Sky-High Interest Rates

By John S.DeMott

Reaganomics and rapid money growth give Wall Street the jitters

Already orbiting at altitudes unimaginable a few short years ago, interest rates moved even higher last week and threatened to shoot the moon. The commercial bank prime lending rate rose to 19%, not far below the record 21.5% set in December. Rates for other financial instruments such as six-month Treasury bills were near record highs. By almost any measure, the cost of money, the lubricant for the U.S. economic engine, was high and heading higher.

There was no mystery about the sharp rises, at least in hindsight. Sensing that the U.S. economy is fundamentally strong and in no danger of recession, businessmen and consumers have stepped up short-term borrowing. Consumer credit in March increased by $3.1 billion to $310.8 billion, and bank loans to businesses rose in April by $1.9 billion to $170.1 billion.

But when the Federal Reserve published figures reflecting that increased loan demand and money growth, American financiers reacted nervously. The report showed that the most important measure of the money supply, which is called M1B and includes money in circulation, checking accounts and checklike NOW deposits at thrift institutions, had grown by a stunning $4.2 billion to $431 billion in the third week of April.

Economists, who had been seeing signs of a slowdown in March and April after a strong January and February, had been predicting money supply declines for over a month as credit demand slackened. When this did not happen, it stirred momentary fears that the Federal Reserve had lost control of the nation's currency and that more inflation and higher interest rates were on the way.

The U.S. central bank moved swiftly to counter the expansion in the money supply. On Monday it raised its discount rate from 13% to a record 14%. Banks that borrow from the central bank to meet their own reserve requirements will now have to pay that rate, plus a 4% penalty if they borrow too frequently, bringing the total cost of funds to some banks to 18%. At the same time, the central bank allowed the federal funds rate, the interest charged by banks on overnight loans to each other, to rise above 20%. The hoped-for result of last week's action: borrowing will lessen, demand for goods and services will ease, the economy will slow down, and inflation will ameliorate.

Laudable though these goals may be, the Fed's action was not joyously welcomed on Wall Street, where investors have much the same attitude toward escalating interest rates as W.C. Fields had toward children and small animals. The day of the discount rate hike, the Dow Jones industrial average plunged 16 points; the next day it lost another 7. There was some recovery as the week wore on, and the Dow closed Friday at 976.40, still well below its high this year of 1024, set only a few days before the discouraging money-supply report.

In bond markets, conditions were even worse, as prices plunged. The Reserve Bank's clampdown came at a particularly bad time for the U.S. Treasury. It auctioned $6.75 billion in long-term bonds and notes last week, and the jump in interest rates meant that the Government was forced to offer investors considerably more than had been anticipated: 14.56% on ten-year notes and 13.99% on 30-year bonds. In February ten-year notes were being sold at 12.89% interest.

Last week's money markets reflected, in part, a growing uneasiness in some sectors of the financial community over whether the Reagan Administration is on the right track toward lowering inflation. The leaders of this group of skeptics are Henry Kaufman, chief economist for Salomon Bros., and Albert M. Wojnilower, chief economist of the First Boston Inc. Both men are among Wall Street's most respected figures, and both are critics of the Reagan Administration's version of supply-side economics. Kaufman believes that increased military spending, without more cuts in social spending, and a large tax cut will increase inflation and send interest rates flying to new highs.

Almost as if to support some of those sentiments and set the stage for tighter Administration policy later, Treasury Secretary Donald Regan warned last week that unless the Government continued its drive against spending, interest rates and the federal budget deficit would sharply higher. He foresaw a swollen fiscal 1981 budget deficit by Sept. 30 of $60 tillion as the Government scrambles to meet mushrooming interest payments on its debt. As recently as March 10, the Administration was predicting a far smaller flow of red ink. Regan also predicted that the top had not yet been reached on interest rates.

Most businessmen, bankers and economists, however, are more sanguine about the future course of interest rates than either the pessimists or Regan. They generally see the prime rate peaking at about 20%, perhaps a little higher, but then falling back to 15% or so by autumn. Other short-term rates will probably do the same. Walter Heller, President Kennedy's chief economic adviser, expects that an economic slowdown in the next month or two will pull down the cost of borrowing money. John E. Barnds, vice president, business and banking analysis at the National Bank of Detroit, feels the "general trend of short-term rates is downward." In New York, H. Erich Heinemann, a vice president of Morgan Stanley, said, "I think we're living through a temporary bubble in interest rates that is not likely to persist."

Despite last week's renewed concern that the rapid money growth would set off new inflation, the battle against high prices is, almost surprisingly, going better than expected. Thanks largely to the small glut of world oil supplies, consumer prices are beginning to slow down. The basic underlying rate of rise for consumer prices remains at about 10%, but the level of inflation for the first quarter dropped to an annual rate of 9.6% from 13.2% in the final quarter of 1980. The Bureau of Labor Statistics reported that the Producer Price Index for April, a precursor of consumer prices, rose at a 10% annual rate, down from the torrid 16.8% pace of the previous month.

But qualms persisted about whether the Federal Reserve is doing its job as well as it should. Although the Reagan Administration officially supported last week's hike in the discount rate, several key officials, including Beryl Sprinkel, Under Secretary of the Treasury for Monetary Affairs, and Lawrence Kudlow, chief economist of the Office of Management and Budget, have been critical in private about Fed policy. They argue that the central bank should control the growth of money more efficiently and worry less about influencing the level of interest rates.

Most economists, though, give the Federal Reserve and its chairman, Paul Volcker, high marks for at least trying to deal with the sheer massiveness of the money supply in a $3 trillion economy. One sign of progress: last Friday the Federal Reserve reported that M1B had declined by $3.6 billion in the last week in April. And Heller admitted: "I don't think that any human being knows how to control that money supply."

Meanwhile, the effects of interest rates, which are as high as those once charged by Mafia loan sharks to their least creditworthy customers, ripple through the economy. Home building is expected to be the hardest hit by the spiraling cost of money. Said Michael Sumichrast, top economist for the National Association of Home Builders: "Housing is dead." The steeper rates may also nip off the recent small spurt in auto sales. But economists generally believed that last week's jump in interest rates should not do severe damage to business in general. Said Otto Eckstein, president of Data Resources, a consulting firm based in Lexington, Mass.: "Housing and autos will suffer, but this will not be enough to trigger a recession."

One beneficial effect of the high interest rates was that they helped push the value of the American dollar on foreign money markets to some of its highest levels in years. The dollar rose to a value of 5.4 French francs last week, its best rate in ten years. European finance ministers, who less than 18 months ago were complaining that the dollar was causing international financial havoc by being too weak, now say that it is causing troubles by being too strong and forcing up interest rates in other countries. They would like to see the U.S. ease back on rates so that they could do the same and help their economies grow faster. In a complex world, there is no pleasing all of the people all of the time.

--By John S.DeMott.

Reported by David Beckwith/Washington and other U.S. bureaus

With reporting by David Beckwith

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