Short-Term Rates Matter, Mr. President

The U.S. economy, as viewed through Bill Clinton’s eyes, is a machine that needs only the grease of low, long-term interest rates to run beautifully. Don’t worry about short-term rates, he seems to imply.

But the President may need to bone up on modern finance: In an economy with so much consumer, mortgage and business debt tied to interest rates of one year or less, his laser-like focus on long-term rates could be dangerously self-deceiving.

Clinton’s message all year has been that short-term rates don’t count for much. Long rates--such as 30-year mortgage interest and 20-year corporate bond yields--affect the economy most, he says, because they represent the costs of large, long-term investments (such as houses, factories) that are keys to job creation and growth.

To a degree, Clinton is right. Long-term, fixed mortgage rates now are at 21-year lows, and that certainly has helped put more people in homes. The National Assn. of Realtors said Friday that sales of existing homes rose 4.6% in May, to the highest level since January.

What’s more, the decline in 30-year Treasury bond yields late last week, to a record low of 6.7%, was a tonic for Wall Street, soothing a jittery stock market.

However, Clinton’s public cheerleading for lower long-term rates as an economic cure-all has become almost mantra-like, and it ignores the very significant effect of rising short rates on Americans’ pocketbooks and psyches.

After Friday’s razor-thin Senate approval of his tax-raising, deficit-cutting economic plan, the President’s comment was all but predictable: “It means we can now move on to a (congressional) conference committee with a clear signal to the financial markets that its interest rates should stay down,” he said.

We know he is referring to long rates, because he always does. Earlier last week, when reporters asked him about the possibility of short rates going up, Clinton’s reply was, essentially, that it would not matter. Long rates should still keep falling, he said.

In one sense, Clinton has little choice but to emphasize long rates. He has virtually taken credit for their falling this year, saying the decline represented a vote of confidence in his economic plan from the markets.

In theory, investors are allowing long-term yields to fall because they believe the federal government will borrow less in coming years. If there is less demand for long-term money, the price of it should drop.

Even as long rates have fallen, however, short rates have moved up. Despite the sluggish economy, investors appear to believe that growth--and inflation--will pick up enough later this year to warrant the first official credit-tightening by the Federal Reserve since 1989.

Because short rates represent the immediate cost of money, they are most sensitive to change in the economy and inflation. While the Fed is said to control short rates, in reality, it just follows the market’s lead. And for now, the market is saying that the next likely move in short rates is up, after three years of decline.

The discount rate on 3-month Treasury bills, for example, is at 3.09%, up from 2.83% in mid-April. The discount rate on one-year Treasury bills has risen to 3.37% from 3.07% in the same period and is up even more when measured from last October’s generational low of 2.84%.

Do such relatively small increases in short rates matter, especially if long rates stay down? The answer is yes, many experts say.

Over the past decade, the amount of consumer, business and government debt in the economy tied to short rates has ballooned. So, each rise in short rates today is a much greater drag on the economy than it would have been in, say, the mid-1970s.

“In each succeeding (interest-rate) cycle, short rates impinge a little more on the economy than in the previous cycle,” said Henry Gailliot, economist at money management firm Federated Investors in Pittsburgh.

While Clinton downplays the importance of short-term rates, they matter a great deal to many Americans. A few examples:

* ARM borrowers. An estimated 25% of the $2.5 trillion in homeowners’ first-mortgage debt is in adjustable-rate mortgages, or ARMs, according to the Federal National Mortgage Assn. That’s up from virtually nothing at the start of the ‘80s. And the percentage of ARM loans is thought to be far higher in California.

Most ARMs are believed to be tied to the one-year Treasury bill rate. So if the upward trend in short rates persists, some ARM holders could see their payments begin to rise before winter.

As ARM rates have fallen since 1991, homeowners with those loans have reaped cash windfalls from having lower payments--an estimated $10 billion last year alone, says Mark Obrinsky, senior economist at FNMA. To begin giving some of that money back obviously would be a painful blow to ARM holders and to the economy.

* Home equity credit line borrowers. Homeowners have about $130 billion outstanding in these wildly popular loans, says David Olson, a private economist in Columbia, Md., who specializes in the mortgage market. About 80% of the credit lines are tied to the prime lending rate, which now stands at 6%, Olson says.

If short rates continue to rise, banks will eventually face pressure to boost the prime as well--even if long rates hold steady or drop further, economists note. A higher prime would immediately mean higher equity credit line payments.

Worse, small businesses--the economy’s best hope for new job creation--would be hurt most by any hike in the prime, because smaller firms are more dependent on short-term bank loans than bigger firms. Small companies generally don’t have access to long-term bond financing.

* Savers and investors. The fuel for the stock and bond market rallies of the past two years has been the great decline in short rates, which has turned many former savers into investors seeking better returns.

If yields on money market funds and bank savings certificates rise, the flow of money into the stock market could slow sharply, because savers would have less reason to hunt for better returns elsewhere.

Obviously, anything that hurts the stock market also hurts the ability of companies to raise equity and further dampens economic expansion in the long run.

The point is, Clinton is right to note the benefits of low, long-term rates, but he may begin to sound like George Bush--i.e., out of touch--if he continues to suggest that they alone offer some magic potion for the economy. Short rates do matter.

The best we can hope for is that the economy continues to grow moderately--without a rise in inflation--and that any further increase in short rates is modest.

The worst-case scenario: Clinton’s tax hikes and medical plan prove inflationary and drive up short rates. His chanting about long rates then would ring hollow.