Over the past few months, there have been repeated predictions that interest rates "are about to peak." Joining and sometimes leading the optimistic chorus had been Federal Reserve Board Chairman G. William Miller, who, one would think, would know better.
But interest rates have not peaked. They have soared, climbing at the steepest rate since the credit crunch of 1974. Yesterday the Fed raised the federal funds rate another notch to just under 9 percent. A 9 percent federal funds rate implies a 10.5 percent prime rate, at least. And some leading analysts say that there is much more to come, with the peak still a year away.
"In my view we're on our way to 12 percent a year from now on the federal funds rate," said Lawrence Kudlow, chief monetary economist for Paine Webber Jackson & Curtis. "I don't think we're more than half way yet in the current interest rate cycle.
The sudden realization that interest rates may have to climb much further - perhaps breaching the painful levels of 1974 - is what has hit the stock market broadside this week, dropping the Dow Jones industrial average by 37 points in just three days.
In explaining the interest rate surge, most commentators say the Fed has been driving interest rates up to "tighten" monetary policy in order to bring down inflation.
But the fact is that monetary policy has been anything but tight, or effective. And that is why analysts like Kudlow and Henry Kaufman, chief economist for Salomon Brothers, think that rates still have a long way to travel.
"The Federal Reserve thus far has raised interest rates," Kaufman said, "but it has not so far slowed the availability of credit."
"There is substantial credit availability for all credit-worthy borrowers," he added. "There has been no denial of credit of funds to any key sectors, ranging from housing, to the consumer to government or business. And it is that problem alone - the ineffectiveness of restraint of the interest rate mechanism and the problem of inflation - that will serve to push interest rates substantially higher."
The Fed has given the illusion of a tight monetary policy through its interest rate increases while at the same time it has been feeding the nation's money base at a near-record rate, negating the impact of interest rates with an extremely loose hand on the money lever.
Through the first eight months of 1978, the basic money supply or M-1 has grown at an 8.2 percent annual rate. That is just short of the 8.3 percent record for a 12-month period. In the past two months, the basic money supply has been growing at an 11.6 percent rate.
Meanwhile, the Fed continues to give up service to the concept of keeping the growth of M-1 below 6.5 percent on an annual basis as the way to conduct a long-term monetary policy that is not inflationary.
But if it were to actually adhere to this policy and try to bring money growth down to this level, it would almost immediately drive short-term interest rates up to 11 or 12 percent - clearly a politically unacceptable level.
"It is axiomatic," said Kudlow, "that bad monetary policy begets worse monetary policy later on. The man who digs a 6-foot hole can get out faster than a man who digs a 12-foot hole. And the Fed has put itself into just such a bad position."
The monetary authorities are caught between a White House that thinks interest rates are already too high, and the financial markets which are concerned about a monetary-induced inflation," he added.
Kudlow, a monetarist, believes that the growth of the money supply is directly related to the growth of the economy and inflation. Feeding the money stock faster than the economy's long-term real growth potential of around 4 percent eventually gets converted into inflation, according to monetarist theory.
The Paine Webber analyst said that the monetarist theory and the growth of the money base over the past 18 months helps explain why the U.S. economy has surprised many forecasters by continuing to show strong growth despite predictions of a slowdown.
"The Keynesian models are the ones that have been predicting a peak in rates and a drop in gross national product, but that just hasn't happened," Kudlow said.
He noted that personal income over the past six months "has been growing at a 13 percent annual rate, which is the fastest since early 1977. And that results directly from the substantial monetary stimulus provided by the Fed."
Kaufman, of Salomon Brothers, considered perhaps the leading Wall Street authority on interest rates, is not a strict monetarist. But he holds an equally pessimistic view of the interest rate overlook for the next 12 months.
"In all sectors we are moving into double-digit interest rates," he said. "I believe as we look back at the experience of the last three years, that we missed our governmental timing, because the expansion of government's monetary and fiscal policies should have been slowed down late in 1976 or early 1977. As a result, whatever we do now is going to be quite painful, both for the financial markets and the U.S. economy."