High Interest Rates: A Who-Dun-It?

WHAT'S responsible for this year's interest-rate hike? Bond yields since year-end are up 1-3/4 to 2-1/2 percentage points overseas. Domestic bonds moved in the same direction, with a rise of more than a point in government Treasuries. The Wall Street Journal asks: ``For 75 years, the Federal Reserve took the blame for rising interest rates. Now it can more easily pass the buck. What's going on?''

Global capital demands are not to blame.

But Fed governors and private commentators are indeed busy turning the finger of suspicion away from Washington. In January congressional testimony, Chairman Alan Greenspan cited ``stronger-than-expected economic data, a run-up in energy prices, and increasingly attractive investment opportunities abroad.'' Uncertainty about the economic side effects of German reunification was great, he said, and markets may have overreacted. After several more weeks of rising rates, he began to identify the source of the rate hike as global: the capital demands of converting most of the communist world to a market economy.

``This is an extraordinary change in the nature of the world's savings and investment which I don't think has any historical precedent, certainly not in the last 40 years.... ''

Mr. Greenspan's thoughts were echoed at the same hearing by Michigan Sen. Donald Riegle (D):

``I don't see how the United States is going to be able to go out and grab the same share of the international savings pool, now that we've got a big new competitor in terms of Eastern Europe, without having to pay a higher price for it.''

The word is out that the Fed has less power to control interest rates now that markets have gone global. For Lyle Gramley, the Fed's chief economic forecaster during the 1970s, this was a complete surprise: ``Whoever thought that developments in West Germany were going to be a very important influence on interest rates in the US? Maybe somebody did. It wasn't me.''

At first glance, global markets offer an alibi to central bankers in Washington, London, and elsewhere. Escalating international interest rates are now attributed to a rising world real rate - the interest rate after subtracting anticipated inflation. But blaming the markets' response to world capital demands is a dangerously open-ended escape route for the Fed. More careful global thinking leaves the central bankers still on the hook.

As economist Milton Friedman recently pointed out, ``Capital markets have long been linked internationally, and that has tended to make real interest rates in different countries tend toward roughly the same level.'' Indeed, pushing the logic to its conclusion and adjusting for risk and taxes, there will be just one real rate of interest in the world. That means we have only to locate one place where inflation-proof bonds are traded and see to what extent the world's real rate of interest has increased.

London is such a place. Margaret Thatcher's Treasury issued index-linked bonds early in the 1980s. The yields on these bonds contrast sharply with those on other ``gilt-edged'' securities. While the latter have been in double digits all year, the former have mostly ranged between 3.5 and 4 percent. Index-linked yields are up about 70 basis points (0.7 percentage points) this year, but that is a lot less than the British nominal rate increase of over 2.5 percentage points. Nearly 190 basis points remain to be accounted for. Nor does the real rate explain US nominal rates.

If enough informed observers take a thoughtfully global point of view, responsibility for neither large increases nor large declines in nominal US interest rates can be laid at the door of world capital demands. Inflation fears are the only plausible culprit.

Rather than look for scapegoats, central bankers should use their powers to anchor the purchasing power of their currencies in the commodity market. Then they might be in the happier position of accounting for falling rather than rising interest rates.

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