News stories last week heralded the fact that the prime rate at most banks moved back into single digits for the first time in seven years. Optimism from many sectors of the economy has naturally followed.
Lower rates will boost the economy with a broad brush. Company profitability will be aided by lower financing costs.
New investment will be encouraged, both because profitability prospects will be enhanced and because the cost of financing new projects will be lower. The bottom line should be better job prospects than before.
There is usually a lag between a drop in the prime and a subsequent decline in rates that translates to the consumer's wallet. Consumer rates (which are intermediate-term) and mortgage rates (which are long-term) don't move as far or as fast as short-term rates on securities such as Treasury bills issued by the government or commercial paper issued by businesses.
But, declines in short-term interest rates do lead to drops in consumer and mortgage rates. In fact, some banks have already begun to lower those rates, and the declines will likely spread, which will encourage continued healthy consumer spending.
Another plus resulting from the rate declines is that they should nudge the dollar's value lower on international markets.
It's true that a lower dollar value adds to inflationary pressures here, but those pressures are likely to be small. Besides, any decline in the dollar will bring welcome relief to U.S. manufacturers by increasing their competitiveness and reducing the swelling trade deficit.
(A strong dollar has meant that foreign goods are cheaper for Americans to buy and that American goods are more expensive for foreigners to buy.)
A final ounce of good news from the lower rates is that a number of other industrial countries will be able to push down their rates without suffering lower values for their currencies.
Such moves should boost growth abroad and help to support the debt-laden developing countries that depend upon a healthy world economy to sell their products and pay the interest on their debts.
But the road to lower interest rates is not paved with pure gold. The plus side to higher interest rates for consumers in the 1980s has shown up in the higher interest income they have earned.
Consumer interest income exceeded $400 billion in 1984, representing almost 15% of personal income. Thus, as we move to a lower rate environment, overall personal income growth is already being stunted and those heavily dependent upon interest income (such as retirees) are feeling the pinch.
More Rapid Growth
The other problem associated with the lower level of rates is that they are likely to encourage an even more rapid growth of the money supply--and the money supply is already well above the target set by the Federal Reserve Board.
In fact, the Fed's most recent report on M1 indicated a $4.8-billion surge over a week ago. Thus, the measure of funds readily available for spending is about $15 billion above the upper limits of growth set by the Fed. The concern, of course, is that rapid money supply growth could lead to higher inflation down the road. History indicates that such a risk does indeed exist.
The decline in interest rates is due mainly to two factors: weak economic growth and persistently lower inflation.
After moving out of the recovery's starting gates at full speed in 1983 and early 1984, the economy shifted into very low gear at mid-1984. Since that time, real economic growth has averaged barely above 2%.
Moreover, the manufacturing portion of the economy has been hammered by foreign competition--leaving both manufacturing employment and production levels little changed from a year ago. A key reason, therefore, for the move toward lower rates is that the Fed is fearful of an economy slipping into recession.
The second reason for declining rates provides better reading. After 15 years of progressively higher inflation cycles, it now appears that this trend has been broken.
After peaking in 1980 at 13.5%, consumer price inflation has moved dramatically lower. In 1983 and 1984, it averaged less than 4%. And both this year's and next year's inflation performance are likely to come in below 4%.
Since interest rates do have an inflation-related component, they have until recently been held higher by fears that inflation would again rear its ugly head. Continued commodity price weakness and modest wage gains, coupled with the softer economy, have alleviated most of those fears--pulling rates down with them.
The $64,000 question is whether the decline in short-term rates is over for now or whether more will come. The answer to that question lies with the overall economy, which should show reasonably good growth (3% or so) and modest inflation in the second half of this year.
If there is any risk to the interest rate outlook, it is that the declines already in place may not be enough to get the economy going fast enough. The result would be interest rates that are even lower. Nevertheless, the best bet still seems to point to short-term rates that stay near current levels for the rest of this year.