The MacNeil/Lehrer Report; Interest Rates

ROBERT MacNEIL: Good evening. As President Reagan is happy to point out, economic recovery is now well underway. The economy is growing faster than expected, even the unemployment figures have begun creeping down. But there's a fly in this sweet ointment: interest rates have begun rising, and some worried economists see the spectre of inflation lurking again. Today, the Federal Reserve Board's top policymaking group, the Open Market Committee, began two days of meetings to decide how to get the fly out of the ointment. The reason for the anxiety is that to fuel the recovery the U.S. money supply has been growing rapidly. Monetarist economists want the Fed to clamp down sharply on the money supply. Fears that it will do so have driven interest rates up since May. That is particularly noticeable in home mortgages, which are now touching 14%. Industries like housing, sensitive to interest rates, don't want a clampdown, saying it will wreck the recovery. On Wall Street today, fears that interest rates will go even higher caused a 17 point drop in the Dow Jones Industrial Average. Tonight, the choice between slower recovery or higher inflation. Jim?

JIM LEHRER: Robin, there are 19 members of the mysterious Federal Reserve Open Market Committee: the seven Federal Reserve governors, including Chairman Paul Volcker, plus the presidents of the 12 regional Federal Reserve banks. They meet in absolute secrecy, like a jury considering a verdict, the college of cardinals choosing a pope. But unlike the other two, the federal bankers usually don't announce their decision. It's up to economists, other experts and the rest of us to read their actions to find out. The money supply is literally the amount of money in circulation in this country. When it grows, some theorists say, it can trigger increases in prices and thus in inflation. But when it tightens that means there is less money available to borrow and the law of supply and demand causes interest rates to rise. If the committee decides to tighten, it can do so by reducing the amount of reserves on hand at private banks or by raising the price of money they loan to those banks, called the discount rate. Everyone from the White House and Wall Street to the small-town homebuilder and would-be car buyer has an opinion on what the committee should do, and a stake in the result. Robin?

MacNEIL: And nowhere is the Fed being more closely watched than in the financial community. One of those who monitor the Fed's actions for a living is David Jones, chief economist and senior vice president of Aubrey G. Lanston, a Wall Street investment firm. Mr. Jones, how do you see the choices facing the Fed today?

DAVID JONES: With the economy running far ahead of track, they have two: one is to do nothing, but that risks a boom-bust cycle. The economy runs ahead, inflation picks up; suddenly the Fed realizes it has to tighten and tighten a lot, and we move into a bust or a recession. I don't think that option was very palatable to the Fed today, and its meeting will last tomorrow as well --

MacNEIL: That is the do-nothing option.

Mr. JONES: Do nothing. I think the alternative would be to begin to tighten on the theory that perhaps a stitch in time saves nine. In effect, tighten a little bit now, begin to put some upward pressure on interest rates and, indeed, the Fed may have already started to do that with the theory that they would bring the economy back to a growth track, which is less inflationary and could last for several years. My view is they may come to that latter solution.

MacNEIL: So you don't see it this evening as a choice between a sharp clampdown on the money supply, going back to a -- the money supply has been growing at a rate so far this year of 14%, right?

Mr. JONES: That's right.

MacNEIL: Going back to their 6% rate that was their rate last year? You don't see a sharp cutback on it, though?

Mr. JONES: I think they'll be cautious as to how fast and how far they pull money growth down. As we saw in the period from 1979 to 1982, when they used to react almost in a kneejerk way by clamping aggressively on money, interest rates would go through the roof. We cannot afford to see that kind of behavior right now from the Fed. The world is still in a volatile and difficult position in terms of a lot of foreign debt, and indeed our economy has only begun to recover. So it looks like the reasonable course of action is moderate restraint, bringing the economy back to a less inflationary potential, and hopefully keeping the recovery going for awhile.

MacNEIL: And is that what you predict they will do?

Mr. JONES: I think they will. It's going to be a close debate, but I think they will in fact move in the direction of moderate restraint, and I feel they have perhaps already begun to move that way.

MacNEIL: Because the money supply fell by $3 billion, or the growth was -- explain to me what happened last Friday. I'm not quite clear.

Mr. JONES: Well, the money supply fell, but it was not yet enough of a move to suggest that the Fed is really clamping down. What I think is happening is, probably there's a major debate going on within the Federal Reserve Board between those who want to clamp down more and those who say we can't clamp down at all. I think the solution is a moderate clampdown, and that it may have already begun.

