The MacNeil/Lehrer Report; 6115; Will Soaring Interest Rates Choke Off Economic Recovery

ROBERT MacNEIL: Good evening. The cost of borrowing money rose yet again today, increasing fears that the economy may face a second bout of recession. Yesterday, the Federal Reserve Board, citing the need to contain inflation by limiting the money supply, raised the discount rate -- the rate it charges to banks -- to 13 percent. Today, big commercial banks raised their prime rate -- the rate they charge favored business customers -- to 19 percent. Wall Street reacted gloomily, with many share prices down. The automobile industry announced rebates and other incentives to attract customers frightened by the higher cost of auto loans. Tonight, with a special look at cars, housing and small business, will soaring interest rates choke off economic recovery? Jim Lehrer is off. Charlayne Hunter-Gault`s in Washington. Charlayne?

CHARLAYNE HUNTER-GAULT: Robin, interest rates are soaring now, but throughout the year they have fluctuated wildly. At the height of inflation fears in early spring, the prime rate peaked at an unprecedented 20 percent. That record high was followed by one of the steepest declines on record, with the prime finally hitting 10% percent by July. Since then, with the economy climbing out of its recessionary slump, interest rates have been spiraling steadily upwards, virtually defying both the principles of gravity and the predictions of when they would peak. Robin?

MacNEIL: First, why are the rates going up so rapidly, and how much further are they likely to go? We put those questions to Lawrence Kudlow, chief economist for the Wall Street firm of Bear Stearns, and former economist with the New York Federal Reserve Bank. Mr. Kudlow, why did the Fed yesterday raise the discount rate?

LAWRENCE KUDLOW: Well, the Fed is trying to send some signals to the marketplace that it wishes to slow down the excessive growth of money supply and credit and bank lending. And also to, I think, attempt to reaffirm its intentions to curb inflation and inflationary expectations, the whole environment which seems to surround the economy and interest rates. I think it`s a rather weak signal, but I think that`s essentially the Fed`s intent.

MacNEIL: What does it mean that so many people, including businesses, want to borrow money at this point? Isn`t that a good sign for the economy and for the recovery?

KUDLOW: Well, I think in the early stages of this recovery, perhaps early in the summer, some business loan demand would be quite appropriate and would in fact be healthy. But what we`ve observed in the last, oh, three or four months, is a literal explosion in the demand for credit, where, for example, business loans are rising at an annual rate of nearly 30 percent. This is exorbitant, it is inflationary, and it suggests that the demand for credit is way outstripping the ability of the economy to produce goods and services. So consequently we`ve got an inflationary problem on our hands.

MacNEIL: Okay. Now, very simply, the Fed raised the discount rate -- the rate it charges banks to borrow -- to 13 percent. And it also raised that little surcharge that it has from two to three percent. So banks can borrow, say. at 16 percent of their big borrowers. Now why did they raise their prime rate yesterday to 19 percent? Today. I`m sorry.

KUDLOW: Yes. The banks are trying to essentially keep up with events. Interest rates in the open market, money market rates -- treasury bills, CDs, commercial paper, Fed funds, the whole constellation of rates -- are now in the 18 to 19 percent area. And banks, of course, are trying to buy those monies, those deposits, and then re-lend them and try and however, to step back a minute, away from the very technical elements of this, and go back to last spring. The government, as you recall, and as Charlayne mentioned, during the wintertime, induced 20 percent interest rates as part of the anti-inflation program. There was some success. The inflationary spiral and the interest rate spiral was broken. And rates declined by a substantial magnitude, and in fact slipped down to about 10 percent, I think, in perhaps early or mid-June. At the same time, however, government policy began to make a classic U-turn, from an anti-inflation program of restraint, to an anti-recession program of stimulus. And frankly, government spending and money supply growth expanded at incredible rates. In the case of federal spending, over 20 percent the last six months. In the case of money growth, over 15 percent. And even by election year standards that`s pretty hefty stimulus. This came at a time when the economy was trying to re-group itself and re-form for a longer-term, sustainable non-inflationary recovery. And all of this credit stimulus and government stimulus created an excessive demand, new inflationary expectations, and this is what causes interest rates to jump. It`s not so much what`s actually happening, but what individuals fear or expect will happen.

MacNEIL: Now, played as part of that, what effect are anticipation`s of Mr. Reagan`s policies having on this interest rate market, the money market?

