Lower rates aren't cure-all many may think

VIEW FROM WALL STREET

May 05, 1991|By Thomas Easton | Thomas Easton,New York Bureau of The Sun

New York - Money is getting cheaper, at least for the moment.

Following the highly visible action of the Federal Reserve Board to cut the discount rate last Tuesday, many banks have formally announced reductions in their prime rate.

Both moves have more symbolic than actual value. The discount rate applies to bank borrowing directly from the Fed, which is rarely done. The prime refers to rates accorded to premier companies, which don't often borrow from banks.

But both the discount rate and the prime are tied to numerous other rates that affect the underlying economy. And so their decline is, at the very least, enough to cheer up the president of the United States.

"I think dropping interest rates is the best way to stimulate economic growth," President Bush told a group of business editors and reporters meeting in Washington last week. "I think we will be coming out of the recession with this reduction."

Using monetary policy to reinvigorate business has a painless feel -- and a particular allure for a president who likes to promise but not to pay. No budgets need be cut, no resources shifted, no new products invented or productivity enhanced. Interest rates simply need to decline.

The argument in favor of last week's action is straightforward. Money is a key component in the production and sale of many products. When a key component costs less and buyers have more to spend, it becomes cheaper to produce and easier to sell.

The cost that companies pay for money is interest rates. And President Bush, his Treasury secretary and four out of five members of the Federal Reserve Board hope that by shifting the rate most directly under government control, other rates will fall, money will become cheaper and businesses will thrive.

That course of action has particular allure today because the industries in deepest trouble -- real estate, banking, autos and the like -- are all highly sensitive to interest rates. After all, lower loan rates should help people to stay current on their debts, as well as make car and home loans cheaper, encouraging housing and auto sales.

The problem, of course, is that life outside the Capital Beltway is rarely so simple. "There are other difficulties out there more important than a quarter-point on the prime," noted Howard Keen, economist for the Consolidated Rail Corp.

Lower interest rates cannot reduce a surplus of commercial real estate. They cannot address the ability of Japanese auto companies to manufacture better cars -- even in the United States -- than their U.S. competitors. They cannot even encourage a bank short of capital to lend.

Moreover, the discount rate is for overnight borrowing, and the prime rate is typically for short-term loans. For business financing, short-term rates are far less meaningful than longer-term rates. Indeed, the two most prominent leading indexes that include interest rates -- those drawn up by Business Week and Columbia University's Center for Business Cycle Research -- don't use short rates at all. Their interest rate component is long-term bond yields, which have budged only a bit.

Worse still, cutting the discount rate to widespread approval from the administration could backfire, undercutting the credibility of the Fed's anti-inflationary monetary policy without repairing the problems impeding economic growth.

Were interest rates really so easy to play with and so effective, the most successful economies would be those with governments particularly aggressive in pushing them down. In fact, the opposite is closer to the truth. Latin American countries, notorious for playing with monetary policy, have experienced hyperinflation. The German central bank had the same experience before World War II. Since then, it has resisted overtly driving down interest rates -- and the Germans now have among the lowest rates in the world.

Wall Street was mildly impressed with last week's cut in the discount rate. Share prices in most of the most troubled sectors rose after the move. And the chirpy mood wasn't limited to brokers. Lyle Gramley, economist for the Mortgage Bankers Association, said that mortgage rates have steadily declined since last fall, returning to levels not witnessed since 1987.

"This is part of a longer-run process of lowering rates, and this last decline will add a little more punch to the market," said Mr. Gramley. "The demographics are not favorable enough to support a real boom in housing, but housing sales are clearly heading up."

Home sales tend to snowball, as a seller successful in finding a buyer becomes a buyer himself, Mr. Gramley noted. He believes the housing market hit bottom in January, a trend that appears to be evident in official statistics on home sales and housing starts. A side benefit, he added, is that many homeowners are now refinancing their mortgages at lower rates, freeing up money that can be spent elsewhere.

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