Prosperity is tied to long-term interest rates


Double-Dip Recession? Plummeting car sales, weak retail activity and rising unemployment claims provide the freshest evidence that America may be slipping back into recession. This fear has certainly affected the Federal Reserve Board, which has continued to cut interest rates to spark recovery. But even though some rates are down to their lowest levels since the mid-1970s, the economy does not appear to be responding.

Many analysts believe that shaky consumer confidence has diluted the Fed's effectiveness, and there is some truth in this. Surveys show that consumer confidence is at a near-record low, and consumer spending is the main component of demand, accounting for approximately 65 percent of gross national product in this country. Nonetheless, consumers rarely lead the way into either recession or recovery. Consumer spending usually continues to rise during recessions, and its growth accelerates only modestly during recoveries. For example, during the 1981-82 recession, while GNP was falling at an annual rate of 2.2 percent, consumer spending rose at an annual rate of 1.0 percent. During the first year of the white-hot recovery that followed, consumption played an unusually large role because of the Reagan tax cuts; even so, the 5.3 percent growth rate in consumer spending lagged behind the 8.6 percent growth rate of overall U.S. spending. Further analysis shows that investment demand -- not consumer spending -- really drives the business cycle. During the recession of 1981-82, for instance, investment fell at an annual rate of 13.2 percent; over the course of the following year, as the economy recovered, it rose at an annual rate of 22 percent.

The Importance Of Housing. The central question, then, is how to boost investment, which has declined 7.6 percent in real terms since the current recession began. The usual answer, of course, is to cut interest rates. This makes it easier for investors to finance projects, especially in the areas of construction and housing, which are so critical to an economic comeback. During the strong recovery of 1982-83, for example, residential fixed investment rose three times as fast as other fixed investment. Today, despite reductions of nearly 50 percent in the interest rates that the Fed controls, there is almost no sign of an investment recovery.

One reason for this is the bank credit crunch, which has made borrowing especially difficult for many individuals and corporations. In addition, the interest rates that affect many long-term investments, including housing, are not the same short-term rates controlled by the Fed. The interest rates that matter on these investments are the rates on money lent over 20 or 30 years.

Even though short-term rates have plunged through Fed action, crucial long-term interest rates haven't fallen much. In April 1990, the interest rate on 30-year government debt was 9 percent; it is currently just under 8 percent. Long-term interest rates remain high because investors fear that short-term interest rates, although currently at very low levels, may come bouncing back. If short-term rates surge, lenders who locked themselves into long-term bonds will regret their decision. Whenever short-term interest rates rise, the value of long-term debt declines because investors can reap similar rewards in a reduced period of time. This explains why so much money is currently parked in short-term assets even though they yield much less.

No Inflation Threat. Short-term interest rates could soar in the future if inflation flares up again and the Fed is forced into another cycle of tight money and high rates to keep prices stable. Investors also worry that the financial needs of Eastern Europe and the former Soviet Union, plus rising budget deficits in the United States and Germany, will create a worldwide capital shortage and drive up interest rates during the next recovery. These possibilities seem remote right now. Inflation appears well under control today, and a global capital shortage won't materialize unless former Communists convince potential lenders that they are good credit risks -- an unlikely prospect. In the meantime, however, long-term global fears are frustrating America's economic recovery.

Critical investment

Investment, not consumption, is the key economic catalyst for both recession and recovery.

Average annualized quarterly growth rates

Consumption Investment

1981-82 recession 1.0 pct. -13.2 pct.

1982-83 recovery 5.3 pct. 21.9 pct.

1990-91 recession 0.7 pct. -4.6 pct.

Stubborn rates

Although the Federal Reserve has aggressively cut short-term interest rates, long-term rates still remain high.

Federal funds rate 30-year Treasury bond yield


j 8.23 pct. 8.26 pct.

f 8.24 pct. 8.50 pct.

m 8.28 pct. 8.56 pct.

a 8.26 pct. 8.76 pct.

m 8.18 pct. 8.73 pct.

j 8.29 pct. 8.46 pct.

j 8.15 pct. 8.50 pct.

a 8.13 pct. 8.86 pct.

s 8.20 pct. 9.03 pct.

o 8.11 pct. 8.86 pct.

n 7.81 pct. 8.54 pct.

d 7.31 pct. 8.24 pct.


j 6.91 pct. 8.27 pct.

f 6.25 pct. 8.03 pct.

m 6.12 pct. 8.29 pct.

a 5.91 pct. 8.21 pct.

m 5.78 pct. 8.27 pct.

j 5.90 pct. 8.47 pct.

j 5.82 pct. 8.45 pct.

a 5.50 pct. 8.14 pct.

s 5.25 pct. 7.95 pct.

o 5.23 pct. 7.91 pct.

n 4.89 pct. 7.95 pct.

Weak housing

High long-term interest rates have retarded recovery in interest-sensitive sectors like housing.

Housing starts, seasonally adjusted annual rates


J 1.57 mil.

F 1.49 mil.

M 1.31 mil.

A 1.22 mil.

M 1.21 mil.

J 1.19 mil.

J 1.15 mil.

A 1.13 mil.

S 1.11 mil.

O 1.03 mil.

N 1.13 mil.

D 0.97 mil.


J 0.85 mil.

F 0.99 mil.

M 0.91 mil.

A 0.98 mil.

M 0.98 mil.

J 1.03 mil.

J 1.05 mil.

A 1.06 mil.

S 1.03 mil.

Originally published, 11.25.91