Whither Interest Rates? Higher Still

Interest rates are rising, and both consumers and investors are asking why. That question can be considered two ways. First, are market forces moving interest rates in the face of unchanged policy on the part of the Federal Reserve, or is a change in Fed policy moving rates in the face of relatively unchanged conditions in the market? Second, and more fundamental, what changes in the economic environment have led either market participants or the Fed to act so as to raise interest rates?

On the first level, the recent increase in the discount rate--the rate that the Fed charges member banks that have a temporary need for additional reserves--would seem a straightforward case of the central bank seeking a general raise in interest rates. For when the banks have to pay higher rates for their reserves, they will have to charge higher rates for the money that they lend or invest.

However in the arcane world of banking and finance, nothing is quite that clear. The Fed in fact raised the discount rate long after many important money-market rates, such as the rate on Treasury bills and bonds and on business and consumer loans, had already risen. Such a lagged response is often, but not always, the case.

When the Fed lowered the discount rate to 8.5% from 12% through seven successive cuts during the second half of 1982, the rate on Treasury bills was generally falling ahead of the discount rate cuts. By contrast, when the Fed made the first of several cuts in the discount rate in early 1986, market rates had been relatively stable, though they immediately responded to the Fed’s lead and declined into the fall.

But even these leads and lags between market interest rates and the discount rate tell us much less than they seem to about whether it is markets or policy that is moving rates. The Fed influences market interest rates every day through its purchases and sales of government securities in the open market. Thus when it finally raised the discount rate, it was putting a stamp of approval on changes in market interest rates that it had already been influencing through its open market operations.

Fed policy can always cause interest rates to rise, and when it comes to very short-term rates, its policies dominate the market. Market expectations about the future have more to do with movements in long-term interest rates, such as the rates on bonds and mortgages.

Beyond these generalizations it is the interactions between policy and market forces that generate most interest rates we observe, and it is generally futile to try to identify the separate influence of each. Both the markets and the Fed are looking at the same complex of economic developments and, in addition, market participants are trying to anticipate how the Fed itself will react to those developments.

Turning to the more fundamental question of what is happening to the economy to explain why interest rates have risen, the usual suspects are inflation, the strength of the economy, the exchange value of the dollar and the budget deficit.

Eight weeks ago in this column, I analyzed where we stood on inflation and concluded that it was not yet heating up as some observers worried, but that it was getting warmer. Fighting inflation is the Fed’s main concern and it can be expected to react to even such early signs of growing inflation risks by raising interest rates.

We learned from the 1970s that inflation, once well under way, has great inertia and is hard to get rid of. This time around, it is quite certain that the Fed will try to keep inflation from getting started rather than let it head clearly higher before trying to bring it back down.

The strength in this year’s economic expansion is a related source of upward pressure on interest rates. The government always talks about wanting a strong economy and points with pride to every economic statistic that shows a rise in housing construction, business investment or automobile sales. Yet it also fears too much of a good thing and worries about the economy going too far too fast, because that would lead to higher inflation. The expansion in 1987 has been stronger than most forecasters had expected and the unemployment rate has already declined to below 6%, a level that in the 1970s spelled inflationary wage pressures from tight labor markets. Thus, quite apart from direct evidence on inflation, which as yet is inconclusive, this sort of economic strength usually spells rising inflation risks and higher interest rates.

Weakness in the dollar has pushed up interest rates in two ways. Most directly, to keep the dollar from falling further, policy-makers have raised interest rates as a way of attracting foreign funds into dollar investments. Less directly, because a falling dollar contributes to higher inflation, it tends to raise interest rates for the reasons already discussed.

The budget deficit is the last candidate to help explain interest rates. For fiscal year 1987, which ends this month, the deficit will drop from about $220 billion last year to perhaps $150 billion.

Unfortunately, this year’s results do not represent a trend toward lower budget deficits in the future. Part of the improvement is the one-time effect of higher tax collections that were generated by last year’s tax reform package. And with decisive policy changes delayed until there is a new president, the deficit will now rise again. Congress has contained defense spending and cut civilian programs.

But with the President refusing to consider raising revenues, attempts to engineer a compromise that would include still more budget cuts and reduce the deficit have faltered. With the economy still expanding briskly as it nears full employment, a higher deficit adds to the pressure for higher interest rates.

Do these developments, which help explain the rise in interest rates that has already occurred, also signal still higher rates in the future?

Pressure on the dollar exchange rate may abate. But the outlook for the budget deficit is unlikely to improve, and the economy should continue to expand at a rate that lowers unemployment further in coming quarters. I doubt that all of this has yet been reflected in Fed policy or the market’s anticipations.

So, in my judgement, interest rates are heading higher.