How High Is 3 Percent?

September 24, 1956

The extent of the national pressure for continued inflation was demonstrated by the reaction in political, business, labor, academic, and journalistic circles to the general rise of the discount rate of the Federal Reserve Banks to 3 percent. The most vociferous reaction was that of Democratic orators, already expressed in the Democratic platform, that this “hard-money policy” was just part of “the Republican crusade against full prosperity for all.”

But this time there were new objections. (1) The higher money rates were not only denounced, as on previous occasions, as “deflationary”; they were also criticized (often by the same people) as (2) ineffective, and (3) actually inflationary.

While even the first and second objections are of course incompatible with each other, either could be justified in principle, depending on the real state of the facts. If a 3 percent discount should prove in itself high enough to lead to an actual contraction of the total volume of bank credit outstanding, it would be deflationary. If such a rate were at least high enough to halt any further expansion in bank credit, it would halt inflation. This, in fact, is precisely the usual purpose in raising the discount rate. If a 3 percent discount rate does not prove high enough to discourage further expansion of bank borrowing, it will of course be ineffective.

HIGH ENOUGH?

At the moment it does not seem probable that a 3 percent discount rate will in itself prove sufficient to halt the present inflation. True, it is the highest rate since 1933; but prior to 1930, 3 percent was the lowest discount rate. The rate went as high as 7 percent in the boom of 1920 and to 6 percent in 1929.

Two current fallacies, however, must be rejected. One is the idea, put forward by a prominent Wall Street house, that: “High taxes make interest rates relatively unimportant to businessmen. The government pays a little more than half the interest charge, so that a 6 percent rate really costs the businessman only 3 percent,” etc. It is not true that the government “pays” half the interest charge, as any businessman whose project does not yield a net profit soon discovers. The government merely permits a corporation to deduct full interest payments before seizing 52 percent of what the company has left as net profit. Higher money rates will still discourage marginal borrowers.

A much more dangerous fallacy is the belief that higher money rates are actually inflationary. One of the country’s leading newspapers, in its news story on the Aug. 24 discount rise, “reported” matter-of-factly: “It will take time for today’s action to be reflected in retail prices. . . . However, the high cost of working capital . . . is bound to be reflected, even if slightly, in the ultimate prices paid by the consumer.”

A DANGEROUS FALLACY

This contention that a rise in short-term interest rates is actually inflationary is disquietingly familiar. I remember encountering it three years ago in an interview with the head of the central bank of a leading European country that had already been, and has since been, ravaged by inflation. The fallacy (1) greatly overestimates the percentage that interest payments on bank loans constitute of the average business firm’s total production costs; (2) falsely assumes that a rise in such costs can be passed along to consumers in higher prices, regardless of what happens to consumers’ monetary purchasing power or willingness to buy; and (3) most importantly, overlooks the fact that higher interest rates themselves reduce the volume of business borrowing compared with what it would otherwise be. They therefore tend to halt the expansion of money-and-credit supply, and consequently to halt the rise of commodity prices.

The present rationalizations of cheap money are another symptom of how deep-seated inflationary sentiment has become. They also illustrate the theme, so well developed in the August Survey of the Guaranty Trust Co. of New York, of how the growth of the doctrine that government must assume “social responsibility” for maintaining continuous “full employment” has in fact led to the growth of fiscal and monetary irresponsibility.