MacNEIL: What would a moderate clampdown be? Can you tell me in concrete terms that we would know?

Mr. JONES: Yes, for borrowers, a businessman now facing a prime rate of 10 1/2% may, by September, be looking at 12 1/2%. A mortgage borrower, at one point, thought perhaps 12 1/2% would be the rate and may be looking at --

MacNEIL: You mean raising the discount rate now or just squeezing the money supply, that interest rates go up of their own accord without raising the discount rate?

Mr. JONES: I think what the Federal Reserve will do will delay any action until a few weeks after this meeting. They're going to watch money; they're going to watch the economy, and then what they'll do is gradually clamp down on money, push rates up gradually, and drag their feet on the discount rate. I do not see a discount rate increase in the next few weeks. Maybe a month from now, maybe a month and a half from now, but it'd be a follow-up move, and it'll come slowly because there is some heat from the White House on that subject.

MacNEIL: And they'll be sensitive to that heat?

Mr. JONES: They will be to some degree. The Fed is relatively independent, but not completely independent. When the White House says, "We don't want a discount rate increase tomorrow," they will listen to that. I don't think it means there will never be one, but it may be delayed.

MacNEIL: How and when will we find out what they've decided today and tomorrow?

Mr. JONES: The markets will begin to tell us perhaps by Friday or Monday.

MacNEIL: How will they know?

Mr. JONES: We have some sensitive rates in those markets. A technical rate called the federal funds rate on reserves traded among banks reflects very quickly a Fed clampdown, and that rate has already moved above 9% from a range of around 8 1/2. So we've already begun to see some tightening in that rate. If that rate should move up to, let's say, 9 1/2, which would be a full percentage point above the earlier level, we would see some evidence that the Fed is beginning to tighten again.

MacNEIL: How does that actually happen? Who knows when to charge an additional half a percent? Tell me, how does it actually happen after this meeting?

Mr. JONES: What happens is this: when the Fed clamps down on the money that it lends to you as a bank or injects into you as a bank through its market operations, you begin to feel it, and what you do is scramble for money from other banks, and when you begin to scramble for funds you bid up this rate, the federal funds rate, at which you buy money from other banks. So the second the Fed begins to squeeze reserves relative to your needs as a bank, you begin to bid more for that rate, and it happens within days after the action. So it's an extremely sensitive rate. Once that rate goes up, the cost of bank money goes up, then the prime rate follows. So it's probably the most sensitive and critical rate in the market.

MacNEIL: Well, thank you. Jim?

LEHRER: There are those who believe the Federal Reserve should tighten the money supply, tighten hard and tighten immediately. That is the opinion of Lawrence Roos, who for seven years participated in Open Market Committee decisions like the present one. He was president of the Federal Reserve bank in St. Louis from 1976 until he retired this February. He is now a special limited partner with the Wall Street Investment firm Bear Stearns. Mr. Roos, is the moderate clampdown the way to go, in your opinion?

LAWRENCE ROOS: Well, I think if it's too moderate I think we're going to repeat the past mistake which the Fed has made over and over again of postponing decisive action and thereby permitting the inflationary pressures to grow to where they ultimately had to clamp down on the monetary breaks in an abrupt manner, which was destructive to any recovery in the economy. Let's just look at a couple of fundamentals in order to understand this. We know -- and I don't think many economists, regardless of what their point of view is, would question this -- we do know that there is a direct relationship between the rate at which spendable money -- that's what we call the M-1 growth -- and inflation. We know --

LEHRER: That's the money -- the M-1 is [crosstalk]

Mr. ROOS: That's what you and I have in our pockets that we can use to spend.

LEHRER: Okay.

Mr. ROOS: There's a direct relationship between that and inflation, although the inflationary consequences of fast money growth aren't usually felt until after a lag of 18 to 24 months. This thing happens in the future. We also know that when people believe, when financial markets believe that inflation is indeed a real prospect for the future, that they tend to increase interest rates to protect themselves if they are making long-term contracts against higher inflation. Now, the Fed, in order to control money growth, sets certain targets each year. Last year they set a target of basic money growth of 2 1/2 to 5 1/2 percent. This was in 1982, and money grew at more than an 8% rate. This year, they set targets of four to eight percent, and money has grown at about a 14% rate. You don't have to be a very brilliant economist to know that money is growing much more quickly than the Fed ever desired to see it grow, and it's grown for nine months at this excessive rate, and I would say that unless the Fed takes immediate action to really pull down the rate of growth of money, I think it's almost certain that we're going to see a resurgence of intolerable inflation, and when people recognize that this is going to happen, Katy bar the door, we're going to see interest rates grow again through the ceiling.