KUDLOW: Well, I think one of the key junctures in the last six months occurred in July, when, first, Mr. Reagan unveiled his tax-cutting program and within a few days Senate Democrats unveiled theirs, and a few weeks after that President Carter unveiled his. And I think that the market took a look at this and recognized that the main political players were all talking about cutting taxes, and all of a sudden the efforts to balance the budget, slow down spending and money growth and fight inflation, seem to have receded and been pushed into the background. And now the name of the game is more stimulus. And this. I think, helped to regenerate or rekindle inflationary expectations, and ironically, interest rates really came alive right about that time in July. And I suspect, now, with the Reagan camp continuing to press for tax-cutting, and with efforts to cut spending very difficult and somewhat doubtful, markets are concerned that this coming winter we will have more budget deficits, more government spending, more money growth, more inflation. And this is driving up interest rates. And the Federal Reserve Board is really following suit, rather than leading.

MacNEIL: How much further, higher, do you think the interest rates may go? And when will they start to come down?

KUDLOW: Well, as you can appreciate, these are tough questions now because in many ways we`re moving into uncharted waters. There`s not much historical data for 20 percent or thereabouts interest rates. I would suggest, however, a couple of specifics. First, I don`t see indications that rates have peaked. Second, I think the economy still has a good deal of life in it. Although some sectors are in trouble, other sectors are doing very well. Third, credit demand is quite substantial, and growing. Therefore, with all that in mind, my guess is rates are going to pass through 20 percent without much difficulty. And I think this process is going to play itself out not just in the next week or two but my hunch is we won`t see a peaking of rates until perhaps sometime well into the winter -- I guess about February or maybe early March. It`s going to take a while, much longer than most analysts, I think, and most people suspect. And the top in rates could be, you know, 22, 24, 25-- all that`s, unfortunately, within reach.

MacNEIL: Thank you. Charlayne?

HUNTER-GAULT: One of the industries most sensitive to fluctuations in interest rates is housing. This time around building permits as well as sales of new and existing homes began to drop as soon as the prime began its rise. A man who can give us some perspective on all of that is Richard Davis, a mortgage banker from Portsmouth, Virginia. A former Democratic Mayor of Portsmouth, Mr. Davis is also vice president of the National Mort- gage Bankers Association. Mr. Davis, just how severe are the problems now in the housing industry?

RICHARD DAVIS: Well, they`re very critical. I think figures came out yesterday which showed that-- as an example, which is one part of the whole thing-- was that there were only 44,000 new housing individual residential units sold during the month of October. That`s an incredibly low figure. It would translate into an annual sales of 550,000--

HUNTER-GAULT: And what would you normally expect?

DAVIS: We would hope to have well over a million. Back in 1968 we set-- not we, but the national priorities said that we needed about 2 1/ 2 million new housing units each year for the next then decade. And we haven`t reached that in any time. But this kind of a falloff is frightening.

HUNTER-GAULT: Are there any sectors that are hurting more than others, in housing?

DAVIS: Well, no. I think that within the housing industry generally it`s pretty much across the board. How basic? I can give you the disease, I can`t give you the therapy. But the two basic things that are confronting both the housing finance industry and housing itself are, one, the inability to corral capital that, in the very fluctuating rate system we`re now using, that would permit the rates of long-term debt to fluctuate with the inflationary rate. We are addressing that through alternate mortgage instruments, and that`s a whole other thing that can be talked about at another time. The critical thing is the first-time home buyer. If we could get them into a home-- it`s odd, but the inflationary spiral, which we all find distasteful, accommodates those who already have homes and have built an inflationary equity. So it`s the first-time home buyer who simply can`t buy a home.

HUNTER-GAULT: So, are you saying that people have stopped coming into, say, your establishment, the mortgage lending business, to even apply for a loan?

DAVIS: Absolutely. In our industry generally -- and the mortgage bankers last year provided about 25 percent of all the single-family home credit in America -- most of my colleagues are, compared to last year, down by about 40 to 50 percent. Our own company is down about 60 percent.

HUNTER-GAULT: How much money do you have to earn these days to buy a house?

DAVIS: A lot. It relates, of course, to the sales price of the house, the amount of equity that you have to put into it, and the amount of mortgage that you`re going to have to finance.

HUNTER-GAULT: But how about this first-time-out buyer you just mentioned? Give me a figure or an example of--

DAVIS: Well, it depends. It varies throughout the country. In California it`s one price, in Virginia it`s another price. But one thing, I suppose -- if we look for some sort of a silver lining -- one interesting thing was that in October the median price of the houses that were sold during that month went from about 68.5 to 65.5 [thousand dollars]. So that it shows that when there is an inability of people to buy, there is some silver lining in that it does cause the median or the average house to go down in price. But--

HUNTER-GAULT: But can people afford that price?

DAVIS: Well, quite obviously, with the statistics I gave you, they can`t.

HUNTER-GAULT: Right. Just briefly, anticipating the change in administrations now, do you see anything on the horizon that might change this picture?

