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
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
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. …