Real Interest Rates Threaten Economy

Article excerpt

Since the spring of 1989, the American economy has grown either weakly or not at all. And all through this period, what economists call real interest rates _ the difference between interest rates on borrowed money and the inflation rate _ have remained high. High real rates are usually seen as a threat to economic activity and an obstacle to a strong recovery after recession.

Such concerns are justified, most economists say.

The real test of the impact of interest rates is their level in relation to inflation. If the prime rate is 10 percent while inflation is rising at an 8 percent rate, then the pinch on consumers is less than if the prime rate is at 8.5 percent, but expected inflation is only 4.5 percent, the present levels for both.

The closer the two rates are to each other, the greater the likelihood that salaries and prices will rise sufficiently to offset the cost of a loan.

Economists typically arrive at real rates by looking at the rates on such things as car loans, mortgages, and Treasury bills and notes, and then subtracting the expected inflation rate. But like so many generalizations in economics, the broad rules about real interest rates fail to adequately reflect their actual impact on individuals.

As Albert Wojnilower, a senior economist at First Boston Asset Management, puts it, "People have to look at their own personal rate of inflation in income and expenses to know what real rates mean to them."

A home buyer who takes a $100,000 mortgage at a cost of 9 percent annually, for example, is hurt if his $100,000 income rises by only 3 percent in the first year of the mortgage. The salary increase is the home buyer's personal rate of inflation in determining the mortgage's real cost. In this case, the rise in salary covers only $3,000 of the $9,000 interest payment.

The buyer's initial real interest rate, then, is 6 percent, and he has to draw from savings, or reduce other expenditures, to cover the cost.

Many Americans are in this fix, which helps to explain why home sales are not booming. Similarly, real rates are high on most auto loans and on credit-card debt.

Or take a clothing store owner who borrows $100,000 at 8.5 percent to stock shirts and pants for the coming year. If he can mark up this merchandise by at least 8.5 percent, or $8,500, then the real interst rate on his loan is zero. But if, like many retailers today, he is forced by weak demand to discount his wares, selling them finally for only the $100,000 purchase price, then the real interest rate on the money he borrowed is high: 8.5 percent.

Such high real costs help to explain why many businessmen are not yet rushing to build up inventories as the recession appears to be ending. …