Home buyers who are paying mortgage rates of 15 to 16 percent, small-business people paying a couple of point over a 20 percent prime rate at the banks and S&Ls shelling out 14 1/2 percent to attract deposits hardly need to be convinced that interest rates are high.
But by one little-noticed measure, interest rates have reached a completely abnormal level, one that could pose a serious threat to the economy even though the Reagan administration has promised that its pursuit of monetary restraint will not depress the economy seriously.
The measure is the so-called "real" rate of interest, or in simple terms, the difference between the underlying inflation rate and long-tern interest yields. For example, if the long-term interest rates on government bonds were 10 percent and the inflation rate were 7 percent, the "real" rate of interest would be 3 percent.
For most of the modern economic era, financial markets have considered conditions to be in balance with a 3 percent "real" rate of return. But after the oil shocks of 1973-74 and 1978-79, inflation advanced so sharply that the "real" rate turned negative. Thus the managers of money policy at the Federal Reserve found justification for a steadily tighter money policy that, combined with the demand for money, pushed interest rates higher and higher.
Almost unnoticed, a strange thing has been taking place recently: Inflation rates have fallen while interest rates have softened only slightly. Thus not only have negative interest rates disappeared, but actual "real" rates of interest have oved into the 5 to 6 percent range, or double the usual 3 percent pattern.
Treasury Undersecretary Beryl Sprinkel, the administration's principal exponent of a monetarist approach, said in an interview that the extraordinary "real" level of interest rates is "unsustainable." Sprinkel said if the Fed pursues with determination the present policies of slowing money growth, the present high level of interest rates, as well as inflation, will recede.
But no one inside or outside the Fed denies that the present extraordinary level of interest rates is the ultimate symbol of the Federal Reserve's imposition of an avowedly "monetarist" policy, in which money growth is all important and interest rates not at all. Perhaps ironically, this policy is being pursued by a board on which the chairman, Paul A. Volcker, and four other governors were appointed by a Democratic president, Jimmy Carter.
"In a monetarist world," said New York expert Henry Kaufman, "You don't look at interest rates. The only thing you're concerned with is controlling the growth of the money supply."
The Fed hasn't been in the business of trying to set or control interest rates since it installed now famous "new operating procedures" focusing on the money supply in October 1979. Thus, says governor Lyle Gramley, interest rates "are going to fall out of an equation that starts with how much money we're willing to provide and how much the economy demands. If you go at it that way, you get a better perspective on where interest rates have to be."
Right now, Gramley says -- and his colleagues almost totally agree -- "interest rates have gotten high enough to slow down the process of economic growth to, practically speaking, zero." The prognosis at the Fed is that the flat economy will take some of the sting out of both inflation and interest rates this summer and fall. At the same time, officials of the central bank believe the tax cut and increases in military spending could start a new round of inflation and high interest rates in the fourth quarter that could carry into 1982.
Throughout Durope, politicians and central bankers, fearful of the rigidity of American interest-rate policy, are pressing the U.S. government to rely less on a restrictive monetary policy and more on fiscal policy. But they have little expectation, short of a major economic bust in the United States, that they can shake Reagan or the Fed.
To explore the factors leading to the doubling of the "real" interest rate and what significance this may hold for the economy, on-the-record interviews with six of the seven governors of the Fed were conducted. Chairman Volcker did not respond to a request for an interview on this subject.
Without exception, the six governors recognized the abnormal, unprecedented nature of real interest rates. Generally, they derive the 5- to 6-percent "real" interest rate by assuming an underlying inflation rate of between 9 and 10 percent (a higher number than the current consumer price index), and measuring that against high-quality corporate or utility bond rates around 15 percent.
And while the candid answers of all six governors showed no inclination yet to shift away from a monetarist focus on growth of money, some of the responses contain the first intimations that individual board members are beginning to question how long they should continue to tolerate the high levels of interest rates.
Governor Charles Partee, a career economist at the Fed who joined the board during the Ford administration on the recommendation of Arthur Burns, believes the current 5- to 6-percent gap between inflation and interest rates probably reflects expectations that inflation will persist for a long period.
"We're holding back the growth of money and credit, and demand is still out there -- you have to explain the demand," Partee said. Reserve Board officials say a growth rate of 6 percent or less in the basic money supply (M1-B) will finance a growth of nominal (money) GNP of about 10 percent. Assuming an underlying rate of inflation that stays at 9 or 10 percent, there isn't much room for real growth. Interest rates, the theory goes, thus have to be high enough to keep economic growth at a very slow pace or actual growth of the money supply will exceed targets. That's the monetarist notion in a nutshell.
But, Partee says, "Inflation is hard to break, and when it does break, the danger is that interest rates will be so high in real terms that we can get a [meaningful] fall-off in real economic activity."
Fed Vice Chairman Frederick Schultz said interest rates are abnormally when measured against inflation and when measured against the underlying rate of growth in the economy, which he put at 2 percent (far below the first-quarter rate of 8.6 percent).