LEHRER: Well, what about the downside of a clampdown? A strong clampdown would cause interest rates to skyrocket -- to go through the roof.

Mr. ROOS: It's a matter of degree, really. If, for example, the Fed caused money not to grow at all; jammed on the brakes so there'd be no M-1 growth the rest of this year, that would precipitate a severe recession. What I would advocate is that we go from this 14% rate, which has already caused certain damage, that the Fed takes action when it meets tomorrow to bring the rate of money growth down to 6% and that the chairman of the Fed tells the world that that is the target for the rest of this year.

LEHRER: Just go call a press conference or a news conference and say, "Okay, this is it." Make it very dramatic?

Mr. ROOS: And say, "We're going to reduce it to 6%," because it they reduce it to 6% after the excessive growth that's already occurred, they're still going to have, oh, 10 or 10 1/2 percent growth for the year, which is way above their targets. They should say they're going to do this; they should say that they're going to -- that this is their target, that they're going to achieve this target and they're going to do whatever is necessary to achieve this objective, and if they do this after maybe a short period of unsettled reaction within the financial community, I think we'd have a much healthier, much sounder, much more tranquil financial market facing us.

LEHRER: And it would not stop the recovery in its tracks?

Mr. ROOS: It certainly would not. It might slow it a little bit, but if we continue to opt for an overheated recovery, which is presently happening, then the consequence of that will be inflation.

LEHRER: What about Mr. Jones' point that while the -- you were a key figure in the Fed for years. He says that the Fed is independent, but it is sensitive to what the White House wants, and the White House does not want what you just advocated.

Mr. ROOS: No, obviously the White House doesn't; the White House has said that it doesn't. And they are the ones who have the political judgments to make, but I would say this, that if I were President Reagan and I wanted to be reelected, if I had the choice of having a slight slowdown in this recovery in the next several months and then to have it proceeding on a steady, positive basis through next year, I'd opt for that rather than have the real problem arise in the middle of this next election year. Then he'll really have to face the music, and I think that would be a severe political as well as economic mistake.

LEHRER: Thank you. Robin?

MacNEIL: As we said, one industry most worried about higher interest rates is housing, which complains that buyers are already being scared off by the new higher mortgage rates. Anthony Frank is chairman of First Nationwide Savings, a mortgage lender based in San Francisco. Mr. Frank is in New York on business. Mr. Frank, what do you think of Mr. Roos' prescription?

ANTHONY FRANK: I think it's tired and wrong and pathetic. It's the same old religion over and over again where we talk about monetarism, which has never worked, and now we have an additional problem, which is that M-1 cannot be measured. Since we've had deregulation on December 14th of last year we've had a growth in the new money market account of $360 billion. That just completely destroys all comparability, all ability to measure monetary growth.

MacNEIL: Is that perhaps -- does that account for some of this large rate of growth in the money supply, the sudden growth of these new accounts?

Mr. FRANK: I think there's no question about it. The other measurements of monetary growth, I'm sure Mr. Roos would agree, are not exceeding their limits. M-2 and M-3 are behaving decently. The only one that's out of control is M-1 and that's because M-1 can no longer be measured. It's a rubber yardstick.

MacNEIL: What would tightening up on the money supply to the extent that Mr. Roos thinks is advisable -- bringing it down to 6% for the rest of this year -- what would that do to your industry?

Mr. FRANK: Well, housing has led the recovery in every recovery since the post-war period, and it's leading this one. It would abort the housing recovery, housing, and thereby abort the recovery. We would have -- we are having a very fragile recovery. The only reason that it's robust at all is we're comparing it with 1982, which was a terrible year. An increase in interest rates would stop this fragile recovery in its tracks. It is not overheated by any means.

MacNEIL: Where is it right now in the housing industry? How discouraging are the present interest rates to homebuyers and builders?

Mr. FRANK: Well, let me give you an example. The FHA rate has gone up 1% in the last few weeks. That means if you postpone buying --

MacNEIL: The federal housing mortgage.

