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December 1982
Vol. 64, No. 10

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3 The New System of Contemporaneous
Reserve Requirements
8 The Fed and the Real Rate of Interest

The Review is published 10 times per year by the Research and Public Information Department o f
the Federal Reserve Bank o f St. Louis. Single-copy subscriptions are available to the public free o f
charge. Mail requests fo r subscriptions, back issues, or address changes to: Research and Public
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63166.
Articles herein may be reprinted provided the source is credited. Please provide the Bank’s
Research and Public Information Department with a copy o f reprinted material.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

The New System of Contemporaneous
Reserve Requirements
R. ALTON GILBERT and MICHAEL E. TREBING
r HE Board of Governors of the Federal Reserve
System recently announced its decision to implement
a version of contemporaneous reserve requirements
(CRR) that will become effective in February 1984.
This article describes both the regime of lagged re
serve requirements (LRR) currently in effect and the
new system of CRR, and explains why each feature of
the new reserve accounting system was adopted.

LAGGED RESERVE REQUIREMENTS
Under the current system of reserve accounting,
reserve maintenance periods— periods during which a
depository institution’s average daily reserves must
equal or exceed its required reserves—cover seven
days ending each W ednesday. An institution’s re
quired reserves for the current reserve maintenance
week are based on its average daily deposit liabilities in
the computation period two weeks earlier, as illus
trated in exhibit 1. Assets counted as reserves in the
current maintenance week include the average daily
vault cash held in the computation period two weeks
earlier, plus average reserve balances held in the cur
rent maintenance period. A depository institution
must keep its average reserves within 2 percent of its
required reserves to avoid incurring a penalty for a
deficiency or losing credit for holding excess reserves.1
1A reserve deficiency up to 2 percent of required reserves in one
maintenance week may be made up the next week without incur
ring a penalty. Excess reserves up to 2 percent of required reserves
may be counted as part of reserves in the following week.

THE NEW CONTEMPORANEOUS
RESERVE REQUIREMENTS
Length of Reserve Maintenance Periods
Reserve maintenance periods will be lengthened
from one week to two weeks; they will cover 14 days
ending every other Wednesday.

Required Reserves on Transaction Deposits
Under contemporaneous reserve accounting, there
will be considerable overlap between the reserve com
putation and maintenance periods for transaction de
posits. R equired reserves in the current 14-day
maintenance period will be held against the average
level of transaction deposit liabilities over 14 days end
ing two days before the end of the current maintenance
period (exhibit 1).

Required Reserves on Liabilities Other than
Transaction Deposits
Required reserves against liabilities other than
transaction deposits (nonpersonal time deposits and
Eurodollar liabilities) will be based on average liabili
ties over 14 days ending 30 days before the end of the
current maintenance period (exhibit 1).

Vault Cash
Vault cash counted as reserves will continue to be
lagged under CRR. Thus, a depository institution’s
3

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

Exhibit 1
Timing of Lagged and Contemporaneous Reserve Accounting Systems
Present Lagged Reserve Accounting System
week 1
week 2
week 3
TWThFSSuMTWThFSSuMTWThFSSuMTW

1-week compu
tation period for
all reservable
liabilities and
vault cash

1-week reserve
maintenance
period

Approved Contemporaneous Reserve Accounting System
week 1
week 2
week 3
week 4
week 5
week 6
T W T h F S S u M T W T h F S S u M T W T h F S S u M T W T h F S S u M T W T h F S S u M T W T h F S S u M T W

2-week computation period for all
reservable liabilities other than
transaction deposits

Reserve Accounting for Liabilities

2-week computation period for
transaction deposits

Accounting for Reserves
Average vault cash in this 2-week
period counts as reserves in the
maintenance period ending 30
days later_____________________

2-week reserve maintenance
period____________________

Note: A “ reserve maintenance period" is a period over which the daily average reserves of a depository institution must equal or exceed its
required reserves. Required reserves are based on daily average deposit liabilities in “ reserve computation periods.”

reserves in the current maintenance period will in
clude average vault cash held in the 14-day period
ending 30 days before the end of the current mainte
nance period, plus its average daily reserve balances
during the current maintenance period (exhibit 1).

