What Goes Down Can Keep Dropping

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The Smiths are in the midst of obtaining a mortgage for their new home. The Federal Reserve has let the money supply grow more rapidly than usual. Should the Smiths: a) go with a variable-rate mortgage because interest rates will fall in the near future; b) obtain a fixed-rate mortgage since increases in the money supply cause inflation that results in higher interest rates down the road; or c) flip a coin? The best response is c.

Forget about trying to forecast long-term interest rates. The decline in interest rates in the first half of 1998 was almost completely unforeseen by economic forecasters. In a survey taken on the last day of 1997, The Wall Street Journal asked 53 leading business forecasters to predict what the interest rate on the 30-year Treasury Bond would be six months later. Twelve of them nailed it by forecasting a number between 5.5 percent and 5.75 percent. The actual rate on June 30, 1998, turned out to be 5.64 percent. Forty experts, however, predicted a number that was too high, with the worst being 6.95 percent. Only one was too low, at 5.2 percent.

The failure to predict falling interest rates is even more disconcerting given that the rate on the 30-year bond has been on a downward trend since 1982. The feeling in late 1997 was that rates simply could not fall lower; interest rates were at recessionary levels and the economy was not in a recession.

Changes in interest rates certainly affect the living standards and spending patterns of American households. However, interest rates aren't incorporated into our Index of Well-Being because their effect on any given household is ambiguous. Rising interest rates are detrimental to households that will borrow money in the near future, but benefit households that receive interest on their savings.

Many analysts assert that high interest rates curtail consumer spending, especially for big-ticket items, but the empirical support is unconvincing. Research suggests that business spending on plants and equipment is somewhat sensitive to interest-rate fluctuations, while consumer spending is not.

In July 1998, the Index of Well-Being edged up to a level of 104.11 from a revised mark of 104.07 in June. The base period for the Index is April 1990, when it was set equal to 100. Its current reading implies that the typical American is 4.11 percent better off than in April 1990.

Leading the way was the leisure sector, driven by a 3.16 percent surge in recreation expenditures. The income and employment sector rose because real disposable income grew by 0.17 percent. The social and physical environment sector grew, thanks to a decline in crime.

Two sectors posted losses in July. The productivity and technology sector slipped 1.14 percent, and labor productivity and energy productivity both gave up ground. The consumer attitudes sector lost 2.7 percent as consumers became more pessimistic about both current economic conditions and future prospects.

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