Mr. FRANK: Right. That would mean, on balance, that your monthly payments would be about $1,000 -- your annual payments about $1,000 a year more now than they would have been a few weeks ago if you had taken out the loan then instead of now. That means you have to have $4,000 more qualifying income. If it goes up another 1% you have to have $8,000 more qualifying income, which is an incredible bulge for a young couple to be able to afford. And so we're pushing people away from housing as their incomes don't qualify anymore.

MacNEIL: You say it will abort the recovery if the money supply is restricted in this way, but what about Mr. Roos' point that if you don't do something to cool it now you run the risk of the old cycle again at much higher inflation in another recession?

Mr. FRANK: There is only one thing hot right now. We have good productivity; we have lowered inflation; we have good money supply in the M-2 and M-3; we have 10% unemployment -- nobody can say that's a symbol of an overheated economy. We have factory production at 70%. That's overheated? There's only one thing overheated, and that's M-1, which can no longer be measured. I mean, we're looking at the same tired old yardstick, which is not valid anymore. And on that basis, that single basis, ignoring all the other aspects, we want to abort the recovery because M-1, which can't be measured anymore, is out of control. It's crazy.

MacNEIL: Whether M-1 can be measured or not, what about the prescription that Mr. Jones makes, that if the Fed will just gently restrict the money supply in the manner he described, of reducing the reserves available to banks for distributing in the federal system, that will cool it enough.

Mr. FRANK: Well, the most interest-sensitive element of our society is housing and automobiles, and that's what leads us out of the recession, and if it aborts those, it'll abort everything else. We don't need to cool things down; it is not superheated. When you're at 70% of capacity and 10% unemployment and an inflation rate of 4% and the highest real interest rates we've ever had in this country as well as abroad, you don't need to cool off. You need to keep stimulating.

MacNEIL: What do you think the Fed should do today and tomorrow?

Mr. FRANK: Nothing.

MacNEIL: Thank you. Jim?

LEHRER: And if they do that, Mr. Roos, what happens?

Mr. ROOS: Well, if they do nothing, I would remind my good friend Mr. Frank -- I'd ask him to think back to conditions back in 1978 and '79 when the Fed did nothing. They did nothing because they felt that M-1 or M-1D, which they called it then, wasn't important -- the same tired old arguments. And inflation resulted, and I don't think that the building industry was in very good shape back in 1978 when we had double-digit inflation and when we had double-digit interest rates. The fastest way, sir, to destroy your industry, to get right back in the awful condition we were in a few years ago, is to repeat the same mistakes based on the same tired arguments that I'm hearing again that caused high inflation and intolerable interest rates at that time.

LEHRER: Mr. Frank?

Mr. FRANK: Well, I think things are very much different now than then. We have a terrific amount of slack in our economy. I think at that time factory production was in the high 80s. Now it's in the low 70s. We had unemployment of 6% then; now it's 10%. We have a lot of slack. We have low wage settlements. We have the high productivity. I think that we've done it. I think that we're on the road to moderate inflation for the foreseeable future. And for the only reason that we worry about M-1 and not anything else that we should now abort what we've achieved through a lot of pain and a lot of people unemployed and a lot of people underhoused, it just doesn't seem right.

Mr. ROOS: Well, I think Mr. Frank and I agree on one thing. We don't want to see very high interest rates in the near future, but I will say to Mr. Frank that it's my belief that if the Fed doesn't take corrective action, if it does nothing, that it's almost certain within the next 18 -- by the end of next year or early in the following year, we are going to see very high interest rates again, and that's where we differ, but I don't think either of us wants those high rates.

LEHRER: But you differ also one other very fundamental way. He says this M-1 thing is it can't be measured. It's crazy to base this kind of decision on that one measurement when everything else adds up differently --

Mr. ROOS: Here is where the same cockeyed arguments that were recited six months ago when I was still in the FONC by some of the people who have this anti-monetarist phobia. They concede to this distortion thing. A study that was done by the Fed staff just recently indicated that the advent of the money market deposit accounts and the SuperNOW accounts almost totally counteracted each other. There has been no such distortion. That was a red herring. That was an excuse the Fed threw out to explain that it had lost control of M-1. This is the same old story. When the game doesn't go the way they want, they look at other targets. M-2 and M-3 -- there have been numerous studies which indicate that they don't affect the economy nearly as directly as M-1 does, so why do we talk about M-2 and M-3?