Carryover Allowance
The carryover allowance specifies the amount of
excess reserves in one maintenance period that a de
pository institution may use to m eet its required re
serves in the next maintenance period, or the amount
of a reserve deficiency that may be held in the follow
ing maintenance period without incurring a penalty.
Each institution will have a minimum carryover al
lowance of $25,000. During the first six months of

CRR, each depository institution will be allowed to
carry over to the next maintenance period excess re
serves or deficiencies up to 3 percent of required re
serves, or $25,000, whichever is larger. In the follow
ing six months, the allowable percentage carryover will
be 2.5 percent. Thereafter, it will remain at 2 percent,
with the $25,000 minimum still in effect. This mini
mum carryover will exceed 2 percent of required re
serves for institutions with required reserves below
$1.25 million.
W ith two-week maintenance periods, a carryover
allowance of 2 percent is effectively twice as large as a 2
p ercent carryover under one-w eek m aintenance
periods. To illustrate this, suppose an institution has
information on its transaction deposits for each day of
the computation period except the last day. Transac-

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

tion deposits were $10 million until the last day, when
they rose to $12 million. For simplicity, assume that
the reserve requirem ent on transaction deposits is 10
percent. Since the institution does not know7about the
rise in transaction deposits on the last day, it holds
average reserves of $1 million during the maintenance
period (assuming no required reserves on liabilities
other than transaction deposits). If reserve computa
tion periods and maintenance periods covered only
seven days, average reserves of $1 million would be
2.78 percent below required reserves of $1.0286 mil
lion. W ith 14-day maintenance periods, in contrast,
the rise of transaction deposits to $12 million on the last
day of the computation period would make the average
reserves of $1 million only 1.41 percent below the
average required reserves of $1.0143 million.

WHY IS THE TIMING OF
CONTEMPORANEOUS RESERVE
ACCOUNTING SO COMPLICATED?

IMPLICATIONS FOR REPORTING
ARRANGEMENTS RETWEEN THE
FEDERAL RESERVE AND
DEPOSITORY INSTITUTIONS

It takes at least one day for banks to compile informa
tion on their deposit liabilities. The two days between
the end of the reserve computation period for transac
tion deposit liabilities and the end of the maintenance
period permits depository institutions to compile in
formation on their deposit liabilities and to make the
final adjustments to their reserve balances for each
maintenance period.
Since there is a two-day lag between the end of the
period over which depository institutions will measure
their deposit liabilities and the end of the period over
which they will hold reserves, the new system of re
serve accounting is not exactly a contemporaneous
one. If maintenance periods had remained one week
under the new regulations, required reserves would

Under the current system of LRR, there is a oneweek gap between the end of the period over which a
depository institution calculates its deposit liabilities
and the beginning of the seven-day period over which
it holds the required reserves. During that interm edi
ate week, each depository institution informs the
Federal Reserve of its deposit liabilities and vault cash;
the Federal Reserve, in turn, informs each depository
institution of its required reserve balances before the
beginning of each maintenance period.
Under the plan for CRR, the Federal Reserve will
notify a depository institution before the beginning of
each two-week maintenance period how much re
serves it is required to hold against liabilities other
than transaction deposits and the amount of vault cash
it may count as reserves. Each depository institution
then must monitor its transaction deposits during the
current computation period for those deposits and hold
the appropriate amount of reserve balances. After each
maintenance period, the Federal Reserve will deter
m ine w h eth er each in stitu tio n ’s reserves w ere
adequate.2
2The arrangements for determining compliance with reserve re
quirements are more complicated under the pass-through arrange
ment. Depository institutions that are not members of the Federal
Reserve System may choose to hold their required reserve bal
ances in their own reserve accounts at Federal Reserve Banks, or
designate other institutions to hold the required reserve balances
for them. Depository institutions that hold required reserve bal

The timing of reserve accounting under the new
system of CRR is designed to strengthen the rela
tionship between money growth and reserve growth
by creating a nearly contemporaneous link between
transaction deposit liabilities and the required re
serves against those deposits. This section explains
why each feature of the new reserve accounting system
was adopted, and the system’s role in binding shortrun money growth more closely to the growth of total
reserves of all depository institutions.3

Two-Week Maintenance Periods

ances for other institutions are called pass-through agents. Under
LRR, a pass-through agent receives a report from the Federal
Reserve before the beginning of each settlement week on the
required reserve balance of each institution for which it holds
reserves. Under CRR, a pass-through agent will have to monitor the
transaction deposits of the institutions for which it holds required
reserves during each settlement period, and the Federal Reserve
will determine after the fact whether the reserve balances held by
the passthrough agent were sufficient, given the liabilities of the
depository institutions for which it holds reserve balances.
'’This paper does not discuss the effects of adopting CRR on mone
tary control. W hether money growth is actually more stable after
CRR goes into effect will depend, in part, on the weight given to
short-run monetary control in the conduct of monetary policy. For
a theoretical analysis of the significance of reserve accounting for
monetary control, see Daniel L. Thornton, “Simple Analytics of
the Money Supply Process and Monetary Control,” this Review
(October 1982), pp. 22-39. The change in reserve accounting from
LRR to CRR also has implications for reserve management by
individual depository institutions, which are not discussed in this
paper. See R. Alton Gilbert, “Lagged Reserve Requirements:
Implications for Monetary Control and Bank Reserve Manage
m ent,” this Review (May 1980), pp. 7-20.
5

