Waiting for interest rates to decline has replaced baseball as the Great American Pastime. Now that interest rates have declined, many of those who waited are finding themselves disappointed in the results.
Investors waited for a strong bull market in stocks to follow a decline in interest rates. A strong bull market took place in bonds, but so far stocks have enjoyed only anemic gains as the initial euphoria over declining interest rates gave way to fear of declining corporate profits in the face of deepening recession.
Homeowners are even more disappointed than shareholders. The normal reaction of homeowners to a period of tight money is to pull their homes off the market for six to 12 months until the Federal Reserve relents and money flows freely again. When mortgage rates rose to 15 percent, many sellers stood back and waited for them to decline, only to see rates continue upward to 18 percent instead. Faced with such high mortgage rates, homeowners tried to maintain both their egos and their asking prices by offering seller financing at concessionary rates of 10 to 12 percent.
Now even concessionary financing no longer masks the decline in real estate values. Home prices have been falling in inflation-adjusted terms for more than a year and now are falling in nominal terms as well, particularly in areas of heavy recent speculation, such as California. Even more discouraging to those waiting for mortgage rates to decline is the fact that the very low level of home sales across the nation suggests that home prices have even further to fall to clear the market.
The current decline in mortgage rates creates more hope than fulfillment in besieged homeowners. Some lenders now charge 16 percent instead of 18 percent, but that is slight relief to most buyers, who find both rates unaffordable. The slight decline in mortgage rates is offset by the decline in potential buyers as the deepening recession throws them out of work or makes them too fearful to commit a huge portion of their incomes for the next 30 years. Much sharper declines in mortgage rates will be necessary to revive the real estate market.
Even the homeowners able to wait for mortgage rates to decline are unlikely to reap much benefit. Much of the benefit from owning a home came from the availability of long-term mortgages with low fixed rates of interest in an economy with high and rising inflaton. Those mortgages effectively passed inflation's benefits on to homeowners and its cost on to mortgage lenders. Savings and loan associations lost about $6 billion last year because they hold too many long-term mortgages with low fixed interest rates, so they are unlikely to go on offering them. The likely alternative is some form of variable rate mortgage that places the burden of inflaton squarely on the borrower.
Like homeowners, businessmen at first reacted to rising interest rates by hoping they would go away soon. They plowed ahead with capital spending projects under the comfortable assumption that those projects could be financed at lower rates in the future and that the goods and services those projects produced would enjoy strong demand. Both those assumptions now look very wrong.
Also like homeowners, businessmen were shocked when interest rates kept on rising. Last summer the long-term bond market virtually closed down for a time and the prime rate rose to over 20 percent, far above the returns available on most corporate investment projects. The bond market opened again as interest rates fell last autumn, but the prospect of paying 15 percent on both long- and short-term debt is very unsettling to corporate treasurers.
Even more unsettling is the growing fear that those new investment projects may not generate any profit worth mentioning, let alone enough profit to pay today's 15 percent financing costs. The worst time to bring a new capacity on line is when a deepening recession is lowering demand for all productive capacity, existing and new. U.S. capacity utilization already is below 80 percent and going down further under the weight of the current recession, so the outlook is bleak for present profits and future gains in business capital spending.
Virtually everyone who waited for interest rates to decline is still waiting for the expected benefits. The recent decline in interest rates has been far more impressive than the results because interest rates are still very high in both absolute and relative terms.
In absolute terms, 15 percent is an interest rate once charged only by Mafia loan sharks. The recent experience with a prime rate over 20 percent tends to obscure the perspective that such rates are completely without precedent in this nation.
In relative terms, a 15 percent interest rate is higher than the long-term appreciaton in both stock prices and home prices. It is also much higher than the underlying rate of inflation, which is currently about 9 percent. That leaves real interest rates at about 6 percent, far above their normal levels during the last generation.
The continued presence of high real rates of interest accounts for the absence of any stimulus to the economy from their recent decline. Normally the Federal Reserve stimulates the economy out of recession by lowering real interest rates into negative territory so that consumers and businessmen have the incentive to borrow and spend.
No such incentives exist today. High real rates of interest are an incentive for consumers to save money rather than to borrow it to spend on homes and autos. Those same high real rates of interest cause businessmen the twin agonies of making new investment projects look unprofitable and of causing a recessionary decline in the goods and services those new projects produce.
Patience is a virtue, but virtue is often its own and only reward. Those who patiently waited for large financial rewards from declining interest rates are still waiting. If the Federal Reserve is serious about reducing inflation permanently, the wait for those large financial rewards will be a long one.