Raising the Interest Ceiling

As inflation zooms, the clamor for controls grows louder

Even on Wall Street, where bedlam often reigns and steel nerves are accustomed to roller-coaster financial markets, investors last week were reaching into their desks for bottles of Valium. As stock and bond prices plunged, limped forward and then dropped again, the nation's moneymen cast a solid vote of no confidence in Jimmy Carter's battle against inflation. Fearful that the President had abandoned the struggle with high prices at least until after this year's election, nervous brokers and bankers scrambled to protect their money from inflation's scourge.

In one day of hectic trading, the Dow Jones industrials plunged 18 points. The New York bond market, which has been in a free fall since the beginning of the year, lost 4% on what traders call "Blacker Tuesday," to distinguish it from the "Black Tuesday" of two weeks earlier. Later in the week bond prices gyrated wildly, shooting up 7% on rumors that credit controls would be announced and then falling when those rumors were denied. The prime interest rate that banks charge their top corporate clients soared from 15.25% to 16.25%, and in some banks to 16.5%, while loan officers mumbled about the possibility of a 17% prime. Meanwhile, the juggernaut of inflation continued to roll. The consumer price index in January rose 1.4%, a compounded annual rate of 18.2%, the highest level in more than six years. Wage and Price Stability Director R. Robert Russell admitted that the nation's underlying inflation rate is now "starting to explode."

Last week's soupc,on of financial panic was set off by the Federal Reserve's move two weeks ago to increase the discount rate, the interest price charged member banks, to 13%. Before the current inflation wave, that figure had never been higher than 8%. Banks immediately raised their own loan rates, driving mortgage levels, for example, from 13.25% to 14% in California.

Even before last week's moves, home building was already being battered by high mortgage costs. Housing starts in January dropped 6% to an annual rate of 1.4 million, the lowest level since July 1976. The Far West, Rocky Mountain and Southern regions are expected to suffer the sharpest housing decline.

Small companies, which often pay banks 17% or 18% interest, are also being severely hit. Moaned Bank of America Vice President Cecil Byrd: "The effect of these rates on loan applications from small business is tremendous. Applications have so fallen off that officers accustomed to having a backlog of ten to 15 loans are down to two or three."

Bankers and economists reacted so strongly last week out of conviction that the Carter Administration has left the Federal Reserve to fight the inflation battle alone through higher interest rates. Said Alan Greenspan, onetime economic adviser to Gerald Ford: "The market looked at the President's budget and saw that the fiscal restraint was all rhetoric and no reality."

An anti-inflation policy based on tight and expensive money but loose federal spending will have a double effect. In the short run, prices will race higher, but eventually restrictive monetary policy will cool inflation by inducing a perhaps severe recession. Said Economist Otto Eckstein: "Paul Volcker has made it clear that he's going to slow down this inflation. If he's going to do that, he has to create a recession. And he's going to keep on raising rates until he does."

The latest turn of the interest rate screw comes after a series of unsuccessful attempts to slow inflation by dramatically increasing the cost of borrowing money. The first was the 1% discount rate increase of November 1978. After each bout of higher rates, economists have confidently predicted recession and lower inflation, but bankers and the public have quickly adapted to the higher level, and prices have soared still higher.

With interest now far above previous levels, Volcker and the Federal Reserve are in uncharted territory, trying to figure out just how tight money must be in order to slow price increases. Innovative financial instruments like money market funds have so outmoded the tools of monetary policy that the Federal Reserve is like a guide lost without a compass.

Meanwhile, calls for more dramatic anti-inflation moves from the Carter Administration, especially for wage and price controls, grow louder. Chairman of the House Banking Committee Henry Reuss now says that such a step would be accepted by Congress, if taken in connection with other tough economic moves. He added, though, that he still opposed mandatory regulations if they were only added "on top of the present nonpolicy."

Some business leaders are likewise beginning to favor controls under certain conditions. In 1971 business's endorsement of a price freeze was a significant stimulus to President Nixon's decision to take that step. Last week the highly respected Henry Kaufman, a partner in Salomon Bros, who often serves as Wall Street's Dutch uncle, called for the declaration of a "national economic emergency." Said he: "We are in a quagmire from which it will be hard to extricate ourselves without substantial risks and pain. The question is 'Do we have the will and the wisdom to face down inflation?' " Kaufman urged a reduction in the growth of nondefense spending to 6% to 7% annually from the current 16%, direct limits on the creation of domestic credit, establishment of a commission to study rebuilding the U.S. economy and "simple mandatory controls that would be of some marginal transitional help." Like Reuss, he supports wage-price restrictions only if buttressed by a comprehensive anti-inflation program.

The Carter Administration, however, shows few signs of shifting from its current election-year program, which consists of little more than monitoring the upward march of prices. A number of policy options, such as spending cuts in the recently unveiled 1981 budget and selected credit controls, have been quietly discussed and then dismissed as politically too risky. Chief Economic Adviser Charles Schultze last week repeated his opposition to mandatory wage and price restrictions, saying they would not help inflation and are "likely to cause harm to the economy." As the presidential campaign grows hotter, the electorate will doubtless demand dramatic action on bread and butter issues--like the rising price of bread and butter.

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