FEDERAL RESERVE BANK OF ST. LOUIS

have been predeterm ined by prior deposit creation for
two-sevenths of each maintenance period. By making
maintenance periods two weeks long, each period for
measuring transaction deposits overlaps six-sevenths
of the period for holding required reserves against
them. Consequently, required reserves are predeter
mined for only one-seventh of each maintenance
period.
Increasing reserve maintenance periods from one
week to two weeks creates the potential for large gaps
to develop between reserves and required reserves
unless depository institutions adjust their reserves to
anticipated levels of required reserves frequently
throughout the maintenance period. If depository in
stitutions wait until the end of each maintenance
period to adjust their reserve positions, the Federal
Reserve is faced with two choices: 1) to allow large
fluctuations in the federal funds rate near the end of
maintenance periods (to force transaction deposits to
the Fed’s target levels), or 2) to adjust the supply of
reserves to accommodate the levels of transaction de
posits created by depository institutions. If the Federal
Reserve chooses to keep total reserves on target,
however, depository institutions will discover that
they must keep their reserves close to the required
reserves throughout each maintenance period, if they
want to minimize their interest-rate risk.

Lagged Accounting fo r Vault Cash
Counting vault cash as reserves on a lagged basis
facilitates the control of total reserves. The Federal
Reserve does not know the amount of coin and curren
cy held by depository institutions until these institu
tions file reports on their deposit liabilities and reserve
assets. If the vault cash held in the current mainte
nance period counted as reserves in the current
period, the Federal Reserve’s errors in estimating cur
rent vault cash would lead to errors in the amount of
reserves the Fed supplied. W ith lagged accounting for
vault cash, the Federal Reserve will know, at the be
ginning of each maintenance period, the exact amount
of vault cash to count as reserves.4
4Lagged accounting for vault cash allows depository institutions to
increase (decrease) their reserves temporarily by depositing vault
cash in (withdrawing vault cash from) their reserve accounts. Con
trol of total reserves by the Federal Reserve could be adversely
affected if depository institutions adjust their reserve positions by
depositing and withdrawing vault cash. Coats finds little or no
evidence, however, that commercial banks have used changes in
their vault cash as a method of reserve adjustment. See Warren L.
Coats, Jr., “Regulation D and the Vault Cash Game,” Journal of
Finance (June 1973), pp. 601-07.

DECEMBER 1982

Lagged Accounting fo r Liabilities Other
than Transaction Deposits
The reserve requirements on non-transaction de
posit accounts would create potential problems for
short-run monetary control if required reserves were
based on the amount of those non-transaction liabilities
in the current period. To determ ine the amount of
reserves for the current period available to “support”
transaction deposits, the Federal Reserve would have
to estim ate the req u ired reserves on the non
transaction deposit liabilities. Errors in those esti
mates would create errors in supplying the desired
amount of reserves available to support transaction
deposits. W ith lagged accounting for non-transaction
deposit liabilities, however, the Federal Reserve will
know, at the beginning of each maintenance period,
the required reserves on these deposits.

W ider Carryover Allowance
The purpose for widening the carryover allowance
under CRR is to make reserve management easier for
depository institutions. They may have difficulty from
time to time calculating their transaction deposits
quickly enough to determ ine exactly their required
reserves by the end of the maintenance period. The
carryover allowance permits discrepancies between
their actual reserves and their required reserves in one
m aintenance period to be offset in the following
period, within the limits described above. The max
imum carryover allowance is initially set at 3 percent of
required reserves, since difficulties in calculating re
quired reserves on a contemporaneous basis are ex
pected to be greatest during the first few months after
CRR becomes effective.
Implications of the wider carryover allowance for the
relationship between short-run money growth and re
serve growth depend on whether depository institu
tions will have significant difficulty in estimating their
required reserves, and how they will manage their
reserve positions. Even if depository institutions can
calculate their required reserves on a contem po
raneous basis, they still might use the carryover allow
ance to avoid the costs involved in keeping their re
serves equal to their required reserves. If depository
institutions would use the carryover allowance to delay
adjusting their reserves to required reserves, widen
ing the carryover allowance will tend to weaken the
short-run relationship between transaction deposits
and reserves.

