Interest rates are taking off again after barely pausing for breath at the bottom of their recent slide.
Marked by another rise in the prime rate yesterday, money market rates have begun to soar again.
Last Thursday's 1-point rise in the Federal Reserve Board's discount rate, while following other rate rises, sealed the upward trend. It triggered both Friday's and yesterday's increase in the prime lending rates of major U.S. banks. Since then money market rates have leaped further. Treasury bill rates at Monday's weekly auction jumped to their highest levels since last spring.
The prime went from this year's low of 11 percent to 13 1/2 percent in just six weeks. It held steady at the low of 11 percent (for most major banks) for less than a month. And while the first 1-point climb was staged over four weeks, the jump from 12 percent to 13 percent took only two weeks.
The extraordinary speed of the turnround this year contrasts dramatically with the mid-1970's recession. Then the prime stayed at its 1974 peak for three months, compared with the 16-day peak this April. The earlier low was not reached for more than two years, and when it came, it lasted for five months.
The decisive rise in the cost of money this time around came sooner than most economists expected: After all it is barely two months since the Fed dropped its discount rate to 10 percent. It is a sharp indication of the problems facing economic policy makers.
Interest rates typically fall during a recession as business and consumer demand for credit drops off. Usually they stay low until the economy is well on the way to recovery. But this time rates began to rise almost before the recession was over.
What is worse, they started their climb from an historically high level. In 1975 the prime fell to 6 1/4 percent, and the yield on three-month Treasury bills dropped close 4 1/4 percent, before interest rates began to rise with the expanding economy. They had peaked after the earlier boom at 12 percent and just over 9 1/2 percent respectively -- compared with 20 percent for the prime and over 15 1/2 percent for the bill rate earlier this year.
Many economists and bankers believe that the cost of money will go on rising as the economy picks up. There are already signs that consumers agree with them. They are leaping back into credit markets, despite the high rates being charged for borrowing, as if they have given up hoping that money will get cheaper. Of course if money continues to get more expensive, the demand for credit will drop off again -- with the housing industry first in line to fell the crunch.
Inflation bears the main responsibility for the higher nominal level of interest rates. Despite the steep slump in the economy in the second quarter of this year, there is little evidence of a marked slowdown in prices or wage rises. And there are clear signs that people expect inflation to stay high, or rise, next year.
Some companies are building cost increases of as much as 15 percent into their calculations for next year, according to government officials. And the recent rise in rates has been due to expectations of inflation as well as to increased demand for credit, according to the New York bankers who have put up their prime rates.
The Federal Reserve Board's attempts to fight inflation also are pushing up interest rates. The Fed has been making clear warning noises that Congress and the administration are heading towards overexpansionary tax and spending policies.
As long ago as July, Federal Reserve Board Chairman Paul Volcker hinted in testimony before several congressional committees that there could be a conflict between monetary and fiscal policies next year if Congress enacted a sizable tax cut.
He said that the Fed would not budge from its firm control of the money supply even if this clashed with attempts by legislators to boost the economy through tax cuts unmatched by cuts in federal spending.
Since Volcker and his Fed colleagues will not sacrifice the money targets, believing that this of itself would be inflationary, the implication is that unless price rises slow down there will be little room for economic growth next year.
As the economy recovers, business and consumers demand for credit will rise, adding to the pressure on interest rates. Fed officials believe that the money targets for next year could probably be met without further sharp rises in rates if nominal gross national product -- dependent on both prices and output -- rose by 10 to 11 percent. But if prices alone rise by this much, and on top of this there is economic growth of between 2 percent and 3 percent (more than now forecast by private or official economists), then rates almost certainly will go up again next year. [TEXT OMITTED FROM SOURCE] That the climb is likely to continue over the coming months. For as long as monetary policy is being used to fight inflation then there will tend to be up-ward pressure on interest rates: The Fed will by definition be trying to hold money growth somewhat below the rise in nominal GNP in an attempt to squeeze out some price rise (at the risk of choking off real growth.)
There is another element in the swings of the past year. Since last October the Fed has been basing its credit policies on controlling money supply directly, rather than through interest rate changes. Rates have been allowed to move violently and widely to find their own level, in the light of the Fed's targets for expansion in the money aggregates.
This switch in policy may well have contributed both to the sharpness of the interest rate swings earlier this year, and to the brevity of both peaks and troughs.
The old policy almost inevitably led to delays between changes in monetary growth and consequent changes in interest rates, as the connection between the two was dependent on the judgement of officials and their assessment of the monetary data rather than on the market.
It is hard to imagine the Federal Open Market Committee deciding to raise rates to their spring levels at anything like the speed that the market pushed them there, if indeed they would have pushed them that high at all. Similarly, the rapid drop in interest rates, as demand for credit dried up in the second quarter and the money supply fell, would not have been likely under the old system.
The end of stable interest rates this month may have been hastened in just the same way as the earlier rise and fall was telescoped. There was considerable criticism overseas and among foreign exchange dealers earlier this year when the Fed let rates fall so sharply, and some foreigners now feel that the present rise is correcting what was too sharp a fall.
Some New York money market analysts complain that the new techniques of money control are destabilizing bond markets, with violent swings in interest rates, to an extent that out-weighs the benefits in terms of more precise control of the money aggregates.