LEHRER: Take that, Frank.

Mr. FRANK: Let me just give you a very quick example. People are now keeping several hundred thousand dollars in their checking accounts because they get paid eight to nine percent on it, so they don't need to to segregate between their savings and their checking anymore. So it's a whole new ballgame. The money market funds, which held $230 billion in money market accounts, which was not part of M-1, have now lost about $70 or $80 billion, which is in M-1. We had income tax refunds this year late, in late May and early June. Traditionally we have them in April. The seasonality doesn't take affect for that. The M-1 doesn't work. My authority is very simple. It's -- Paul Volcker, the chairman of the Fed has said that he won't look at M-1 anymore.

LEHRER: What about his other point, Mr. Roos, that he says flatly if the Fed does what you want, it's not only going to ruin his industry, it's going to ruin everybody else, and this recovery is dead.

Mr. ROOS: I would say that if the Fed announces after its meeting tomorrow that it's going to let bygones be bygones, not try to bring the average money growth for this year to within the target but merely to set a target range of 6%, and if they make this clear and if they start producing on their promises, I think you're going to see a breath of fresh air wafting through the financial markets that'll really stimulate the economy rather than cause the dire effects. I don't think 6% would cause a severe dislocation of the economy.

LEHRER: You feel, of course, Mr. Frank, that that wind would blow other things away, correct?

Mr. FRANK: Well, we've never seen the Fed be very good at fine tuning, even gross tuning, and you know, they can undershoot. When they shoot for six, they could hit three, and then it'd be like hitting a brick wall and we're right back to it again, and people who are dreaming of employment and dreaming of housing and dreaming of buying cars find that their dream is ripped away from them. And I don't want to experiment on something that hasn't worked so far.

LEHRER: Robin?

MacNEIL: Mr. Jones, how would financial markets from your view on Wall Street react to Mr. Roos' prescription of making the growth and announcing it as 6% for the rest of this year?

Mr. JONES: It would be tough going. The markets are already very uneasy about the possibility that the Fed is in fact in the process of tightening and may tighten some more. We've seen the stock market fall; we've seen the bond market fall. It would be very unsettling to the markets. So my feeling is that they have to be cautious. They do have to move, but you can't use a simple rule. You can't use a simple rule for money supply growth, but yet, I want to move, if I can -- maybe I can be the referee in this debate to some degree. I don't think the Fed is going to talk a lot about money at this meeting, surprisingly enough. I think they're going to talk a lot about the economy, and coming back to the economy, in fact, I'm surprised at how strong it is. It's running at about 8% in terms of what economists call real growth, which is underlying growth after inflation. I think the Fed would like to see four -- if it runs at 8% it could run for a year or two, but then we get the inflation and then we get the boom-bust cycle. I think the Fed would like to see, and maybe even the administration in its heart would like to see 4% over several years sustained at low inflation. That would be the golden age. So I think what the Fed will do is this: they'll try to tighten moderately in order to change the trajectory of the economy from something that was stronger than expected because of housing and cars and consumers that have developed more confidence and have more buying power, to a trajectory that can last for awhile. And I think essentially that's the reason why we'll come out with this moderate tightening action.

MacNEIL: Let me ask each of you very briefly -- we have a minute left -- for the benefit of people who may be trying to plan their economic affairs in the next few months, Mr. Roos, where do you think interest rates -- let's just take the average straight home mortgage rate. Where do you think it's going to be three or four months from now?

Mr. ROOS: I think if the Fed follows the advice that we've heard on this program this evening, interest rates will rise. Mortgage rates will be up maybe 200 basis points. Long-term bonds will rise. This is the same thing we've heard before and we've always had that consequence to overly exuberant monetary growth.

MacNEIL: What is 200 basis points in --

Mr. ROOS: Two percent.

MacNEIL: Two percent. So it'd be as high as 16%. What do you think it will be from what you heard this evening?

Mr. FRANK: We have an inflation rate in this country of four to five percent. The mortgage rate should be 11. I think it'll hit close to this level because I think that eventually they'll take Mr. Roos' advice and not mine. The rate should be 11.

MacNEIL: We have to leave it there. Mr. Roos in Washington, thank you for joining us; Mr. Frank and Mr. Jones in New York. Good night, Jim.

LEHRER: Good night, Robin.

MacNEIL: That's all for tonight. We will be back tomorrow night. I'm Robert MacNeil. Good night.