Tax Reform Is Sure to Depress Interest Rates
Stock prices took a tumble last week and analysts blamed fear of rising interest rates. That fear is a bit surprising considering all the factors at work to take rates in the opposite direction.
Some of those factors are obvious, such as the sluggish economy and very low inflation. One is less so: the new income tax legislation nearing final passage.
What was supposed to send rates higher was a combination of events. Business growth would be fast enough to stimulate increasing loan demand.
The massive federal deficit would sop up too much money, leaving too little for the rest of the economy. The sharp decline in the value of the dollar meant that it was supposed to take a lot more of them to purchase imported goods, creating renewed inflation and thus more pressure to push rates up.
The aftermath of all of this, some forecasters warned, would be another recession.
And stock market enthusiasts, nervous about that, react by selling off some their holdings every time there’s a new economic statistic that might support that view.
What has happened instead is that interest rate cuts are spreading.
Resistant to Change
In addition to the much-publicized decline in rates on bank loans and home mortgages, banks have begun cutting what they pay on passbook savings accounts, even trimming what they charge on credit card balances.
Those credit card charges have been highly resistant to change up to now.
At the same time, the public isn’t exactly rushing out to borrow or to buy, despite lower interest charges. True, there’s still heavy demand for mortgage refinancing, but that’s more a hangover from the high rates that home buyers found themselves forced to accept up to a year or so ago. Retail sales have been almost flat for some time.
When the auto industry sought to generate some interest in the 1986 models still in inventory, it practically had to wipe out interest on the car loans to generate buyer response. It’s all part of the broad economic adjustment to the near-disappearance of inflation.
There’s no incentive to rush out and buy things, because there’s little fear that those goods will cost more later. To the contrary, there’s hope that prices on some things will fall. That’s keeping the economy from growing much.
So is the attitude among corporations that costs must be controlled and expansion plans slimmed or shelved to keep profits up in the face of little growth. On top of that, the very prospect of even lower interest rates means there’s no rush to borrow now.
The sluggish economy also means that foreign producers trying to sell goods to this country are finding that despite the cheaper dollar, they have to be restrained in raising their prices if they want to maintain market share. So even the dollar decline isn’t generating much inflation.
Rates to Fall
Add it all up and there’s not much to bolster interest rates. And that’s even before considering the impact of the new tax law. Over the next two years, income tax rates will fall sharply.
That means that savers will get to keep a bigger share of the earnings on their deposits. It also means that borrowers will save less on taxes by deducting interest payments; hence, borrowing will cost them a lot more.
Beyond that, the new law eliminates deductions entirely for many kinds of borrowing. Even refinancing first and second homes will face tougher tax treatment, since in most cases interest on any loan balance greater than the original cost of the property plus improvements made on it won’t be tax deductible.
Two things are likely to happen as a result: To generate loan volume, banks are going to have to lower interest rates for all kinds of loans. And to do that, they’ll have to hold down what they pay for savings deposits. Savers probably will be willing to accept somewhat less because they can look forward to paying less tax on what they do receive.
In short, tax reform has produced a strong incentive to push the economy back on a pay-as-you-go basis. Stock market gyrations notwithstanding, that means lower interest rates.