DECEMBER 1982

FEDERAL RESERVE BANK OF ST. LOUIS

In contrast, suppose that depository institutions will
have to estimate their required reserves under CRR,
because of incomplete information on their transaction
deposits near the end of the computation periods for
those deposits. In particular, suppose that by the end
of each reserve maintenance period, which is every
other Wednesday, each depository institution has in
formation on its transaction deposits through the prior
w eekend, b u t lacks inform ation on transaction
accounts for Monday, the last day of the computation
period for transaction deposits. Each institution esti
mates transaction deposits on that Monday as the level
over the prior weekend. To avoid penalities on reserve
deficiencies or the unprofitable holding of excess re
serves, each depository institution would keep its re
serves equal to its estimate of required reserves, and
use the carryover allowance to accommodate differ
ences between estimates of required reserves and final
values. An institution that has an increase in its transac
tion deposits on the Monday before the end of a
maintenance period will end up with deficient re
serves; it will not know about the rise in transaction
deposits on the last day of the computation period, but
will lend to other institutions any increase in reserves
that resulted from the unexpected deposit inflow. An
institution that had a reduction in transaction deposits
on the last day of the computation period will have
excess reserves, since actual required reserves will be
less than the estimated level, and any loss of reserves
due to the unexpected deposit outflow will be replaced
by borrowing reserves from other institutions.

Under these conditions, widening the carryover
allowance need not have adverse effects on the moneyreserve growth relationship. Deviations of reserves
from required reserves at individual institutions would
not necessarily weaken the short-run money-reserve
growth relationship, since those deviations would tend
to be offsetting. The implications of the wider carry
over allowance, therefore, will depend on whether it is
wide enough to accommodate the errors that deposi
tory institutions make in estimating their required re
serves on a contemporaneous basis, yet small enough
to induce them to keep their reserves close to their
estimates of required reserves.

CONCLUSIONS
The Federal Reserve has adopted a new system of
contemporaneous reserve accounting that will become
effective in February 1984. The new system of reserve
accounting is intended to strengthen the relationship
between transaction deposit balances and the total
reserves of depository institutions. The timing of re
serve accounting under the new system appears to be
complicated. Each feature, however, was adopted to
facilitate short-run monetary control, while making
allowance for the difficulties that depository institu
tions will have in measuring deposit liabilities and
holding required reserves on a contemporaneous
basis.

The Fed and the Real Rate of Interest
G. J. SANTONI and COURTENAY C. STONE
“T he ad m inistration m ay choose to hide its head,
ostrich-like, in th e w arm sands of econom ic dogm a, but
th e rest of us m ust face the facts. W e cannot tolerate
these sky-high interest rates— rates that until recently
w ould have been considered usurious. C ongress m ust
act to bring dow n these killer interest rates before they
bring dow n our econom y and the strength and security
of our nation.”1

URING its last session, which ended on Decem
ber 23, 1982, the 97th Congress considered several
bills that were intended to achieve a “balanced mone
tary policy.” Each bill proposed that the Federal Re
serve focus its policy actions on the level of real interest
rates as well as the quantity of money.
The Fed was to announce publicly its targets for real
interest rates, much as it does now with its monetary
growth targets. Senate Bill S.2807 specified “yearly
targets for positive real [our emphasis] short-term in
terest rates.” One House bill, H.R.6967, emphasized
long-term interest rates and required the President of
the United States to comment on every monetary poli
cy action. Another House bill, H. R. 7218, required
the Federal Reserve to “establish monthly ranges
of targets for short-term interest rates, consistent
with historical levels of real interest rates [our empha
sis]. . . . ” The initial Senate Concurrent Resolution
128, which was passed in modified form on December
23, 1982, asked “that the Board of Governors of the
Federal Reserve and the Open Market Committee
should take such actions as are necessary to achieve
and maintain a level of interest rates low enough to
‘Remarks of Senator Robert C. Byrd, Congressional RecordSenate, August 3, 1982, pp. S9699-700.
Digitized for 8
FRASER

generate significant economic growth and thereby re
duce the current intolerable level of unemployment. ”
Although the resolution does not specify the real rate
per se, it is this rate that is relevant for economic
growth.
The nominal and real interest rates shown in table 1
are typical of those that have provoked congressional
concern. They were part of the supplementary m ate
rials accompanying SenateBill S.2807. In this instance,
the real interest rates are derived by subtracting the
inflation rate from the various nominal (or market)
interest rates for the years shown.
Two aspects of these real rate measures have caused
widespread public concern. First, real rates were
negative during certain years in the 1970s. Since the
real interest rate presumably designates the interest
rate received after netting out the impact of inflation,
negative real rates indicate that individuals who loaned
their savings at the nominal rates shown in table 1
ended up poorer as a result; borrowers, on the other
hand, increased their wealth by borrowing at negative
real rates. Second, and perhaps more politically signifi
cant, real rates allegedly have been “sky high” over the
past few years. These high rates presumably have re
tarded economic growth and contributed to lower in
vestment and higher unemployment. Although the
bills that Congress considered differed in certain re
spects, they shared the same basic notions: that the
Federal Reserve can influence real rates of interest
significantly and that monetary policy should attem pt
to lower them.
There are several questions that immediately arise
when considering the implementation and usefulness
of real interest rate targeting for Federal Reserve poli
cy. Which of the host of nominal interest rates should