DAVIS: Well, I was hopeful. The earlier speaker was saying that the did not expect a great deal of change with the new Republican administration. Although I was state party chairman of the Democratic Party in Virginia, and we really got licked. I am looking forward and praying that President- elect Reagan will do the things that he says. The tax cut`s all right that has already been discussed. But he has always told us during the campaign that that would be compatible with a reduction in the deficit spending. And unless and until the federal government gets out of deficit spending and increased borrowing, the housing finance industry simply cannot succeed in this country.

HUNTER-GAULT: All right. Thank you. Robin?

MacNEIL: One industry, automobiles, today fought back against higher interest rates. Ford and Chrysler both announced incentives to ease the impact of high rates for car loans. Chrysler is offering rebates that get bigger as interest rates rise. Ford is offering auto loans at 12 percent on some models. To discuss just how higher interest rates and other factors are affecting Detroit, we have Maryann Keller, auto industry analyst for the Wall Street firm of Paine Webber. Mrs. Keller, what has been happening recently to car sales?

MARYANN KELLER: The domestic car industry staged a feeble recovery during the early part of the 1981 model year. Car sales had been at a seasonally adjusted rate of about six and a half million during the summer, and they moved up to about seven million in October, and that rate persisted into early November. The figures that were announced two days ago, however, showed a very precipitous drop, not only in unit volume from last year, but in the calculation of the seasonally adjusted rate it has fallen to 5.6 million.

MacNEIL: And how much are higher interest rates the culprit in that?

KELLER: I think there are a combination of factors here. I guess I would put some blame on higher car prices as well. But there`s no doubt that interest rates are discouraging purchases. People are having to finance a much higher-cost automobile, and simultaneously have to pay a much higher financing charge on it. So most people, when they buy an automobile, look in terms of the monthly payment. And if they can afford the monthly payment, they feel that they can afford the automobile. We`ve had ? fairly stiff increase in new car prices, which by itself pushed the monthly payment up at the onset of the new model year. And now financing charges on new auto loans are rising along with other interest rates and it`s pushing the car, unfortunately, out of the reach of many buyers.

MacNEIL: How do interest rates affect the car industry besides inhibiting buyers?

KELLER: Well, I think it has an instantaneous effect on the car dealer. Interest rates tend to move up a bit more slowly on consumer loans, but the car dealer`s floor planning costs are directly related to the prime. He`s paying one or two percent over prime to finance the cars that are on his lot. And at today`s prices that can amount to well over a hundred dollars a month in interest costs for each automobile on his lot. And so he becomes very concerned about the outlook and generally he reduces his orders to the factory, and the immediate effect is in fact production cutbacks, which are now beginning to happen. The obvious effect from that, of course, will be that unemployment levels in the auto industry will start to climb again,

MacNEIL: What is this going to do in particular to Chrysler`s hopes of recovery, after all the public bailout loan guarantees?

KELLER: Well, I guess I for one felt that Chrysler`s assumptions about the state of the fourth-quarter market were a bit on the optimistic side in terms of how many cars they believed that they could sell and how much inventory their dealers would be willing to add on. It`s obvious now that their hope for a profit in the fourth quarter is not going to be fulfilled, and I myself believe that they are going to have a loss of anywhere from $200 to $300 million in the quarter. Looking ahead, they have indicated that they need at least $200 million more from the Federal Loan Guarantee Board. I think that they will probably, in short order, require the rest of the government funds that are available to them. It seems to me that Chrysler is facing a very severe financial dilemma at this point, and I have a feeling that the Reagan administration is going to have to deal with this fairly early on.

MacNEIL: We`ll come back to that. Charlayne?

HUNTER-GAULT: Now for a look at how small businesses are being affected by high interest rates. John Bowser, executive director of the Philadelphia Urban Coalition, spends much of his time counseling small businessmen and helping them with their financing. Mr. Bowser, what kind of small businesses are suffering from these high interest rates?

JOHN BOWSER: Small businesses that are largely dependent upon consumer sales, those in the retail sector, and those who may be engaged in light manufacturing largely dependent upon government contracts or large orders are going to suffer greatly. There`s going to be probably a slowdown in payment, and certainly there may be some expectation on the part of consumers to build some cash reserves for themselves and to cut down their spending.

HUNTER-GAULT: What kinds of rates do businesses like that have to pay these days to borrow money?

BOWSER: The reality is that most small businesses that are dependent upon the SBA guarantee programs for much of their capital formation--

HUNTER-GAULT: You mean the Small Business Administration?

BOWSER: Small Business Administration. Are paying, generally, two to two and a half percent above prime. And most of them have what is known as floating interest rates, which allows those rates to increase every 90 days. So that this high interest rate will in fact translate immediately in the small business over a 90-day period. And will impact on long-term capital assets that are not necessarily performing at a level to underwrite these costs.

