High Rates Could Keep The Recovery In Its Cradle

The U. S. economy is headed toward recovery with a lot of excess baggage. The recession did little to lighten the load of heavy debts, unsold real estate, shaky banks, and fiscal disarray in Washington and many states. That's weight enough on this fledgling upturn, but the heaviest of all might be long-term interest rates. Although the Federal Reserve Board has cut short-term rates, long rates remain stubbornly high.

Long-term interest rates influence the credit-sensitive demand for cars, homes, and other high-priced consumer goods. These are the kinds of cyclical items that lead recoveries and give the business cycle its swing. Clearly, the latest data on car sales, home buying, and durable-goods orders are looking better, but the numbers still do not show the bounce associated with a normal recovery.

That's partly because the recent pattern of long-term rates has been anything but normal. Long rates usually fall in recessions, although not as much as short rates. But this time, they didn't drop at all (chart). Yields on 30-year Treasury bonds, for example, remained stuck in the 8%-to-9% range that they had occupied during the final stages of the expansion. And now, long rates are under strong upward pressure.

Any bond trader can tell you why. For the next few months, the U. S. Treasury will be in the bond market asking for about a billion dollars a day. States and municipalities will also have their hands out. And capital needs around the world are growing every day. On top of that, the private sector has to finance an economic recovery that traders fear will fuel inflation. Will people buy all this paper? Only if yields are high enough.

Long-term rates will fall only if the recent signs of economic strength start to fizzle, or if the price indexes show stunning improvement in inflation. That means the price that the economy may have to pay for lower rates on mortgages and other consumer and business loans may well be a lackluster recovery that will keep the credit markets unclogged and price pressures down.


For now, the recovery is concentrated on the output side of the economy, as opposed to the demand side. That's because companies' vigilance over inventories has drained stockpiles so much that some producers, especially carmakers, must ramp up production.

However, this process will lead to a full and lasting recovery only so far as demand growth allows. That's where consumers hold the key, and high long-term interest rates are only one of the obstacles that will be blocking a consumer rebound in coming months.

So far, businesses are getting extra output from the same employees. Unless new hiring picks up, consumers' incomes aren't likely to rise any faster than their spirits. In June, consumers remained optimistic about the economy's prospects in the coming months, but job worries kept them pretty downbeat about the here and now.

The Conference Board's index of consumer confidence edged up to 78, from 76.4 in May. But the gain was concentrated in consumers' outlook for the next six months. The expectations index rose to 101.1 last month, from 95.5 in May. The reading on current conditions, however, fell for the 10th month in a row, to 43.3, from 47.8 (chart).

The big concern is jobs. The Conference Board reports that 37.5% of those surveyed think work is hard to get, a jump from the 23.7% expressing that concern last summer. And only 8.6% of consumers feel jobs are plentiful. That's much lower than May's reading, and it's a sharp decline from the 23.4% who felt that way a year ago.

The latest data on state unemployment claims appear to verify the notion that jobs are scarce. True, new filings for jobless benefits have been falling since they peaked in March. But that only suggests that companies are laying off fewer workers. The total number of people who are collecting benefits continues to rise.

In early June, 3.6 million were receiving benefits, up by 136,000 from the previous week and the highest level in eight years. The large number of continuing claims means the economy is still not generating many new jobs, so people are finding it difficult to get off the unemployment line.


Businesses will have to see a sustained pickup in demand before they start hiring again. And interest rates may have to fall a bit more before order books fill up fast enough for manufacturers to build up the production momentum necessary for a lasting recovery.

The latest news from durable-goods factories certainly looks encouraging. New orders for durable goods rose 3.8% in May, to $120.5 billion, on top of a 3.6% gain in April (chart). Although the April and May advances were broad, they were only moderate. Moreover, May orders were still about 7% lower than they were last summer.


Shipments of durable goods also rose in May, by 1%, to $121 billion. Most of that increase came from the auto sector, reflecting the recent upturn in new-car sales. Domestically made new cars sold at an annual rate of 6.5 million in mid-June. Sales for the first 20 days of June are running at about 6.4 million, an improvement from the 6.1 million pace of May, and the exceptionally weak 5.5 million rate in April.

The increase in car buying is paring inventories and creating some optimism in Detroit. Auto output is slated to rise in the third quarter. Carmakers are expected to produce about 6 million cars, at an annual rate. That's up from about 5.3 million in the second quarter, with most of the increase coming in July. Taken by itself, that would add about one percentage point to the annual growth rate of third-quarter gross national product.


For other makers of durable goods, however, the summer may not be as busy. Even with the uptick in new demand, the backlog of total orders edged down by 0.1% in May and is 1.4% below its pace of a year ago. Unfilled orders for durable goods haven't risen since December, 1990. With the backlog of demand still falling, producers have little reason to boost output beyond what's necessary to fill current demand.

Manufacturers of capital equipment, in particular, could run into trouble if interest rates rise by much more. Orders for nondefense capital goods increased by 4.2% in May. But demand had collapsed earlier in the year. Excluding the booming aircraft sector, the backlog of unfilled orders is down 4.9% from a year ago. So while capital-goods production may pick up in coming months, the rebound is shaping up to be pretty tepid.

Machine-tool makers, whose orders tend to foreshadow the path of capital-goods output, don't offer any encouragement. The Association of Manufacturing Technology reports that demand for machine tools, which are used by other manufacturers, fell in May for the fourth consecutive month. May orders totaled $155.8 million, down 19.6% from April and 24.5% below their year-ago pace. Domestic demand is especially weak.

For the rest of the year, durable-goods manufacturing will be vulnerable to any upward shift in interest rates. The Conference Board's survey shows that consumers' buying plans for big-ticket items, such as appliances, are already weak. And higher borrowing costs would make businesses rethink their capital spending plans.

In addition, rising mortgage rates threaten to derail the housing rebound that is beginning to take hold. In May, sales of existing homes increased by 6%, to an annual rate of 3.5 million. That was the fourth solid gain in a row. Home prices are also rising a bit, another sign that demand is strengthening.

The danger is that higher rates could cause problems during the important summer selling season. A retrenchment would hurt not only homebuilders but the makers of home-related goods as well.

As the recent pickups in housing and autos show, high long-term interest rates aren't likely to prevent an economic recovery from getting off the ground. But on top of a shaky consumer sector, a glut of commercial real estate, weak banks, and deteriorating government finances, lofty long rates could easily keep the economy from flying very high.

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