visible on charts.

The Missing Premium. Why? Says Walter Heller, a member of TIME's Board of Economists: "This is a mystery to all of us." Economists do have some explanations, however. The most important: not only current price rises but expectations of future ones have diminished to the point where lenders no longer feel they have to tack a high "inflation premium" onto loan charges --and businessmen would not pay such a premium anyway.

The Consumer Price Index in April rose at an annual rate of 4.9%--a bit more than in previous months but a far cry from the pace of 1974 and 1975. The behavior of interest rates indicates that businessmen and lenders believe the improvement is real and will continue. In that environment, businesses have less need to borrow: their costs are rising less rapidly, while their profits and cash flow are up sharply. So the demand does not exist to support high interest rates, even if lenders tried to get them.

Corporate treasurers, indeed, are actively trying to avoid borrowing from banks; they remember too vividly the pain of 12% interest rates. Instead, companies are using their higher profits to repay past debt and in some cases pile up huge reserves of Treasury bills and other securities that can quickly be turned into cash. The idea: when the company needs money, it can sell the securities rather than borrow. Even when they do borrow, companies are shying away from banks and either selling commercial paper (a kind of IOU) at rates below the bank prime or tapping the bond market.

Another factor keeping interest rates low is that the Federal Reserve Board has been creating enough new money to accommodate loan demand. That has turned out to be less money than almost anyone a year ago would have thought necessary: the nation's money supply in the twelve months through April grew only 6.1%. But the judgment of Federal Reserve Chairman Arthur Burns as to how much is enough proved surprisingly accurate. One reason is a change in what Burns calls "financial technology": corporations now may open interest-bearing savings accounts and quickly shift the funds, when needed, into checking accounts. That and other means of switching funds electronically from one account to another speed up the flow of money between debtors and creditors, and have the effect of increasing the money supply more than the official figures show.

A few critics now think that interest rates are too low. Otto Eckstein, a member of TIME's Board of Economists, fears that if rates do not rise gently this year, they will go up so abruptly in 1977, when loan demand should finally revive, as to jolt the economy. Burns does now seem to be trying to nudge interest rates up a bit; among other things, he intends to dole out money more slowly. His new target is money-supply growth of 4 1/2% to 7% a year, down from the 5% to 7 1/2% he had been aiming at for the past twelve months. But the rise in loan charges does promise to be gentle, and for the foreseeable future, 12% interest rates seem likely to remain only an unhappy memory.

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