QUESTION: Inflation is moderating and the economy is showing signs of slowing down. Why aren't interest rates falling?
ANSWER: Largely because the demand for credit is still great and the Federal Reserve, in order to reduce inflation, is restraining growth of the money supply. In addition, many regulations that used to penalize savers with only small amounts of money to invest are being dropped, which has the effect of increasing the interest rates that borrowers must pay. With money becoming more and more like any other commodity traded in a relatively free market, supply and demand are determining the price -- which in this case is the interest rate.
Q: Republican leaders in Congress claim high interest rates are basically the fault of Wall Street. What, if anything, can Wall Street do to bring down interest rates?
A: Wall Street is just a catch-all phrase meaning financial markets. There is nothing that participants in the markets can "do" to bring down rates. However, if the supply of money increased or the demand for it fell, borrowers would be able to find lenders willing to lend at lower rates. This would happen not just in New York City but in Washington and elsewhere, too.
Q: The Reagan administration blames high interest rates, at least in part, on the Federal Reserve Board. How does the Federal Reserve affect interest rates?
A: Primarily by affecting the rate of growth in the money supply or, more broadly, the growth of the amount of credit available to the economy.
Q: And how does the Fed do that?
A: Mostly by increasing or reducing the level of reserves in commercial banks. These reserves -- which represent a set portion of deposits and certain other sources of money at banks and other financial institutions -- must be kept in non-interest-bearing deposits at Federal Reserve banks. When the Fed sells part of its inventory of Treasury securities, it absorbs money from the banking system. Because much of the money on deposit at banks at any moment has been loaned to borrowers, this movement of money from the banks to the Fed tightens credit conditions. In response, interest rates rise and financial institutions make fewer loans. The entire process can slow or reverse overall growth of the money supply. When the Fed adds reserves by buying Treasury securities, it adds money to the banking system with the opposite result.
Q: From the very start of the Reagan administration last January, White House advisers have warned that the reaction of the bond market was the key to the success of the new economic program. Why?
A: Because the administration was counting on interest rates dropping sharply once its new program was in place. The drop was supposed to result from a change in expectations and would occur once financial markets became convinced the Reagan administration, unlike its predecessors, was committed to fighting inflation by carefully controlling growth of the money supply and reducing government spending.
Q: The administration seems fully committed to just those goals. Why has the bond market collapsed?
A: No one is fully sure, but there probably is a combination of reasons. First, the Reagan tax cut and projected increases in defense outlays indicated that large budget deficits were likely to continue. With the Fed holding down money growth, and Treasury borrowing increasing, not decreasing, interest rates went up, not down. Meanwhile, the potential payoff from the tax cuts in terms of more saving and greater investment in new plants and equipment, which would mean more productivity and lower inflation, still lies in the future.
Second, there have been many changes in regulations affecting financial institutions and in the way in which the Federal Reserve operates in the market. Since October 1979, the Fed has been seeking to influence growth of the money supply though bank reserves rather than by pushing certain interest rates up and down. These changes have added greatly to the short-run volatility of interest rates, and this increased uncertainty has led investors to demand higher returns to protect them against the higher risk of loss.
Finally, the recent improvement in inflation may not be regarded by investors as permanent enough that they are willing to accept lower returns on their longer-term investments.
Q: In the last 10 years, inflation has risen sharply. Isn't it reasonable to expect the cost of money to rise just as much as the cost of other goods?
A: Yes it is. But interest rates are far above the current level of inflation, and far above what most forecasters say will be the inflation rate in 1982 and 1983. Historically, long-term interest rates have averaged about 2 1/2 or 3 percentage points more than the inflation rate. Now they are 6 or 7 percentage points higher.