While 11 U.S. senators confronted him before television cameras last week, U.S. Federal Reserve Board Chairman Paul Volcker stoically pressed on. Head bowed, Volcker silently doodled on the cover of his prepared statement to the Senate banking committee while the politicians—six of whom are up for reelection this fall—railed against the Fed’s tight-money policy and high interest rates. The reason for Volcker’s apparent equanimity: an optimistic— and controversial—prediction in his report that, despite record government borrowing, interest rates will likely fall in the United States during the remainder of this year.
Already borrowers throughout North America have been offered a small amount of rate relief. Last week Volcker’s agency cut the discount rate— the U.S. equivalent of the Bank of Canada weekly rate—from 12 to 11.5 per cent. In turn, the cut prompted many leading U.S. banks to reduce their prime lending rate by half a percentage point to 16 per cent. In a sympathetic move north of the border, the Bank of Canada rate was reduced for the second week running, sparking prime lending rate reductions by four major banks.
Although the rate cuts and Volcker’s testimony were greeted by major stock market rallies, many economists and financiers warned that it is still too early to trumpet the end of the high interest rate burden. In Volcker’s view, recent progress against inflation should team up with expected improvements in corporate cash flows—which will reduce private sector borrowing requirements—to keep rates down during the coming months. But his analysis was challenged by many observers. Michael Manford, chief economist for Merrill Lynch Royal Securities Ltd.,of Toronto, argues that the U.S. government’s ballooning need for new cash—which reached $50 billion in the current quarter alone—will place upward pressure on the cost of money. Says Manford: “It’s going to take time,without a really staggering recovery, to offset that.” What’s more, he says, many companies will likely use their restored cash flow to rebuild badly drained inventories rather than cut back on borrowing. According to Manford, this means that U.S. rates could shoot up again in the fall and not drop until the new year.
Predictably, the cut in Canada’s bank rate last week did not pass without criticism. Progressive Conservative MP Don
Blenkarn noted that the bank rate is still a full point higher than in January, “when we saw the worst economic performance in one quarter in this country’s history.” As well, the country’s long-term interest rate look is not as promising as the United States’. Part of the problem is Canada’s poorer economic performance. Says Peter Martin, chief economist at McLeod Young Weir Ltd.: “Our corporations are downright unhealthy.” On top of that, Canada’s 11.8-per-cent inflation rate is about fiveper-cent higher than its U.S. counterpart. But the biggest blow of all could
come this November when $12.8 billion worth of Canada Savings Bonds offered last year at 19.5 per cent come up for redemption. According to Manford, the government will have to maintain the high yields on the bonds to convince Canadians to hold on to them. This, he says, could push the prime rate up to 19 per cent. As in the United States, Canadian interest rates will likely fall in the new year. But even if Volcker’s scenario proves correct, the prospect is that Canada’s economic recovery will lag far behind that of its neighbor.
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