HUNTER-GAULT: What will happen to most of them if the interest rates continue at current levels or go higher?

BOWSER: Well, we`ve got two problems. I don`t think that the small business community in general has had an opportunity to build any reserves from the last surge in interest that you mentioned earlier, in April. So that I think many of them are much more vulnerable now than they were in April, and likely to go out of business. The invisibility of monetary policies that`s sensitive to small business troubles me greatly. In the Carter administration credit constraints, they did build in some exemptions for small business, but the mechanics weren`t there to implement those or to monitor those exemptions, so they really had no substance other than being a written concept that never got implemented.

HUNTER-GAULT: How large a community are we talking about? And in the context of the overall economy, if these businesses did go out of business, what kind of impact would it have?

BOWSER: There are those who would say that the small business community in the aggregate employs more than 50 percent of the work force and accounts for more than 50 percent of the Gross National Product. So we are talking about, in the aggregate, a very significant proportion of our economic strength.

HUNTER-GAULT: And this would significantly effect the unemployment rate, if these businesses were to go bankrupt?

BOWSER: Oh, absolutely. And I think I`d be remiss not to make mention that the development of minority entrepreneurs in cities, which is very critical to the cities` viability and the cities` unemployment problem, certainly find themselves in a very precarious position.

HUNTER-GAULT: Have you seen or heard anything in the Reagan economic proposals so far that make you either hopeful or fearful for these kinds of entrepreneurs?

BOWSER: Well, I think that the jury`s still out. I would be just cautious. I don`t see much evidence to support that profits would be invested in areas where they`re not being realized, so I`m skeptical about the idea of tax credits on development districts, but the jury`s still out on that, and there may be some underpinning of public policy with respect to that that makes some sense. But as things stand right now, I think that needs to be planned in more specific terms.

HUNTER-GAULT: Any specific one thing you could throw out. just briefly?

BOWSER: Well, I think we need to give visibility to the small business community. I think we need monetary policies coming out of the Federal Reserve System relating to its member banks that can in fact be monitored and implemented. I think the Federal Reserve still lives in a realm where small business is someone doing in the neighborhood of $100 million a year, and that`s just the realm of fantasy.

HUNTER-GAULT: AH right. Thank you. Robin?

MacNEIL: Mr. Kudlow, you said earlier that other parts of the economy are still strong. Are these not typical stories for the economy as a whole?

KUDLOW: Right. They are not. I clearly-- and I agree with what`s been discussed insofar as housing and automobiles and also the small business area. But, we`ve had such an exceptional degree of stimulus in the last six months that this is affecting the economy, and it`s affecting it in many ways. Income is rising. I believe in the last four or five months personal income has grown about 14 percent annual rate, and industrial production is rising very quickly. Certain categories of the economy are showing good strength. For example, the energy categories -- energy sales, energy production -- very strong. Military, defense, aerospace are quite strong. Computers seem to be strong. Food sales are strong, and in general non- durable sales are strong. And I suspect, although there is some pessimism now, that the Christmas retail sale season will probably turn out to be a little better than people expect. So in my view there are a number of categories where there`s economic strength offsetting the weakness in other categories. And what we`re getting is, because of the high interest rates, we`re getting a reallocation of the income available to be spent away from certain sectors and towards other sectors.

MacNEIL: Well, is it too alarmist, then, to say that the much more expensive money may. as I said at the beginning, choke off the recovery or push us back into another bout of recession, or is that likely?

KUDLOW: Well, a couple of points. I don`t want to paint a rosy economic picture, because I don`t believe that. I think the economy has a lot of imbalances and structural problems. I think the high interest rates are going to hurt even more. And since I think the rates arc going higher, I think the damage will be greater. I fully expect a business slump in 1981. My point is, however, in the short run, let`s say the next three, four, five months, the stimulus is going to take an effect. The interest rates don`t have quite the influence they used to have. When you take the tax deductions out of interest rates, and when you adjust interest rates for inflation, real after-tax rates are much lower than the market rates that are always quoted. And let`s take a 20-percent prime rate. If we assume a 50-percent tax bracket, then actually it`s a 10-percent prime rate. And, if we assume a 12-percent inflation rate, then actually it`s minus two percent, which is not high -- that`s very low.

BOWSER: The problem in the small business community is a little bit different.

MacNEIL: I regret very much to say that that`s the end of our time this evening. It was very interesting, all of you. Thank you, Mr. Davis, for joining us. Mr. Bowser, Mr. Kudlow, Ms. Keller. Good night, Charlayne.

HUNTER-GAULT: Good night, Robin.

MacNEIL: That`s all for tonight. We will be back on Monday night. I`m Robert MacNeil. Good night.