Interest Rates: A Troublesome Rise

IT was just about a year ago that interest rates began falling sharply, a decline that the Nixon Administration and private economists have since been counting on to help lift business out of the 1970 recession. But in the past three to four months, the rates have been rising again (see chart) and the bounceback has gone high enough to stir worry. Henry Kaufman, a partner of Salomon Bros., warned last week that a continuation of the rise would "eventually abort the economic recovery" by making financing difficult.

Last week New England Telephone & Telegraph Co. sold $200 million worth of bonds at 8.2% annual interest, compared with a low of 6.8% on a Bell System borrowing in late January. The new rate is more than halfway back up to the Bell interest peak of 9.35% in June 1970. Short-term interest rates have risen less strikingly, but even so, bellwether three-month U.S. Treasury bills early last week were selling at almost 4.5% interest, the highest rate since mid-January. The rising rates seem to be pulling some money out of the stock market. Last week the Dow-Jones Industrial Average fell 15 points to 907, substantially below the recent high of 951 in late April.

Puzzling Reversal. The interest turnabout seems contradictory. The Federal Reserve Board in the first quarter expanded the nation's money supply at a 9% annual rate. Consumers are saving at a near-record clip, putting still more lendable cash into financial institutions. About a fourth of U.S. industry's plant capacity is still idle, indicating no great need for expansion funds.

Wall Street has an explanation for the puzzling reversal: the Federal Reserve last year pushed down interest rates too far and too fast. Word went around the financial community that the board, in order to slow this precipitous decline, had decided to cut back on its expansion of the money supply. As a result, some investors, who had bought bonds in anticipation of a continued drop in interest rates, sold again, causing bond prices to drop and pushing rates back up.* Once rates began rising even slightly, corporate treasurers who had any thought of eventually borrowing decided to do so immediately, before rates rose still further. The increasing demand for credit became a self-fulfilling prophecy: it drove down bond prices and hiked interest rates.

This explanation suggests that the current rise in interest like the earlier fall, has gone beyond what the economic fundamentals dictate. Unfortunately, the Federal Reserve Board cannot move with impunity to reduce interest rates again. A drop in U.S. lending charges below those prevailing in Europe touched off last month's international monetary crisis (TIME, May 17) by starting a hemorrhage of U.S. dollars to Europe in search of higher returns. No one is anxious to repeat that experience.

Home-mortgage interest rates have not yet risen, but they are likely to. At an average 7.5%, they are no longer competitive with the yield that lenders can get on bonds and other long-term investments. An increase in mortgage rates could stop the upturn in home building that has so far helped propel the modest economic recovery. Further, the rise in long-term interest rates indicates the financial community's lack of confidence that the Nixon Administration's policies will eventually defeat inflation. A rule of thumb in the credit markets is that the "basic" interest rate on long-term borrowings tends to hold unchanged at 3%; the actual rate is 3% plus the prospective rate of price inflation. At minimum, the current situation suggests that the U.S. economy has already received all the help it is going to get from lower interest rates.

* The interest paid annually on bonds is a fixed percentage of their face value. Thus when the prices of bonds drop, new buyers actually receive higher interest rates.

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