Inflationary Interest

For most bankers and businessmen, nothing seemed more certain two months ago than a continuing slide in interest rates. That conviction was nurtured by expectations of a slackening economy, the energy crisis, wilting loan demand and a less restrictive money policy by the Federal Reserve Board. To the astonishment of most experts, inflation has made hash of those predictions; both long-and short-term interest rates are scooting back up, some to record highs. Soaring loan costs are now hurting businessmen trying to finance expansion programs, municipalities seeking public improvements and millions of people wanting to buy homes.

Major banks, led by Manhattan's Bankers Trust Co., last week lifted their prime lending rate to businessmen to 10%, equal to the high of last December and up l 1/4 points in only three weeks. In addition, since mid-March, rates on 90-day commercial paper--unsecured loans between corporations --have gone from 8.5% to 9.7%, banks' one-month certificates of deposit from 8.8% to 10.1% and Treasury bills from 7.8% to 8.4%.

The startling rise in interest rates has left big bond-underwriting houses with huge, expensive inventories that they cannot sell profitably. The brokers stocked up on bonds, expecting to make a profit as yields dropped and prices rose. Instead, as soaring short-term rates attracted ever more investors, yields on bonds, too, have had to be boosted substantially--and even then have not been high enough in some cases to attract buyers. The situation has become so grim that one of Wall Street's most venerable investment bankers, Lehman Bros., announced last month that it would sharply reduce its bond underwritings.

The basic reason for the jolting reversal, says Robert F. Tighe, partner in Bear, Stearns & Co., is that the credit markets "have to finance inflation." As other prices rise, lenders insist on higher interest yields. They are getting them too, because business-loan demand has exploded despite a weak first quarter. Many corporations are rushing to borrow to pay the soaring costs of buying raw materials and other inventories. Some companies are also borrowing money now that they will need later; they fear that the Government will eventually move to a sterner anti-inflation policy that will create a credit shortage. In the week ending April 3, business borrowings in New York alone hit $736 million, the biggest total ever in a non-tax-payment period.

Tight Rein. At the same time, the lifting of the Arab oil embargo and early signs of renewed strength in the economy have shifted the Federal Reserve's attention away from trying to stave off a recession to quelling inflation--even at the cost of towering interest rates. For example, though the Federal Reserve does not appear to be holding an excessively tight rein on the money supply, it has shown itself increasingly unwilling to open up enough to accommodate the upsurge in loan demand. For the three weeks ending April 3, the last date for which figures are available, the money stock grew at a relatively modest annual rate of 7.6%.

Another indication of the Federal Reserve's stiffening attitude is the rising rate for federal funds--money that banks borrow briefly from one another when they overlend to their customers. The interest rate on this money, which the Federal Reserve strongly influences, has leapt from 8.8% in late February to more than 10% today. Federal Reserve Chairman Arthur Burns recently explained: "We at the Federal Reserve are determined to follow a course of monetary policy that will permit only moderate growth of money and credit."

Of all the industries adversely affected by high interest rates, housing probably will be the hardest hit. In periods of rising interest rates, the chief sources of most mortgage money dry up. Depositors in savings and loan associations and savings banks withdraw their funds and put them into better-paying investments such as Treasury bills. According to experts in the Federal Home Loan Bank Board system, which supervises S and Ls, the process has already begun. Result: the housing industry, which was beginning to show signs of an upturn--1.8 million starts in February v. 1.4 million in December--could well be hammered down again.

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