DECEMBER 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Nominal and Estimated Real Interest Rates: 1960-82__________________
Interest Rates (in percent)
Federal
Funds Rate
Nominal

90-day
T-Bill Rate

Aaa Corporate
Bond Rate

Prime Rate

New Home
Mortgage Yield

Real1

Nominal

Real1

Nominal

Real1

Nominal

Real1

Nominal

Real1

Inflation
Rate2

1960
1961
1962
1963
1964

3.2
2.0
2.7
3.2
3.5

1.6
1.1
0.9
1.7
2.0

2.9
2.4
2.8
3.2
3.6

1.3
1.5
1.0
1.7
2.1

4.8
4.5
4.5
4.5
4.5

3.2
3.6
2.7
3.0
3.0

4.4
4.4
4.3
4.3
4.4

2.8
3.5
2.5
2.8
2.9

___
—
—
5.9
5.8

—
—
—
4.4
4.3

1.6
0.9
1.8
1.5
1.5

1965
1966
1967
1968
1969

4.1
5.1
4.2
5.6
8.2

1.9
1.9
1.2
1.2
3.1

4.0
4.9
4.3
5.3
6.7

1.8
1.7
1.3
0.9
1.6

4.5
5.6
5.6
6.3
8.0

2.3
2.4
2.6
1.9
2.9

4.5
5.1
5.5
6.2
7.0

2.3
1.9
2.5
1.8
1.9

5.8
6.3
6.5
7.0
7.8

3.6
3.1
3.5
2.6
2.7

2.2
3.2
3.0
4.4
5.1

1970
1971
1972
1973
1974

7.2
4.7
4.4
8.7
10.5

1.8
- 0 .3
0.2
2.9
1.7

6.5
4.4
4.1
7.0
7.9

1.1
-0 .6
-0 .1
1.2
-0 .9

7.9
5.7
5.3
8.0
10.8

2.5
0.7
1.1
2.2
2.0

8.0
7.4
7.2
7.4
8.6

2.6
2.4
3.0
1.6
- 0 .2

8.5
7.7
7.6
8.0
8.9

3.1
2.7
3.4
2.2
0.1

5.4
5.0
4.2
5.8
8.8

1975
1976
1977
1978
1979

5.8
5.0
5.5
7.9
11.2

- 3 .5
- 0 .2
- 0 .3
0.5
2.6

5.8
5.0
5.3
7.2
10.0

-3 .5
-0 .2
-0 .5
- 0 .2
1.4

7.9
6.8
6.8
9.1
12.7

- 1 .4
1.6
1.0
1.7
4.1

8.8
8.4
8.0
8.7
9.6

-0 .5
3.2
2.2
1.3
1.0

9.0
9.0
9.0
9.6
10.8

-0 .3
3.8
3.2
2.2
2.2

9.3
5.2
5.8
7.4
8.6

1980
1981
19823

13.4
16.4
13.3

4.1
7.0
8.5

11.5
14.1
11.5

2.2
4.7
6.7

15.3
18.9
15.8

6.0
9.5
11.0

11.9
14.2
14.4

2.6
4.8
9.6

12.7
14.7
N.A.

3.4
5.3
N.A.

9.3
9.4
4.8

1The real Interest rate shown equals the nominal rate minus the annual percentage change in the implicit price deflator.
2Annual percentage change in the implicit price deflator.
3Through third quarter of 1982.

be chosen as the one on which to focus? Which of the
wide variety of price indexes should be used to obtain
the inflation measure necessary to derive the real rate?
W hat should policymakers do when different real rate
measures yield different signals (compare the behavior
of the real rate measures in table 1 for 1978 and 1979) ?
W hat should policymakers do when their real rate
targets conflict with their monetary aggregate growth
targets?
Although these questions are interesting, this article
does not address them. Instead, the purpose of this
article is to show that policy discussions based on real
rate estimates derived in the manner shown in table 1
are fundamentally misdirected. First, these estimates

are inaccurate. Second, the Fed’s impact on them,
whatever such measures actually represent, is differ
ent from that generally perceived.

