simard@loral.UUCP (07/26/84)
[Do not write in this space]
With interest rates a matter of such concern to the economy, and the
political picture, a look at some underlying principles may be useful.
Interest rates (as actually charged of the borrower) are the sum
of the real interest rate (what the lender actually makes) and
the inflation rate. Since the rate of inflation is subtracted
directly from the lender's proceeds from the loan, the lender
if forced to consider not only the inflation rate at the time
the loan begins, but what it may be over the entire term of the loan.
For this reason, lenders are rather intimidated by the recent history
of inflation (recent meaning over the last ten years or so) and
find it difficult to lend long-term for attractive rates. Witness the
crisis of S&L's holding fixed-rate mortgages whose interest was less
than the loss of value of the loaned funds. So lenders include a
safety factor to protect them against future inflationary shocks. If
consistent, long-term policies that effectively reduce inflation
(such as we are seeing now) are in force long enough, lenders may
gain enough confidence in the long-term picture to relax their
inflation premiums.
Another major factor is the Federal Reserve (the Fed). Originally
the 'lender of last resort', the Fed is now the greatest single
influence on interest rates (but they do not determine rates, as
some believe). By controlling the injection of funds into the
banking system (and thereby regulating monetary aggregates), the Fed
affects the supply side of the supply/demand equation for credit.
The curve is something like this:
* *
Interest rates * *
* *
* * *
Rate of monetary expansion
What this means is, at a certain rate of monetary growth, interest
rates are minimized. This occurs when the growth is essentially
equal to the growth of productivity of goods and services. As long
as the amount of currency generally tracks the goods and services it
is used to purchase, prices are stable and inflation is low.
If money expands less than that, there is a shortage of dollars and
credit demand pressure builds, forcing up interest rates (the left
side of the curve). If money expands faster, more dollars chase
the same goods, prices rise, and you have inflation, a la 1970's.
The best way to locate the correct point on the curve is to keep
an eye on the market prices of fixed-supply commodities, such
as precious metals. Stability in these prices are a good indicator
of a non-inflationary situation (other factors are also included, but
are of lesser significance).
What has been happening this year is that the Fed is using monetary
targets set last year, before the explosive expansion of the U.S.
economy began. Therefore, we are on the left side of the ideal
curve, experiencing a shortage of credit.
Since much of the budget deficit is debt service, and in the light
of the depressed price of gold, it would behoove the Fed to re-evaluate
the monetary targets in the light of this year's economic performance.
This would not eliminate the problem of high interest rates, nor
the deficit, but it would go a long way to bringing both into line.
--
Ray Simard
Loral Instrumentation, San Diego
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