Interest Rates in the Clouds

By Christopher Byron

Expensive money becomes the newest double-digit menace

On the campaign trail last summer, Ronald Reagan promised that, as President, he would see to it that interest rates came down and stayed down. His pledge is already something of an embarrassment around the White House. Instead of declining, as Administration economic officials have been predicting all spring, interest rates have continued to hover at near record levels, weakening businesses, slowing growth and making a mockery of economic and budgetary planning by companies large and small alike.

Last week the Administration officially admitted that its optimism about interest rates has so far been wildly overblown. The backpedaling, which came as part of the Administration's midyear economic review, raises some doubt as to whether rates will decline very much this year at all.

Much of the midyear review was distinctly--and determinedly--upbeat. In March the Administration had forecast a 1981 full-year inflation rate of 11.1%, but that figure has now been scaled back to a barely single digit 9.9%, while the 1982 forecast has been shaved by slightly more than one percentage point, to 7%. The lower inflation reflects the softening demand for petroleum, but some economists are now warning that the worldwide oil miniglut may soon end, sending prices, and inflation, upward again.

At first glance, overall economic growth figures for 1981 also looked better. Instead of the modest 1.1% real increase that was anticipated in March, the Administration now projects a more respectable 2.6%. Much of the improvement is a result of robust expansion in the first quarter, when business grew at an annual rate of 8.6%. Many economists fear that prevailing high interest rates may flatten the economy for almost the rest of the year.

There was no disguising the gloomy interest outlook. In March the Administration had somewhat brashly predicted that rates for 91-day U.S. Treasury Bills, the short-term securities that the Government uses to finance much of its day-to-day activities, would be 11.1% for the year as a whole. Yet for the first six months of 1981, the average rate has been 14.58%, and last week it stood at 14.56%. Though the Administration has now boosted its full-year forecast to an average of 13.6% for the bills, even that figure may prove too low.

Since interest on the public debt already accounts for 10% of the federal budget, the high rates are making it harder and harder for the Administration to curb spending. It projects a fiscal 1981 deficit of $55 billion, virtually unchanged from its previous forecast. Actual spending may still rise by at least $6 billion over earlier projections, to $661 billion during the period, with most of the increase coming from interest rate charges.

Just as the high rates crimp the Government, so too do they squeeze businesses. Customers have less to spend, company overhead goes up and profits disappear. In recent months, that grim pattern has become a fact of life for more and more businesses. The gathering retrenchment is an important reason that practically every major indicator of future economic activity, from orders for machine tools by businesses to the issuance of construction permits for new homes, is now flat or pointing down.

The largest and most profitable U.S. firms are generally having the easiest time coping with the high rates. Business remains robust throughout the defense and aerospace industries, as well as in many mining and natural resource fields. Says Lawrence Klamon, senior vice president of the Atlanta-based Fuqua Industries Inc., a leading Sunbelt conglomerate (1980 sales: $1.5 billion): "Being a large corporation, we have access to capital funds. We can always go to the bank and get another couple of million dollars."

Not all businesses are so lucky. The highly interest-sensitive housing and auto industries have been particularly hard hit. In addition to the industry's giants, tens of thousands of suppliers, contractors and independent dealers and retailers are suffering as well. With business loan rates now in excess of 20%, automobile dealers are finding that they simply cannot afford to carry the cost of a lotful of cars to show to choosy customers. Thus the smaller dealers wind up losing sales to larger competitors who can lure shoppers in with the promise of immediate delivery from a more plentiful inventory.

The nation's thrift institutions, with upwards of $800 billion in assets, have been caught in the worst pinch of all. Savings and loan associations and mutual savings banks provide about half of all residential real estate mortgage financing in the U.S., but they are now having to pay as much as 16% and 17% for some deposits. Since few would-be home buyers are willing to take out mortgages at anywhere near those rates, hundreds of those institutions are slipping deeper and deeper into the red. As a consequence, the Commerce Department last week reported that housing permits dropped 16.4% in June. Warns Irwin Kellner, chief economist for New York's Manufacturers Hanover Trust bank: "If these high rates continue for another two months, I would not be surprised at all to see several large thrift institutions either go under or be forced to merge with larger and still solvent competitors."

Sluggish growth and staggering interest rates have combined to cause a rising number of bankruptcies. Failures of businesses with assets of even more than $1 million are rising sharply. One is Jefferson Screw and Bolt Industries of Elizabeth, NJ. Heavily in debt because of its expensive shop-floor tooling machinery and saddled with a poor credit rating, the company was forced to let its 300 workers go and close up altogether earlier this month. At the time, the cheapest loans it could arrange were at a near usurious 24.75%.

Just where interest rates will now move is anybody's guess. Confesses William A. Niskanen, a member of the President's Council of Economic Advisers: "We should admit that we are puzzled by all this. The reason why rates are staying so high is not obvious to me."

Administration officials are baffled because they have been insisting all along that a tight money policy by the Federal Reserve, when coupled with cuts in federal spending, would bring down interest rates. Lately, the Federal Reserve has certainly been doing its part. Since April the growth of the nation's money supply has been at a near standstill, and in the past month the so-called MlB, the nation's most widely watched measure of money, has actually been below the Fed's annual target range of a 3.5% to 6% increase.

What troubles Wall Street moneymen, however, is not Federal Reserve Chairman Paul Volcker's tight-money tactic, which they generally support, but the lack of an equally resolute stance on fiscal policy. Some bankers and analysts fear that the President's tax cut plans, plus his projected defense spending buildup, will more than offset the Administration's deep spending cuts elsewhere in the budget, and thus increase the need for federal borrowing. Interest-rate pessimists like investment bank Economists Henry Kaufman of Salomon Bros, and Albert Wojnilower of First Boston Corp., who have been nicknamed Dr. Doom and Dr. Gloom along Wall Street, assert that the prime rate could ratchet up at least above its peak of 21.5% and possibly as high as 25% before the end of the year.

Some bankers even argue that technical factors alone will keep rates from dropping by very much in the months ahead. With long-term interest for such investments as top-rated corporate bonds now as high as at least 15%, corporate treasurers have been postponing bond sales and covering their money needs on a week-to-week and month-to-month basis in the short-term market. In June alone, business demand for such credit jumped at an annual rate of 32%, to $319 billion. Moneymen speak of a "shadow bond calendar" of $10 billion to $15 billion in potential corporate debt that has been waiting to surge into the long-term bond market once interest rates come down.

Though financial razzle-dazzle plays are certain to keep interest rates in turmoil for months more at least, any easing off on monetary policy would assuredly bring only a temporary benefit. An increase in the money supply would first knock rates down slightly, but then it would send them leaping to still higher peaks when inflation exploded anew. The financial markets seem to be telling Washington that they want less federal spending and borrowing. Only if that occurs will interest rates come down and Stay down .

--By Christopher Byron. Reported by Bernard Baumohl/New York and David Beckwith/Washington, with other U.S. bureaus

With reporting by Bernard Baumohl, David Beckwith

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