THE LINK BETWEEN NOMINAL AND
REAL INTEREST RATES
Nominal interest rates quoted in financial markets
typically differ from real interest rates. Conceptually,
the nominal rate of interest, i, can be thought of as the
sum of two expected rates of change in value: the
expected real rate of interest, r (which indicates the
expected rate of change in the value of present goods
that are converted into future goods), and the expected
rate of inflation, Pe (which is the expected rate of
9

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

Table 2
Average Annual Growth Rates of M1 and Prices and
Average Levels of Selected Nominal Interest Rates
1954-66

1967-821

Difference2

M1 growth

2.47%

6.37%

3.90%

Inflation rate

2.19

6.49

4,30

Aaa corporate bond rate

4.06

8.76

4.70

20-year Treasury security yield

3.78

8.12

4.34

Commercial paper rate

3.45

8.13

4.68

90-day Treasury bill rate

2.86

7.20

4.34

'Through III/82.
^Significantly different from zero at the 5 percent level.

change in the value of goods in terms of money). This
relationship is shown in equation l .2

positively associated w ith m ovem ents in m oney
growth.3

(1)

The data in table 2 are consistent with the proposi
tion that prices, nominal interest rates and money
growth move in the same direction over longer time
periods. The average growth rate in M l increased by
about 4 percent between the two long periods shown.
Hand in hand with this increase in money growth went
higher inflation and higher average levels of nominal
interest rates of about the same m agnitude.4

i = r + Pe

MONEY GROWTH, INFLATION AND
NOMINAL INTEREST RATES
There is no question that monetary policy affects
nominal interest rates. As equation 1 indicates, the
expected rate of inflation is a major component of the
nominal interest rate. In part, this expectation de
pends upon the expected rate of growth in the money
supply. If people should suddenly expect that the
Federal Reserve will increase the monetary growth
rate permanently, the expected rate of inflation will
rise, causing nominal interest rates to rise as well. The
reverse holds if individuals should suddenly expect
that the Federal Reserve will reduce the monetary
growth rate. Thus, over long periods, we would expect
that changes in prices and interest rates would he
2Equation 1 shows the widely used approximation of the Fisher
equation. For an extended discussion, see Irving Fisher, Apprecia
tion and Interest (Augustus M. Kelly, 1965). There are two caveats
that should be called to the reader’s attention. First, if there are
taxes on interest income, the expected real rate in the Fisher
equation measures the gross real rate, not the after-tax net real
rate. Second, even barring taxes, equation 1 correctly describes
the relationship underlying the nominal interest rate only if the
expected rate of inflation is held with certainty, i.e., the price level
expected in the future is held with certainty. If this is not the case,
equation 1 is inaccurate and must be amended by introducing some
measure of the “spread” in price expectations. For further discus
sion, see Levis A. Kochin, “The Term Structure of Interest Rates
and Uncertain Inflation,” (University of Washington, April 1981;
processed). Again, we ignore this complexity; for the purpose of
our criticism, the expected inflation rate is assumed to be held with
certainty.
Digitized for10
FRASER

While monetary growth and the nominal rate of
interest are closely related in the long run through the
link between monetary growth and expected inflation,
it is the short-run link between monetary policy and
the real rate of interest that chiefly concerns Congress.
The question that naturally arises is, “Why is the real
rate of interest of interest?”
3For some recent studies on the relationship between money
growth and inflation, see Keith M. Carlson, “Money, Inflation and
Economic Growth: Some Updated Reduced Form Results and
Their Implications,” this Review (April 1980), pp. 13-19; Keith M.
Carlson, “The Lag From Money to Prices,” this Review (October
1980), pp. 3-10; John A. Tatom, “Energy Prices and Short-Run
Economic Performance,” this Review (January 1981), pp. 3-17;
Dallas S. Ratten, “Money Growth Stability and Inflation: An Inter
national Comparison,” this Review (October 1981), pp. 7-12;
Michael D. Rordo and Ehsan U. Choudhri, “The Link Between
Money and Prices in an Open Economy: The Canadian Evidence
from 1971-1980,” this Review (August/September 1982), pp. 1323; and Zalman F. Shiffer, “Money and Inflation in Israel: The
Transition of an Economy to High Inflation, ” this Review' (August/
September 1982), pp. 28-40.
‘For further discussion, see G. J. Santoni and Courtenay C, Stone,
“What Really Happened to Interest Rates?: A Longer-Run Analy
sis,” this Review (November 1981), pp. 3-14.

WHY DOES THE REAL RATE
MATTER?
Technically, there are several ways in which the real
rate of interest can be defined. Looked at one way, the
real rate of interest is the net rate of increase in wealth
that people expect to achieve when they save and
invest their current income. Alternatively, it can be
viewed as the expected reduction in wealth that indi
viduals face when they choose to consume goods now
instead of saving and investing; in this sense, it repre
sents the relative cost or price of current consumption
in terms of foregone future consumption.5 As a con
sequence, the real rate of interest influences the pro
portion of present resources devoted to producing
goods that will be consumed immediately instead of
durable goods (capital goods) that will provide con
sumption goods in the future. The real rate of interest
is a relative “price which links one point of time with
another point of time. 6

