Interest rates holding their altitude on old inflation upcurrents

Administration officials, most notably Treasury Secretary Donald Regan, have been protesting for some time that interest rates are too high. Being the former head of the nation's largest brokerage firm, Mr. Regan knows a good deal about how the market sets interest rates.

During the course of United States economic history, investors have earned about 3 percent on the best fixed-income investments - US Treasury bonds. That statement requires some explanation. The coupon on government bonds has obviously not always or even frequently been 3 percent. Moreover, bond prices fluctuate, so what an investor actually makes on an investment from the day he buys a bond to the day he sells it (or it matures) depends on the fluctuation in price as well as the coupon yield. Finally, the fixed interest rate on the coupon has been influenced by market forces which have included some kind of inflation premium.

When all these factors are eliminated, however, it appears that the true cost of money in the US economy has been about 3 percent. It is correspondingly higher for investors other than the US government, who are presumed not to be as low a credit risk as the sovereign.

During the late 1970s, inflation grew worse and lasted longer than most bondholders expected. For several years, they actually had a negative yield on their holdings, if the coupon yield was balanced against the principal loss on a bond from year to year.When investors finally became shell-shocked and fled from the bond market at the end of the 1970s, a higher yield structure evolved to compensate them for their inflationary expectations.

What the Treasury secretary has been implying is that the inflation premium in the long-term bond market today is too high. Well, is it or isn't it? The surface evidence would indicate that government bond yields are too rich today. Richard Hoey, the chief economist of Becker Paribas Inc., the investment banking firm, does a periodic sampling of the long-term expectations of inflation. In his latest poll, he finds that there has been a rise in inflationary expectations from a level of 6.35 to 6.66 percent. This is not substantially higher than the current rate, which is running less than 5 percent.

If one were to apply Mr. Hoey's survey to the present bond market, he could say that in a perfect market the rate on government bonds would be 6.66 percent, plus the long-term cost of 3 percent for money, or slightly under 10 percent. This compares with a current yield on government bonds in excess of 13 percent. Why, then, does the market for government bonds not comply with Hoey's survey and with the opinon of the Treasury secretary and give us a yield of 10 percent? Three possible reasons come to mind. The first is that many investors do not believe that an inflation rate of 7 percent is sustainable for the long term. That is, unless inflation is reduced to, say, something under 3 percent, it will remain a factor in the thinking of those who set wages and prices and will tend to creep up year by year, as it did in the '70s.

A second is that investors fear that working out of the foreign debt problem will in the end have inflationary implications. One might call this factor an uncertainty premium. And the third is that, given the demand for funds that has arisen partly from the string of record high US government deficits, the actual cost of money has gone up from 3 percent to 4 percent or even higher.

Three years ago, when government bonds reached a 15 percent yield for a brief period, it was possible to say that the US economy just wouldn't run on 15 percent money and that something had to give. There was a massive bond rally as the 1981-82 recession got under way. Given the shifts to floating rates in the larger part of the credit structure and the fact that bonds are not yet anywhere near 15 percent, it isn't at all as clear that we are close to a turning point in the bond market.

Nevertheless, real (that is, with the expected inflation left out) returns of close to 7 percent on government bonds today have to be looked at as a unique situation. The question is: Is Donald Regan right, or are the investors right who conclude it's a safer thing to bet on more inflation?

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