Interest Rates Are Lower--Does That Equal ‘Right’?
For economic wallop, what compares with collapsing oil prices? Well, declining long-term interest rates. Since early 1985, they have dropped roughly 3 percentage points. Lower rates have ignited the stock market, stimulated housing construction and favored business investment. If the economy is improving--and February’s rise in the unemployment rate to 7.3% still leaves some doubt--lower interest rates are a main reason.
What happened? With hindsight, it’s easy to say that lower long-term rates reflect lower inflation. But this broad generalization slides over the reality that the sharp drop in interest rates was neither predicted nor in any direct way caused by the Federal Reserve Board, Congress or the White House. As recently as October a group of 50 economists forecast an average 1986 rate of 11.2% on high-quality corporate bonds; by early March the rate was 9%.
The basic lesson is how little we understand and control the economy. Sound economic policies--an efficient tax system, a balanced budget, stable prices--can promote confidence and long-term economic growth. But our mastery of business cycles or changes in specific industries is illusory. Economic policies are blunt instruments that in a complex economy have unintended side effects.
For all their importance, interest rates remain a subject of immense confusion and mystery. The striking aspect of the current decline is that long-term interest rates have dropped far more than short-term rates. Since January, 1985, for example, rates on long-term Treasury bonds have fallen more than 3 percentage points while those on short-term Treasury bills have declined roughly 1 percentage point. Other interest rates have followed this pattern so that average rates of fixed-rate conventional mortgages declinedfrom 12.3% in January, 1985, to 10.7% in February, 1986.
The implication is that the Federal Reserve has so far played a secondary role in lowering rates. Its direct influence is concentrated on short-term rates. For example, the Fed lends to banks (which make mostly short-term loans) at the so-called discount rate. In May, 1985, the discount rate was lowered from 8% to 7.5%. The next reduction, to 7% on March 7, followed the decline of long-term rates. At most, the Fed’s influence over short-term rates explains a third of the reduction of long-term rates.
And the rest?
One popular theory is that the declining prices of oil and lower prospective budget deficits have improved American investors’ expectations of inflation and future interest rates. This theory makes sense, but is not totally convincing. For starters, about half the decline in long-term interest rates occurred last November--before the steep fall in oil prices or the passage of the Gramm-Rudman balanced-budget law. There has also been conflicting economic news. A depreciating dollar, which makes imports more expensive, darkens the inflation outlook, and one court has already ruled the Gramm-Rudman measure unconstitutional.
Nor is it clear how much expectations have changed. Consider a regular survey of 462 financial professionals by Richard Hoey of the brokerage firm of Drexel Burnham Lambert. In January, 1985, the respondents forecast average inflation of 5.2% over the next decade. Last month the forecast for the decade still exceeded 5%, even though the survey’s expected inflation for 1986 had declined. Similarly, the forecast in June, 1985, for the fiscal 1990 budget deficit was $166 billion; last month the estimate was $142 billion. These are not startling changes.
To be sure, it’s possible to quibble over details. Since last month’s survey, oil prices have declined further. (The respondents predicted an average of $19 a barrel for 1986; by early March some “spot” prices had dropped to $12.) And, of course, the survey may not reflect broad investor expectations. But that’s the point. The economy is not a finely calibrated machine, but the result of millions of individual decisions. Crowd psychology influences interest rates, just as it does the stock market.
No one doubts the importance of interest rates. Kept too low, they encourage inflation by promoting excessive borrowing. Kept too high, they kill investment and economic growth. For the moment, lower rates promise to be a tonic. In January, housing starts (at an annual rate) exceeded 2 million--the highest monthly level since February, 1984.
But our ignorance is unsettling. In the end, lower rates may be a delayed reaction to lower inflation. But we do not know what is precisely the “right” level of interest rates--low enough to promote healthy expansion, but high enough to contain inflation. Even as lower rates help the economy today, could they be laying the groundwork for higher inflation tomorrow?
