Interest rate picture may not clear up soon.

What's a banker to do? The outlook for interest rates is anything but clear, and bankers' recent unsavory experiences with rates have them highly tentative about investment strategy. Earlier this year, a number of banks were caught napping when money tightened and interest rates rose. They may have become accustomed to a gentle environment: February's action was the first tightening of money since 1989, and in 1993, money policy had been consistently accommodative.

Some bankers will tell you that the timing could not have been worse, because brand new accounting rules made rising interest rates especially costly. The rule, Financing Accounting Standard 115, compelled many banks for the first time to deduct from their capital accounts the unrealized bond portfolio losses caused by rising rates. Also, mounting rates shut down lucrative mortgage refinancing activity and ravaged the values of certain mortgage-backed security holdings.

With the lack of clear direction in the markets, bank investment and asset/liability professionals are a bit off their stride. Long-term interest rates are stubbornly higher than either anti-inflationists or economic expansionists would like. The economy seems to be in good balance, however, and the reports on current inflation remain benign. Underlying this market skittishness in the face of good economic news is the interplay between the Federal Reserve and incipient inflation forces.

Economic fundamentals for the economy, and by extension, banks, are probably brighter for 1995 than they have been for a long time. (To be sure, 1993 presented banks with an extraordinary surge in profitability, but 1993's results depended not so much on banking fundamentals as on fat yield curve profits born of unusually easy money and a weak world economy.)

Borrowers More at Ease

The stage is set for a strong but orderly economic performance in 1995 (although the distribution of benefits will be socially out of balance) that should support healthy bank loan growth the rest of this year and next. Consumers and businesses have cut their debt burdens significantly in the last couple of years, although their debt ratios are still high. But the debt reductions, combined with a little more confidence in individual economic prospects, have borrowers feeling more comfortable about taking on more credit.

Also, business capital investment should be brisk in 1995. Productive capacity continues to tighten as producers use up the slack in their production facilities. While spending on traditional plant and equipment typically accelerates at this stage of the business upswing, this time it will be reinforced by businesses' large-scale investment spending on technology.

U.S. exports may provide the most bullish news next year. The economies of Europe and Japan finally are following the U.S. economy out of recession, raising these nations' demand for imported goods. This year's decline in the dollar makes the foreign prices of American goods much cheaper, and thus more attractive to foreigners. Moreover, American labor costs have become extremely competitive with those of Continental Europe, where recession-driven government policies protected unproductive but highly paid jobs.

In addition, the United States' Western Hemisphere neighbors also will benefit from rising foreign demand for their products. This demand will strengthen the economies of these important trading partners and increase their demand for U.S. products as well. And so far, the North American Free Trade Agreement is proving a boon to U.S. exports and job creation. Through it all, the U.S. dollar should stage a comeback against major western currencies.

Finally, the nation's fiscal house is in better order than most observers believed possible just a year ago, when the 1993 deficit-reduction act was being debated in Congress. To be sure, a massive deficit can be expected again next year. The size of the deficit, however, has declined nicely as economic growth and new tax measures have stimulated revenues, while spending has been reasonably contained.

Why then, just as the economic party gets rolling, are the stock and bond markets sitting it out? Investors are waiting for a breakout on the upside or the downside, but prices refuse to move decisively. This schizophrenic investor thinking is caused, on one hand, by a certain ebullience over rising world economic strength, and offset, on the other hand, by fears about rising inflation and the Federal Reserve's resolve to raise interest rates accordingly.

A Preemptive Strike

The Fed intends to cool the economy before it overheats--it's the Fed's classic role of taking away the punch bowl before the exuberance gets out of hand. By nudging interest rates up to check too-rapid growth, the Fed believes it can hold the line on inflationary expectations. In truth, the Fed is probably able to succeed only in checking the short-run inflation outlook.OCTOBER 1994 INDEX OF ADVERTISERS Advertiser Page # Affiliated Financial Services Inc. 6AIM 33Ameritech 30-31Bankers Systems Inc. CV3Beneficial 23The Capital Edge 56CFI ProServices, Inc. 36Credit Card Marketing 84-85EDS 13Fair Isaac 15First Data Corp. 65FIserv, Inc. CV2-1Forbes 17Freddie Mac 44-45, 50-51Goldman Sachs 25IBCFP 57Information Technology 5IPS 77ITP 71ITT Financial Services 66Invest Financial Corporation 60-61Jack Henry & Associates Inc. 68Logs Group 62, 63M&I Data Services, Inc. CV4Montgomery Securities 11Morrison Cohen Singer & Weinstein 74National Computer Print, Inc. 6Okra Marketing 18Pershing 26Plansmith 87Primus 53Salomon Brothers 54Sendero 58Sheshunoff 67, 83Spacesaver 75Sprint 29SU Group 35Systematics 7Unisys 20-21Warren, Gorham & Lamont 73

Long-run inflationary expectations are another matter altogether. The bond market reacts strongly to long-term expectations and, while it sometimes seems to react sharply to Fed tightenings, such as August's, such a reaction is more illusion than reality. Reality is that pricing on 30-year bonds is related to expectations for inflation and economic growth over the next three decades. Conceivably, a single Fed tightening today might impress the bond markets, but not much.

Thirty-year Treasury bond yields increased from a low of 5.9% in October 1993 to 7.5% by early September. In economic terms, part of the increase is real, as opposed to inflationary, and based upon an expected strong economy. The real interest rate is the part of the nominal interest rate that reflects such phenomena as demand for credit and accelerated private spending: economic growth. Part of the increase--the bad-news side of the interest rate story--reflects a higher expected inflation rate over the life of the bond.

Unfortunately, there is little reason to hope that the Fed will become accommodative or that interest rates will return to late-1993 levels next year. Given the buoyant economic outlook, real long-term rates ought to hold between 3.5% and 4%, a little above levels of the past year or two. And given present long-term bond rates, between 7.2% (10-year) and 7.5% (30-year), you can assume that today's long-term expectations for inflation are running at about 3.5%, somewhat above the current 3%. To hard-line money professionals, 3.5% is too high.

The Fed will try to hold the line on short-term inflation, hoping it can calm investors' long-term fears. The Fed's critics are pretty well-balanced now between expansionists and anti-inflationists. Significantly, the Clinton Administration recently has taken a sideline seat. David Jones of Aubrey G. Lanston & Co. has suggested that administration officials might prefer tight Fed policy now rather than the Fed having to squeeze the economy next year, when the 1996 presidential election campaign will start up.

The net result is that short-term rate hikes probably will not subside until the last half of 1995. Long-term rates will continue to hold up under the good news-bad news mix of solid economic performance and long-term inflationary doubts. The result? Expect financial markets to hold at their sticking point a while longer.

Donald G. Simonson holds the New Mexico Banker's Chair in Banking and Finance at the University of New Mexico.

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