High Long-Term Rates Stalling Recovery

Conditions affecting longer-term interest rates in the credit markets appear to be out of phase with attitudes about inflation and the potential for profits in the markets for goods and services.

This discordance is one factor holding back the economic recovery in the United States.

Judging from the current level of longer-term interest rates, one might imagine that the credit markets believed businesses could raise prices by 5% to 6% a year over the long term.

Such figures can be calculated as residuals from a corporate bond yield of 8.5% or more and an assumption that the real rate of return on capital over time would be on the order of 3% - not far from the potential real growth rate in the economy.

Obviously, these numbers are conjectural. Neither future inflation nor the potential real return from capital investment is knowable with certainty.

Real return, for example, could be higher in the initial stages of a recovery that had some momentum. But real return could also be lower over the long run, if productivity growth remained slack.

Whatever the exact numbers, from a borrower's viewpoint the bond market would seem to be priced to a belief that inflation will turn out to be substantially higher than the potential real return on investment.

This belief is at odds with current conditions in the market for goods - conditions that are probably influencing attitudes of corporate decision-makers.

Inflation has slowed considerably during the past two quarters.

As reported with gross national product statistics, the fixed-weight price index for final sales to domestic customers rose only about 2.25% a year in that period, about half its rise in the preceding two years.

While some of the slowdown in inflation may be temporary, the current price for longer-term credit nonetheless appears too high to spur recovery.

The credit price requires either an ability by businesses to raise prices - and this at the moment looks impractical - or a real rate of return on investment so high as to be unsustainable over the long term.

Rates May Have to Fall

Of course when the yield curve is steep, as it is today, the relatively high cost of long-term credit can be at least partly offset for a time by lower short-term rates. However, short rates may have to be even lower if they are to provide a strong thrust toward a satisfactory recovery, given the uncertainties that now overhang business and financial markets.

The sharp drop in stock prices a week ago should be interpreted as a product of the discordance between credit and goods markets.

Whatever stock values may ultimately represent, on an ongoing basis they reflect expectations about profits in the goods market and the interest rate on risk-free credit instruments (Treasury securities).

The rise in the Dow Jones industrial average to the 2,900-to-3,050 range, with a relatively high price/earnings multiple, since midyear was based on lower interest rates and expectations of increased profits.

Optimism about profits has obviously weakened, along with confidence in the economy, and the market has become subject to much more downside risk.

Restoring Confidence

Confidence is not likely to rise much until the conditions in goods markets and credit markets come into better alignment. While that could occur as a result of at least temporarily lower short-term rates, it would also be desirable to reduce long-term rates.

Some countercyclical debt management by the Treasury Department - which has long eschewed such a role - would be desirable in current circumstances, although debt management is, admittedly, a minor policy instrument.

The present level of long-term rates is not solely the product of investors' inflation expectations and the real rate of return. It is also affected, at least at the margin, by the actual and expected supply of longer-term Treasury debt.

If the Treasury today were to significantly lower the amount of new 30-year debt issues and shift offerings into the short-term sector, this would probably help move the longer rates toward levels better related to underlying economic conditions in the goods market.

Such actions would increase the chances that private business and mortgage borrowers could lock in more reasonable credit costs. That would mean a lift for the economy.

Mr. Axilrod is vice chairman of Nikko Securities Co., New York.

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