Only the Longer-Term Expected Real Rate
Is Relevant
If the purpose of policy is to influence the behavior
or actions of individuals, the real interest rate that is
relevant is the longer-term expected real rate of
interest.7 It is easy to see why only the “expected’ real
rate is important. The actions that people take today
are determ ined by their expectations about the
future.8 In and of themselves, the consequences of past
'’See, for example, Armen Aleliian and William R. Allen, Exchange
and Production: Competition, Coordination, and Control (Wads
worth Publishing Co. Inc., 1977), pp. 424-59; One of the first to
adopt this view of the interest rate was Galiani who wrote in 1750,
as cited in Eugen V. Bohm-Bawerk, Capital and Interest (Kelley
and Millman Inc., 1957), pp. 48-50; Irving Fisher, The Theory of
Interest (Kelley and Millman Inc., 1954), pp. 61, 339; Friedrich A.
Hayek, The Pure Theory o f Capital (The University of Chicago
Press, 1941), pp. 168-69; Frank Knight, “Capital, Time, and the
Interest Rate,” Economica (August 1934), pp. 257-86.
fiFisher, The Theory of Interest, p. 33. See, as well, George J.
Stigler, The Theory o f Price (The Macmillan Co., 1966), p. 276.
7In reality, it is the after-tax, longer-term expected real interest rate
that is relevant. We ignore the impact of taxes, because introducing
them into the analysis would simply add complexity without affect
ing the substance of our criticisms of real rate estimations. How
ever, the reader should be warned that, because taxes drive a
wedge between the gross real rate and the relevant net-of-tax real
rate, their impact must be taken into account if a useful measure of
the expected real rate is to be obtained.
s“. . . Every act of production is a speculation in the relative value of
money and the good produced.” Frank Knight, “Unemployment:
And Mr. Keynes’ Revolution in Economic Thought,” Canadian
Journal o f Economics and Political Science, vol. 3 (1937), p. 113.
For a complete treatment, see Fisher, Appreciation and Interest,
pp. 1-100.

decisions are irrelevant for current decisionmaking.
History cannot be relived, nor can the present con
sequences of past decisions be undone. While we can
learn much from past failures and successes, it is only
the information that they provide about potential
future outcomes that is relevant for current decision
making.
Because the distinction between “looking forward’’
and “looking backward” is so crucial in understanding
economic behavior, economists have coined terms to
differentiate between them. The relevant interest rate
for guiding economic decisions (and the one that this
discussion concerns) is the ex ante real rate— the one
that is expected before decisions are m ade.9 The in
terest rate that is irrelevant for current decisionmaking
is the ex post real rate— the one that is obtained by
looking back to see what actually occurred. By itself, it
is nothing more than a historical datum.
It is equally important to recognize that changes in
the longer-term expected real rates have a greater
influence on resource use than do shorter-run, ex ante
real rates. In the short run, for a variety of reasons,
profitable resource reallocation is more limited or con
strained than it is in the long run. Economists charac
terize this by referring to resource use being fixed in
the short run, but variable in the long run. Thus, policy
actions must influence the long-run, ex ante real rate if
they are intended to have a significant effect on peo
ple’s behavior.

Relative Price Impacts
For policymakers concerned with aggregate eco
nomic activity, the real rate is particularly important.
Since all goods are more or less durable, that is, they
yield streams of consumption services that last over
varying lengths of time, the real rate of interest in
fluences the relative price or rate of exchange between
each good in the economy and every other good. A
change in the real rate means that the whole spectrum
of prices has changed.10
9“The rate of interest is always based upon expectation, however
little this may be justified by realization. Man makes his guess of
the future and stakes his action upon it . . . Our present acts must
be controlled by the future, not as it actually is, but as it appears to
us through the veil of chance.” Irving Fisher, The Rate o f Interest
(The Macmillan Co., 1907), p. 213.
10Irving Fisher notes that, “Interest, if not explicitly, will implicitly
persist, despite all legal prohibitions. It lurks in all purchases and
sales and is an inextricable part of all contracts. ” The Theory of
Interest, p. 49. See, as well, pp. 58, 32.5-81. For further discus
sion, see Hayek, The Pure Theory o f Capital, p. 353; Knight.
“Unemployment? And Mr. Keynes’s Revolution in Economic
Thought, p. 113; Milton Friedman, Price Theory: A Provisional
Text (Aldine Publishing Co., 1962), pp. 245-66.
11

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

Employment Consequences

General Price Level Impacts

A change in the price of more durable goods relative
to less durable goods, which is part and parcel of a
change in the real rate, reflects underlying changes in
relative demands for all goods and services. These
demand shifts will produce significant changes in in
vestment and job opportunities across industries. As a
result, total em ploym ent may decline following a
change in the real rate of interest until labor and re
source use have adjusted fully to the new relative
demand pattern.

