NEWS ANALYSIS : Drop in Long-Term Rates Brings Hope for Economy

High long-term interest rates--seen as a major obstacle to the nation’s economic recovery--have finally begun to crack, fueling a stock market surge and new hopes for a decisive end to the long recession.

Responding to the drop in rates, the Dow Jones industrial average leaped 45.12 points Wednesday, after a 51.87-point jump the day before. The index closed Wednesday at 3,379.19--nearing the all-time high of 3,413.21 set June 1.

While relentless prodding by the Federal Reserve Board has driven interest rates on short-term loans and investments dramatically lower, long-term interest rates on home mortgages and corporate and government bonds have stayed relatively high. Investors and economists believe that a sustained drop in long-term rates is needed to lay the groundwork for a much healthier economy over time.

That is because as mortgages get cheaper, more Americans can afford to buy homes. And as companies large and small refinance their long-term debt at lower rates, they save cash that can be used to expand their operations and hire more workers.

The yield on 30-year Treasury bonds, the benchmark long-term interest rate, has fallen to 7.44% as of Wednesday, nearing the lowest levels in 14 years. As recently as May, that yield was more than 8%.

That drop has pulled down other rates, including long-term fixed-rate mortgages. The average rate on those loans now is 8.08%, the lowest since Richard M. Nixon was President nearly two decades ago.

Economists, mindful that their early expectations of renewed growth this year were too optimistic, now generally take a cautious view of the economy’s potential, even with a big break in long-term rates. Nonetheless, they say the drop in long-term rates unquestionably provides the missing ingredient for the recovery.

“We should not make the mistake to think that lower (long-term) rates by themselves will revive the economy,” said Norman Robertson, chief economist at Mellon Bank in Pittsburgh, Pa. Still, he said, “Lower rates are going to help.”

Perhaps best of all, falling long-term rates hurt virtually no one--unlike the plunge in short-term interest rates, which has slashed the incomes of many older people dependent on bank certificates of deposit and other short-term savings vehicles.

Ironically, the burst of optimism on Wall Street this week has its roots in recent dismal economic data. A stream of government reports have confirmed that the economy slowed in June and that consumers are again growing wary of spending money.

The Fed, which controls short-term interest rates, cut those rates further on July 2--for the seventh time since 1990--in an attempt to spur the flagging economy.

But experts agree that it is long-term interest rates that have the greatest direct influence on economic activity. The Fed, however, does not control long-term rates: Professional and individual investors do by buying and selling government bonds that mature over five, 10 and 30 years. Until this month, they have demanded extraordinarily high interest rates for longer maturities, fearing that future inflation would wipe out their investment.

But now, many investors are rushing to buy long-term bonds, apparently convinced that a slow-growth economy guarantees a 2% to 3% inflation rate--low enough to justify a significant decline in long-term interest rates ahead.

“I think there’s been a slow and steady change in investors’ perceptions” about the economy and interest rates, said Abby Cohen, investment strategist at the brokerage Goldman, Sachs & Co. in New York.

Monthly inflation reports this year have consistently shown that price increases in the economy have been minimal, even as growth resumed earlier this year, Cohen noted. In addition, a surplus of job hunters has kept labor costs restrained, she said.

Faced with that evidence, more investors now appear to believe Fed Chairman Alan Greenspan’s comments last week that long-term interest rates “have a good way to go down,” assuming inflation is under control. Although no one is predicting a straight line down for long-term rates, many experts say the psychology that has kept those rates so high may finally be broken.

The benefits to the economy from even a small decline in long-term rates can be extraordinary.

For example, because major companies tend to finance their operations with longer-term bonds, lower long-term rates can mean a corporate windfall.

The Compton-based Ralphs Grocery chain provides a case in point: The company has been paying 14% annual interest on $300 million of older bonds. Last week, Ralphs refinanced those bonds at a rate of 10.25%.

The interest savings from the lower rate--nearly $12 million a year--will be used for capital expenditures within the Ralphs chain, spokesman Alan J. Reed said.

At the household level, the Mortgage Bankers Assn. estimates that nearly 3 million homeowners will refinance their mortgages this year because of falling interest rates. The net result will be $6 billion a year in homeowners’ pockets that would otherwise have gone toward mortgage interest, said bankers association Chief Economist David Lereah in Washington.

That figure may even be understated given the drop in long-term rates this month and a further fall expected in the weeks ahead, Lereah says. His association’s index of mortgage refinancing activity has rocketed from about 400 in the spring to more than 1,200 now, indicating that refinancings have tripled.

Still, most economists now couch their estimates of the economy’s gain from lower long-term rates in more cautionary tones than they used last year.

Despite declines in mortgage rates, for instance, sales of new homes have not revived significantly this month, said David Seiders, chief economist at the National Assn. of Home Builders in Washington.

Interest rates are only part of the equation when people mull buying a new house, Seiders noted. Of greater concern to many potential buyers is job security, he said.

What the latest stock market surge is saying, however, is that a slow-growth economy in the near term may be the best alternative: By keeping inflation fears in check, a slow economy should allow long-term interest rates to continue falling, ultimately building a stronger base for sustainable new growth.