Interest rates and inflation: Their link may be changing

The Economy

October 13, 1997|By Jay Hancock

BEHAVIOR experts call them "paradigms" -- patterns of unexamined, third-nature assumptions that frame our view of the world.

Here are some paradigms of the 1990s: It is impolite to generalize about race. The purpose of the running game is to set up the passing attack. Money and fame trump happiness and rectitude. Interest rates must stay high because inflation is always clawing at the door.

One of those paradigms is fixing to shift, some economists believe. If they're right, don't refinance your mortgage just yet.

Since 1981, the interest yield on high-grade corporate bonds has stayed four, five percentage points and more above the inflation rate.

This is not random coincidence.

Inflation rots money. Make a loan at 6 percent when inflation is 8 percent, and you'll actually have less money after the note is paid off than you did at the start.

Amazing as it seems, once upon a fiscal quarter there wasn't such a fat cushion between inflation rates and bond coupons. In fact, interest rates used to dive below inflation, making like the U.S.S. Nautilus for months at a time.

In the early 1950s, inflation hit 9 percent, but bond yields bobbed along around 3 percent for most of the decade. Bond yields actually were less than stock dividend yields until 1958. How's that for a parallel universe?

The mind-set was different. The Great Depression of the 1930s was as close to 1952 as Ronald Reagan's first term is to us now. People were used to falling consumer prices, not rising ones. Bankers remembered when they couldn't make loans at any rate; they weren't about to push their luck by asking 4 percent from prime borrowers. Inflation was a theoretical abstraction or, at worst, a side effect of war.

So, when consumer prices started gurgling up in 1951, investors paid no attention. They happily bought 3 percent bonds and felt wise when the issuer didn't go bankrupt. Meanwhile, inflation gnawed their capital, unseen.

The 3 percent paradigm blew up in 1958.

Inflation had worsened, topping 3 percent two years running, even though war was visible nowhere. Perhaps, bond investors started to think, inflation and peacetime could cohabit. Perhaps the mighty U.S. economy could heat up prices easier than they had thought. Perhaps they'd better demand an inflation insurance premium in the form of higher interest rates.

The bond market was never the same.

Inflation, indeed, had barged inside, shed its overcoat and settled onto the parlor couch. With the Vietnam War, it stayed over for dinner. With the 1970s oil crisis, it broke into the liquor cabinet.

Inflation breached 5 percent in 1969, 6 percent in 1973, 11 percent in 1974 and 13 percent in 1980.

Interest rates flopped around like beached mackerel, then settled into the 5-points-over-inflation layer. That's 5 percent "real return," a yield that would have made J. P. Morgan giddy and that can be blamed mainly on lenders' lingering inflation complex.

They've been trying to get over it for years, and this month they were close to a breakthrough.

Corporate-bond yields fell in early October below 7 percent -- a depth that had previously been plumbed this decade, but never when the economy seemed so vigorous.

In the reigning mind-set, brisk growth always fires inflation. Over and over again in the past five years, the merest flash of economic speed has sent interest rates popping even while prices snore. Inflation has passed 3 percent just once since 1991, and then just barely.

But economists such as MIT's Lester Thurow and Merrill Lynch's Bruce Steinberg argue that the inflation-growth axis is broken. Global commerce is simply too competitive for companies to raise prices, they say. And computer-bred productivity lets the economy grow without pressing prices, anyway.

The bond market was starting to believe. Warren Buffett's $2 billion purchase of Treasury debt last summer was a huge bet that interest rates would fall.

But last week Alan Greenspan warned about inflation. Germany raised interest rates. The producer price index blipped up. The old paradigm got some new scaffolding, plaster and duct tape, and rates headed back upward.

Thurow calls inflation "an extinct volcano."

But for years now, borrowers have continued to trudge up to the crater and launch their interest payments over the precipice, in sacrifice.

Pub Date: 10/13/97

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