As Rates Rise, So Does Risk of Recession
What’s going on? Interest rates are rising, the value of the U.S. dollar is skittering up and down like the price of some unstable commodity, and the bond and stock markets are careening from euphoria to despair.
What’s happening is that the U.S. government, as represented by the Federal Reserve Board and its chairman, Paul Volcker, is trying to achieve a delicate balance of growth without inflation for the U.S. and world economies. But to do so, it is taking some risk of provoking a U.S. recession.
Not to beat around the bush, things will probably turn out all right. But to understand why, it’s also a good idea to know the risks.
So first the bad news. Interest rates are rising because the Federal Reserve is allowing them to do so, hoping to signal the international currency markets that it wants to stop the decline in the value of the dollar.
One recent interest rate signal was subtle--tightening money just when demand for bank loans from customers needing to pay taxes was at its highest--but clear enough to cause the bond and stock markets to take a swan dive this week and to spark a debate among market professionals and economists as to whether the Fed has shifted to a policy of higher interest rates that would slow the economy.
Shift May Be Real
Ominously, one notable forecaster says the shift is real. Albert M. Wojnilower, senior adviser to the First Boston investment firm--who has known Volcker since they worked together in the 1950s--believes the Fed is worried enough about higher prices that it wants to put brakes on the economy.
And that tells you how interlinked the world’s economies have become.
The higher prices Volcker is worrying about are for imported goods--the Toyota that costs more in dollars because the yen’s value has increased so much. Imports account for 10% of the U.S. gross national product, and the Fed chairman fears higher prices will become a pattern in our economy.
Also, there is concern that a too-cheap dollar will price foreign goods out of the U.S. market and devastate the Japanese and West German economies. And there are fears that a weakening dollar will discourage Japanese investors from buying U.S. Treasury bonds and thereby helping to fund our government’s budget deficit. The result of all those fears: higher interest rates.
Falling Dollar, Rising Rates
There are risks, of course. One is that the Fed, by signaling its willingness to raise U.S. interest rates to support the dollar, will only deter investors from buying U.S. securities until they’re sure the currency has stabilized--which could set up a vicious spiral of a falling dollar and rising rates.
The second risk is more serious: that an increase in short-term interest rates, as well as mortgage rates, could stall consumer spending. And that could send a none-too-robust economy into recession.
But there is good news, too. For one thing, exports are rising. Yes, you see the massive trade deficits reported in the headlines and on television--$15 billion in February. But that outsized figure, like the price of the Toyota, reflects higher prices due to shifting currencies rather than actual numbers of automobiles, VCRs or machine tools. In actual product numbers, U.S. industry is selling more abroad these days. And that’s a pattern likely to continue, says Richard Berner, a vice president of Salomon Bros., in a new study on U.S. trade.
In other words, American factories will have lots of work making goods to supply foreign markets, even as we continue to run big trade deficits in terms of currency values.
The prospect of that work is one reason we saw a report this week of rising business investment in plant and equipment. The industrial Midwest, which has suffered so much from foreign trade in this decade, could now begin to benefit.
Another piece of good news is that the underlying rate of inflation in the U.S. economy is not that strong, maybe 3%, resulting from actual cost and wage pressures. The reason for the other 1.5% to 2% of our current inflation? Once again, blame currency shifts, but recognize that it cuts both ways--while the dollar was strong we lived well on imported goods and enjoyed low inflation.
However, the fact that the underlying rate is 3% is good news because it means that interest rates could come down to around 6%--meaning a mortgage rate of 8.5% to 9%--in six months or so if the world’s economies do achieve the delicate balance in which the growth of Japanese and German industry does not have to be at the expense of American jobs, and vice versa.
The situation today--with Japan’s domestic economy flat and Germany’s scarcely growing--is anything but balanced. The world, in short, is on the brink of recession.
The last time this happened, in the 1930s, the world fell into depression because no nation exercised leadership for the global economy. Is America exercising leadership today?
Fitfully, at best. To really lead, suggests C. Fred Bergsten, a Carter Administration Treasury official who now heads Washington’s Institute for International Economics, the U.S. government would have to raise taxes and eliminate the budget deficit, thus “unwinding a cause of the present imbalances.” The resulting growth of confidence in our leadership, says Bergsten, would compensate for the risk of slowing our economy.
Meanwhile, Paul Volcker does what he can with interest rates.
