INTEREST RATES are now dropping, which is a good thing. But they are dropping fast, which is not. It's another sign of the economy's weakness in the developing recession.
Interest rates, like the inflation that lifts them, had been going up ever since 1977. One useful guide is the prime rate -- the interest charged by big banks to their best commercial customers. It went up to 15 percent last fall after the currency crisis, when the Federal Reserve Board tightened monetary policy to rescue the falling dollar. It inched up further over the winter, while the inflation rate was accelerating dangerously. That led to another drop in the dollar's international value, and another presidential attack on inflation. That was the mid-March speech in which Mr. Carter pledged to balance next year's busget, and reported another tightening of credit by the Fed. In response, interest went to unprecedented levels. By early Arpil, the prime rate was 20 percent.
Interest rates are set in the uneasy tension between borrowers and the Fed. The Fed sets, at least roughly, the amount of money to be lent and borrowers bid for it. Each side spends a great deal of effort trying to guess what the other is going to do next.
In the first half of April, a lot of borrowers dropped out of a market that has become prohibitively expensive for them. That was the Fed's purpose -- to force people to be much more restrained and cautious in their borrowing. The bidding fell off and, on April 16, the prime rate began to drop. It's now back down, at some banks, to 17 percent.
But even at that price, businesses are taking fewer loans than expected and the money supply has dropped well below the Fed's target. It gives rise to speculation that the Fed will conclude that it has overdone its squeeze, and will now make more money available to the banks to lend to their customers. That would push rates down even faster. But the Fed's chairman, Paul Volcker, has repeatedly said that significant improvements in interest can come only after significant improvements in inflation. What's happening to the inflation rate? The Producer Price Index for April shows a sharp drop. The Consumer Price Index comes in two weeks. If the improvement is dramatic, financial relaxation seems likely.
The sharp swings in interest rates over the past two months demonstrate the anxiety and uncertainty that currently rule the money markets.
Under these circumstances, neither the Fed nor any other authority can be entirely sure what effect its actions will have. Inflation has changed the rules of the game and deranged the careful calibrations that used to guide policy.