"These real interest rates are very high in relation to almost anything you want to look at," said Schultz, a former Florida banker and politician viewed as a conservative Democrat when Carter appointed him two years ago. If the gap between inflation and interest rates doesn't begin to narrow over the next six months or so, Schultz said, the Fed will need to give the whole matter "some very careful thought, because it's high, it's very high.
"If my analysis is right, then we're not doing enough to cool [inflationary] expectations, or this volatility of interest rates is really more of a problem than we see it at this point in time. Or there's some other factor in there that I don't see at this stage of the game."
In terms of inflationary expectations, Schultz makes the point that while President Reagan is undoubtedly a great communicator, "rhetoric alone" will not change the way corporations or individuals behave. He adds that "for 15 years now, people in government have been telling the people of this country that we were going to get inflation under control, and we haven't done any such damn thing. It's been just the opposite."
Governor Nancy Teeters, a former Brookings economist and congressional budget expert, says the unusual level of real interest rates is a reflection of the Fed's restrictive money policy: "The rate of growth of the nominal GNP is such that the economy is basically demanding more money, but is being held back by the restricted growth in the monetary aggregates."
Five months ago she said, she would have agreed with the proposition that monetary policy had overshot its targets and ought to be loosened. But after the astonishing performance in the first quarter (which she said she did not understand and thus was reluctant to forecast what's ahead), Teeters argued that this is not the time to shift policy.
"Maybe down the line, the time will came to pay a little more attention to interest rates and a little less to the money supply," she said.
Governor Lyle Gramley said it is "possible" that interest rates have become too restrictive, but he's not ready to come to that conclusion yet. Gramley theorized that real interest rates have soared to present comparative levels because "monetary policy during the eary years of the postwar period worked more through changes in availability and less through real interest rates than it does now."
In other words, when things got tight lenders would not make loans at any price. There were legislated ceilings on government-guaranteed mortgages and usury ceilings in most states.
"Now," Gramley says, "what we have seen over the whole postwar period is a series of innovations in financial markets which have led almost uniformly to a complete breakdown of those blockages of credit which used to be so important in the process of monetary restraint. Anybody can get credit at a bank if he's willing to pay the price."
In Gramley's view, real interest rates "have become the cutting edge of monetary policy. They have to be much higher than they used to be to get the same amount of restraint."
Gramley, after a long career at the Fed, was for a short time a member of the Council of Economic Advisers in the past administration. He was Carter's last appointee to the board. Gramley recalled that last year's "consensus" among private and public economist was that recession would last all through 1980 and would be followed by a feeble recovery in 1981.
Instead, by last October, it was evident that a recovery was well under way, he said, "and everybody expected it to end right away. It didn't -- and it didn't, I think, because interest rates have to be a lot higher than any of us relize in developing these forecasts, to act as a severe restraining device on economic activity."
Governor Emmett Rice, generally considered a liberal Democrat, says he is "concerned" about the rise of real interest rates but nonetheless argues that they are the logical consequence of the monetarist policy being pursued by the Fed. Rice concedes that there are risks in the policy concludes there is less risk in the Fed's present course than there would be in any other.
"We've already begun to see some decline in market rates of interest," Rice said. "We've also seen in the last three months some decline in the rate of inflation, as measured by the CPI. Now, whether this presages a decline in the basic or underlying rate of inflation, I think it is too early to say."
Governor Henry Wallich, a Republican apointed by Richard Nixon in 1974, said in a telephone conversation from West Germany that "real interest rates are very important" and that the current high level, resulting from strict adherence to a money-supply goal, "gives promise" of reducing inflation.
Although he admitted that "in an inflation, we can't be sure what the right rate of interest ought to be," Wallich said he would hesitate to depart from present policy. "If we have another sharp drop in interest rates like we had last year," Wallich said, "it would be interpreted by the public as a sign we have given up the fight against inflation."
Wallich believes as even more significant measure of interest rates is "real interest after taxes." Broadly speaking, he argues, since taxes reduce the effective interest rate, this is what should be compared with inflation rates.
A recurring theme in the reflections of all of the board members interviewed was that the economy, now stronger overall than anyone had predicted, has weak sectors -- such as housing, the thrift institutions and the auto industry -- that are particularly vulnerable to a monetarist policy that ignores the impact of high interest rates.
Schultz, for one, critices "those people who say the volatility of interest rates doesn't make any difference, that what you ought to do is just stick with the growth of the money supply on a target, hold it there, and to heck with how volatile interest rates are."
One of the things wrong with that approach, Schultz says, is that lenders add an extra premium to cover "uncertainty," which helps explain the abnormal level of the current pattern of real interest rates. In turn, this casts doubt on economis forecasts, as Teeters suggested.
"This is a very different world from the one I grew up in," Gramley sighed. "I used to think I was really a hotshot forecaster, but I have become very humble about my forecasting abilities. In part, that's because real interest rates are serving a different role than they once did. I add up the pieces, but I can't add them up any more. I just don't know what's gonna happen . . ."