Some Interest Rate Roulette

By Christopher Byron

The recession rumbles on, and all bets are off

For millions of Americans, from cash-strapped home buyers to laid-off auto workers to jittery Wall Street investors, the single most cheering result of the economy's spring-long slide has been the dizzy drop in interest rates from their alpine heights of last winter. Only three months ago, banks were charging their best corporate clients 20% interest. That rate last week was down as low as 11 1/4%. The question now is whether it will stay down, and for how long.

When the cost of money shot up early this year, consumer spending tailed off, the economy and the stock market started to slump, and unemployment lines began to lengthen almost everywhere. Yet now that the recession has cooled the demand for money, the high cost of borrowing has steadily dropped. This is making it somewhat easier for people to buy a house or a car, or perhaps just go out to dinner on a credit card.

Meanwhile, a series of surprising actions by the Federal Reserve in recent weeks suggests that Chairman Paul Volcker would like to see those volatile rates remain low in order to prevent the recession from getting any worse. The Fed has switched from a draconian clampdown on the growth of money all spring to a breathless 14.9% annual rate of increase in June. Moreover, it has begun cautiously lowering the levels to which it will let certain key interest rates sink. At the same time, the U.S. central bank, in a further effort to feed cash and credit back into the economy, is also phasing out the panoply of temporary credit controls that it placed on the economy last March.

There are already signs that the changes are having at least a modestly stimulative effect. During June, retail sales climbed 1.4% from May's depressed level, and construction starts on new houses jumped to an annual rate of 1.2 million units, an increase of 30% over May. But this is still far below last June, when 1.9 million dwellings were built on an annual basis.

Automakers last week reported that sales during the first ten days of July showed a modest improvement, dropping 19% below the same period of 1979, instead of the 23% decline that the industry has been experiencing since January. And mercurial Wall Street continued its recent strong showing, as the Dow Jones industrial average hit 923.98, its highest level in three years.

The steep economic downturn still continues. Figures released last week showed that the nation's business declined at an annual rate of 9.1% between April and June. And industrial production plunged 2.4% last month, matching May in the steepest such drop since January 1975, when the economy was struggling to climb out of the last recession.

President Carter will send to Congress this week his midyear economic review, and the reading will be glum. As late as March, the Administration was gamely forecasting a 1980 budget deficit of no more than $36 billion to $38 billion and a 1981 surplus of $16.5 billion. But with unemployment soaring and tax receipts slumping, those optimistic targets now lie hopelessly beyond reach. As a result, the 1980 deficit is currently projected to be $60 billion, followed by at least another $27 billion in red ink next year.

The review's unemployment and inflation forecasts are particularly discouraging. Instead of the earlier prediction of a jobless rate of 7.2%, the Administration now foresees unemployment by December at 8.5%, and that rate will last well into next year. In March the Administration foresaw an average 1980 inflation rate of 12.8%, dropping to 9% in 1981. Yet in spite of the economic downturn, the Administration does not expect inflation to abate at all next year. And despite this weak economy, President Carter continues to oppose steadfastly any tax reduction legislation this year. Carter and Republican Presidential Candidate Ronald Reagan are going to opposite corners on the tax cut issue. Reagan demands a $36 billion reduction in both personal and corporate taxes starting in January, while the President says that any tax relief must await better economic times.

With business uncertainties abounding in a presidential election year, Federal Reserve Chairman Volcker has be come the center of attention. His apparent pirouettes in money policy are coming under attack for causing the leap-and-lunge unpredictability of interest rates. He is also being blamed for both the harshness of the recession and the prospect of renewed inflation. Complains Lawrence Brainard, a senior economist for Bankers Trust in New York: "What we have seen so far is a flip-flop policy--first too tight, then too loose. The Fed is now stimulating the money supply in order to counteract its earlier tightening, and just at a time when everyone in Washington is talking about a tax cut. In short, we could wind up in 1981 with a new surge in inflation and a stagnant economy--a British-style stagflation that would be the worst of both worlds."

Adds Economist Allan Meltzer of Carnegie-Mellon University in Pittsburgh: "The Fed is committing its usual mistake of boom and bust. It has made the recession worse than it needed to be through overly restrictive monetary action, and its corrective action will now only increase inflation on into the future."

But other critics charge that the present pace of monetary expansion is too slow, and that the Fed should speed up money expansion still more. Says H. Erich Heinemann, vice president of New York's Morgan Stanley investment banking firm: "If the Fed persists along its present course, the slowdown in monetary growth will be the sharpest since 1930. By relaxing its restraints so reluctantly, it is making the recession deeper than it needs to be; and this is bound to lead to excessive expansion later on." Much of the criticism is unfair. As it announced last October, the Federal Reserve is now at tempting to regulate the money supply by concentrating on controlling the amount of financial reserves in the system, rather than by the more traditional method of pegging interest rates at some desired level.

The approach was almost universally praised when Volcker first announced it nine months ago, and its only real problem so far has been the severity of the recession itself. Though the Fed has, in fact, been steadily increasing the reserves in the system, consumers have simply not been borrowing. Monetary growth has thus been undershooting the Fed's target of about a 6 1/2% maximum annual in crease in the basic money supply. Mean while, the lack of borrowers has helped cause interest rates to drop still farther.

The bewildering result has been to put the Federal Reserve in a conflict between its national economic goals and its international ones. Lower U.S. interest rates might be beneficial for the domestic economy, but they could easily provoke a renewed dollar panic overseas. Since April, falling American interest rates have caused the dollar to lose nearly all the ground it gained during the winter, when U.S. rates were skyhigh, against key foreign currencies like the German mark, Swiss franc and Japanese yen. The U.S. thus might be forced to raise interest rates only in order to protect the dollar. Concedes one top Fed official ruefully: "We simply cannot ignore interest rates completely, because we cannot ignore the value of the dollar abroad. We are already hearing rumblings by our European counterparts that if we allow U.S. interest rates to fall lower, the dollar will be in for some real trouble."

Ultimately, the careering interest rates simply mirror the topsy-turvy American economy. As soon as it begins to show signs of struggling back from recession, something new, like the prospect of a fresh climb in interest rates, threatens to knock it back down. --By Christopher Byron, Reported by William Blaylock/Washington and Frederick Ungeheuer/New York

With reporting by William Blaylock/Washington, Frederick Ungeheuer/New York

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