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Lower Interest Rates? The Price May Be A Weak Recovery

Business Outlook


Forecasting interest rates is a lot different from predicting gross national product. Economists stand to lose more than their credibility. They can lose someone's money.

Right now, the outlook for interest rates is especially dicey. No one has a clue about what the Federal Reserve's next move on short-term rates will be. Worries in the bond market about inflation and the huge borrowing needs of the Treasury Dept. are clouding the outlook for long-term rates. And on top of it all, the recovery has not yet revealed its true identity: Will it be Arnold Schwarzenegger or Pee Wee Herman?

To be sure, the Bush Administration would like the economy to show some muscle as it heads into the 1992 election year dragging along a $350 billion budget deficit. But the Fed and the bond market are more comfortable with the consensus forecast of a relatively meek recovery (chart). Given their power to influence the outcome, the central bank and bond traders seem more likely to get their wish.

If that's true, the Fed will be able to hold short rates fairly steady during the second half. The rate on three-month Treasury bills, for example, has held close to 5.6% since early June. And long-term rates should remain in the range they have occupied for most of the year, 8.25% to 8.75%, as the improving outlook for inflation offsets the Treasury-led flood of new borrowing.


This consensus view sounds nice and neat, but it might not be that simple. First of all, stable Fed policy is no sure bet. And judging by Fed Chairman Alan Greenspan's remarks to Congress on July 16, the chances for additional easing in coming months are greater than those for a new round of tightening.

Greenspan's glowing prospects for inflation seem to preclude the need for higher short-term interest rates, as long as the recovery isn't overly strong. The central bank looks for consumer prices to rise in the range of 3.25% to 3.75% this year and 3% to 4% in 1992.

Moreover, Greenspan suggested that the squeeze on credit creation in the banking system, along with the failure of money growth to pick up, is a genuine risk to the recovery. He seemed to leave the door open to lower rates if the upturn shows signs of faltering.

Sluggish growth in money and credit is attracting increasing concern from both Washington and Wall Street. Top White House economist Michael J. Boskin calls the problem of credit availability "the single biggest threat to a sustained recovery." Many private economists question the upturn's viability in the face of unusually weak money growth. And even Fed officials admit to surprise over the latest money numbers.

M2, the most closely watched money measure, fell a sharp $6.9 billion in early July. M2 is now growing at an annual rate of only 3.1% from the fourth quarter of 1990, well below the midpoint of the Fed's 2.5%-to-6.5% target range (chart). During the first two quarters of the past five recoveries, M2 has grown somewhere between 8% and 16%, at an annual rate.

Some economists believe that money growth moves the economy, and some think that it is simply a reflection of business activity, but either way, the latest numbers do not bode well for an economy that is, according to most analysts, now three months into a recovery.

A lot depends on the rate at which money turns over, or velocity. As money turns over faster, a given pace of M2 can support greater growth in the dollar value of GNP. However, during the first year of the past five recoveries, M2 velocity has grown appreciably in only one case--and that was the short-lived recovery in 1980.

Without a pickup in either money growth or velocity, the current pace of M2 is inconsistent with the Fed's own forecast of 3% economic growth in the second half of 1991 and 2.25% to 3% in 1992. Amid sluggish money growth, the Fed will not lift short-term interest rates. Indeed, another cut in the federal funds rate, from 5.75% currently, seems likely by autumn.


Forecasting long-term interest rates is no piece of cake, either. In some ways, long rates are more important to the economy than short rates. They influence the credit-sensitive demand for houses, cars, and other items that help give the business cycle its swing. And long rates are largely outside the Fed's control.

For now, the bond market is a little leery of Greenspan's bright inflation outlook. But even a slightly less sanguine view of future price growth, combined with the expectation of modest economic growth, makes a strong case that the yield on 30-year Treasury bonds, for example, should be well below its current level of about 8.5%.

The problem is a relentless supply of new Treasury issues, expected to hit the market this quarter at a clip of about $1 billion a day. This is clogging the markets and keeping yields higher than they would otherwise be, particularly in relation to short-term rates (chart). In past recoveries, the yield spread typically widens, but it does so because short rates are falling faster than long rates, not because long rates are rising.

The failure of long rates to decline as they have in past recessions may be starting to hurt the recovery. Production of durable goods, where long rates play a crucial role, has been a leader in this upturn. However, new orders received by manufacturers of durable goods fell 1.6% in June, and after revision, the May gain was much less than originally reported (chart).

The housing recovery is also at risk. A July survey by the National Association of Home Builders noted a second consecutive month of erosion in home-buyer traffic, current sales, and builders' expectation of future sales.


There is no hope for any break in Washington's borrowing needs. The federal budget deficit narrowed to $2.5 billion in June, much less than the $11.1 billion gap in June, 1990. However, a calendar quirk, which depressed outlays, and delays in the bailout of failed savings and loans caused the shrinkage.

The White House estimates that the budget deficit is swelling to $282 billion in the 1991 fiscal year, which ends in September, from $220.1 billion in 1990. The Administration expects the gap in 1992 to balloon to $348 billion, as the costs of the S&L bailout continue to mount.

For the near term, such pressures on the credit markets will keep long-term interest rates higher than other fundamentals would allow. The deficit will jump to about 5.8% of GNP in 1992. That's only a shade below the record of 6.3% hit in 1983, which resulted in high real interest rates that substantially crowded out private investment and stifled productivity growth. Such a scenario seems likely in the early 1990s as well.

Moreover, if the Administration does not get its projected 3.6% in economic growth next year, the deficit could top $350 billion. Indeed, the Fed's goals for the economy are clearly at odds with those of the White House. Given the central bank's ability to influence the economy, its forecast of 2.25% to 3% for real GNP in 1992 looks like the upper limit on economic growth that the Fed feels is consistent with achieving its inflation goals.

The improving outlook for inflation should vent some of the upward pressure on long rates. Price increases always slow in the early stages of an economic recovery, reflecting the time lags required to eliminate excess capacity in the markets for goods, services, and labor.

Add to that the Fed's preferences for slower price growth, and the bond market's inflation fears seem way out of line with reality. All this means that long-term rates will eventually decline from their current levels, but that might not happen until 1992.

Until then, what's shaping up is a battle between the Fed's objectives for inflation and the Administration's needs for economic growth. Clearly, lower long-term rates would please the White House as the Presidential campaign nears. But the irony is, it will probably have to lose its battle with the Fed in order to get them.JAMES C. COOPER AND KATHLEEN MADIGAN

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