The New Economic Order Will Hold Down Interest Rates

This time last year, a BUSINESS WEEK survey of 50 economists projected that the benchmark 30-year Treasury bond would be yielding 7.9% right now. Not even close. At about 6.25%, the yield stands at a 21-month low, and from all signs, it's on the verge of dropping through 6%. Wishful thinking? Hardly.

The yield on 30-year Treasuries last fell below 6% in October, 1993, when it hit 5.83%, the lowest since 30-year bonds were issued in 1977. But it didn't stay there long. The plunge was largely a market overreaction to President Clinton's budget-cutting efforts.

This time could be different. The bond market is recognizing that the economy is undergoing important structural change. The U.S. is moving into a climate of fiscal responsibility, watchful monetary policy, and a competitive corporate sector--a combination that will foster sustained low inflation and interest rates.

Recent trends only reinforce those perceptions. Fourth-quarter economic growth is slowing, perhaps a lot, after last quarter's 4.2% spurt. Inflation is already below 1995 forecasts, and because productivity gains are restraining unit labor costs, it may best 1996 projections of about 3% as well. Dramatic improvement in the U.S.-Japan trade balance has brightened the outlook for the dollar. And the Federal Reserve seems likely to cut rates in the wake of a budget deal.

Sub-6% rates will be a vitamin-B shot to this expansion (chart). Cheaper borrowing costs will help prolong the capital-spending boom, give housing a second wind, and let homeowners refinance and improve their cash flow. The rule of thumb is that a one-percentage-point drop in interest rates adds $100 billion to gross domestic product over two years.

A BUDGET DEAL with credible deficit cuts is the last piece in the sub-6% scenario, but it's a ways off. Congress and the White House have put aside their bickering, reopened the government, and appear ready for some serious haggling that could bring results by Dec. 15, when the new temporary funding measure expires. The Air Force One fiasco, however, illustrates how difficult and partisan the negotiations will be.

Some progress is visible. Tax cuts are on the table. The White House seems amenable to balancing the budget in 7 years instead of 10, and Congress seems willing to give a bit on its economic assumptions that project GDP growth of 2.3% through 2002, vs. the Administration's 2.5%. The deficit impact of that small difference compounds over time. Moving the forecast toward the White House numbers will require smaller spending cuts to achieve balance.

Another area for compromise could be the widely accepted overstatement of the consumer price index, which is used to adjust the cost-of-living increases in entitlements, including Social Security and Medicare. The White House and Congress might well agree to a lower cost-of-living adjustment as a way of achieving real spending cuts in these politically sensitive areas.

Meanwhile, with no official increase in the debt limit, the Treasury Dept. will have to continue its unprecedented financial patchwork to avoid a default. Treasury's strategy of temporarily converting certain forms of government debt into cash (which effectively raises the debt limit and allows new borrowing) has indefinitely removed the default threat.

IF NOT FOR THE UNCERTAINTY surrounding the budget follies, the economy's sluggishness might have already brought the 30-year yield to less than 6%. The government shutdown has delayed some monthly data along with the Commerce Dept.'s unveiling of the new chain-weighted GDP, but data compiled by private sources show that growth is flagging.

The latest assessment of homebuilders, for instance, looks weak. The National Association of Home Builders' Housing Market index, a composite appraisal of current demand, buyer traffic, and sales expectations, fell sharply in November (chart). In fact, the monthly drop was the largest in 10 years.

Even though mortgage rates are at their lowest levels of the year, the NAHB said that softer current demand accounted for most of the weakness in the November index. October housing-start figures, originally scheduled for release on Nov. 17, are delayed until Nov. 28, but both home buying and building appear to be easing back from their vigorous third-quarter pace.

The economy's softer tone will make it easier for the Fed to justify a widely expected cut in short-term interest rates after Washington finalizes its budget package. Although some Fed members have publicly embraced the notion of easing policy in the face of credible deficit-cutting, others remain adamant in their opposition to a monetary quid pro quo.

However, from the recently released minutes of its Sept. 26 policy meeting, the Fed appears to be giving more attention to the economy's downside risks than the minutes from Aug. 22 indicated. One can only conclude that, in the face of increasing signs of sluggishness in the economy, sentiment within the Fed for a rate cut probably increased further at the Nov. 15 meeting. Grounds for a rate cut may well be developing, irrespective of the federal budget outcome.

ANOTHER, AT LEAST PERIPHERAL, factor in the thinking in both the bond market and Fed policy is the dollar's recent firming, especially vs. the Japanese yen. A stronger dollar increases the attractiveness of U.S. bonds, and it gives the Fed more international leeway to cut rates. The dollar now seems entrenched above 100 yen, trading as high as 102 recently.

A key reason is the shrinking in Japan's trade surplus, especially with the U.S. The pace of imports coming into Japan is significantly outstripping the rise of exports. That trend will continue in the months to come, as Japanese companies shift production offshore, and as Japanese exporters continue to suffer from the yen's strength compared to its level in recent years.

In October, Japan's trade surplus with the U.S. plunged 44.2% from a year ago, to $2.7 billion, the lowest level in five years, according to data from Japan's Finance Ministry. Moreover, after seasonal adjustment by BUSINESS WEEK, the drop during 1995 looks exceptionally steep (chart).

Autos account for a big chunk of Japan's trade adjustment with the U.S. In October, auto imports from the U.S., totaling 13,658 vehicles, soared 67.3% from a year ago. Many of those came from Japanese plants in the U.S., but 5,284 came from the Big Three, 66.8% over a year ago.

The firmer dollar, noninflationary growth, and a new attitude toward deficit-cutting all represent structural changes in the U.S. economy. As the angst of corporate restructuring and the battles in Washington show, these changes do not come easily. But they do add up to one important benefit for the future: lower long-term interest rates. To reach that goal, though, it may be best if the President and Congressional leaders no longer ride in the same airplane.


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