In certain circumstances, an unexpected increase in
the real rate of interest directly influences the general
price level as well.12 Money is a durable good that
yields a flow of services over time. Because an unantici
pated rise in the real rate reduces the values of durable
goods relative to those of nondurable goods, it also can
reduce the price of money. Since the price of money is
simply the inverse of the general price level, one possi
ble result of an unexpected rise in the real rate is a
one-time rise in the general level of prices— an in
crease that some people (but not economists) common
ly call a “burst” of inflation.13 Such unanticipated in
creases in the price level will produce unexpected and
seemingly capricious wealth reductions, as well as
wealth redistributions among people.
It is not surprising, given these consequences, that
changes in real rates of interest are a m atter of public
concern. These changes produce fluctuations in the
aggregate price level, unexpected changes in people’s
wealth and sizable impacts on employment and re
source use.

Wealth Impacts
In addition, real interest rate changes produce wideranging wealth changes. To see how this operates,
consider an example in which investment opportuni
ties expected to repay $1.05 in one year, or $1.10 in
two years, or $2.65 in 20 years are each “worth” $1.00
today; in each case, the rate of return or “the interest
rate” is 5 percent.11 If the interest rate suddenly and
unexpectedly should rise to 10 percent, the present
value of these particular future claims would all drop.
In fact, they would decline in value to about $.96, $.91
and $.39, respectively. These are the new amounts
that, if invested at 10 percent, would grow to the
specified future amounts over the respective time
periods.
In other words, increases in the real rate of interest,
other things being the same, will reduce the present
value of existing claims to future values, even though
these future values remain unchanged. This means
that unanticipated increases in the real rate of interest
will reduce the wealth of all individuals who own such
claims, with the more sizable reductions inflicted on
those who own the more durable assets (those yielding
the longer streams of expected future values). Owners
of bonds, stocks, houses, land, etc., lose wealth when
the real rate of interest unexpectedly rises.
The opposite occurs when the real rate of interest
unexpectedly declines. In this event, people who own
durable assets will find that their wealth has increased,
with larger percentage increases going to those whose
assets are more durable.
"The numerical examples use simple annual compounding—that
is, the future amount due in year t is “deflated” by 1/(1 + i)1 to
obtain its “present value.” Continuous compounding would pro
duce only marginal differences in the numbers shown.
Digitized for12
FRASER

THE REAL INTEREST RATE CANNOT
BE DIRECTLY OBSERVED; IT MUST
BE ESTIMATED
The real rate of interest, a key economic variable,
cannot be directly measured or observed.14 It is im
possible to get exact firsthand knowledge of it.
The problem is that our direct knowledge of interest
rates comes from the nominal rates that are deter
12The example considered here is one in which there is a general
shift in the public s time preferences toward present at the ex
pense of future consumption. Other possible shifts, for example,
an increase in the demand for money at the expense of other assets
or an increase in the investment demand (due to new innovations),
could have different impacts on both the real rate and the general
price level than those described in the text.
13The terms “inflation” and “inflation rate” are subject to consider
able variation in meaning. People generally take the rate of infla
tion to mean the rise in some price index between the dates that it
is measured. On the other hand, economists often, but not always,
refer to inflation as the longer-term trend movement in prices;
thus, they distinguish between “the rate of change in the price
index” from one period to the next and “the rate of inflation.” Fora
recent discussion, see Lawrence S. Davidson, “Inflation Misin
formation and Monetary Policy,” this Review (June/July 1982), pp.
15-26. Although it grates on our economic sensibilities, we use
the “rate of inflation” in its popular (non-economie) sense in the
following discussion.
14From this point on, the term “ex ante" is deleted to simplify
discussion. However, since we intend to analyze interest rates
that affect behavior, references to “the rate of interest” refer to the
ex ante interest rate unless otherwise noted.

FEDERAL RESERVE BANK OF ST. LOUIS

mined in credit markets. As we discussed earlier, these
typically are considered to represent the sum of the
expected real rate and the expected rate of inflation
that credit market participants anticipate for the period
of a specific loan. Neither the expected real interest
rate nor the expected inflation rate is directly observ
able— only their sum is a matter of record. When
nominal interest rates fluctuate, it is not directly possi
ble to determine whether movements in the ex ante
real rate of interest, the expected inflation rate or some
combination of both, is responsible. This problem
forces researchers and policymakers to confront the
issue of measuring the unseen.

Pitfalls in Estimating the Real Rate
There have been numerous attempts to derive esti
mates of the expected real rate of interest using the
conceptual framework shown in equation 1. The
general method of obtaining these estimates involves
the following steps: (1) Estimate the unobservable ex
pected inflation rate; (2) Subtract this measure from
the observed nominal interest rate; and (3) Label the
remainder “the real rate of interest. ”15
There is nothing inherently amiss with this pro
cedure; it suggests simply that, in the opinion of the
researchers, it is easier and more accurate to first esti
mate the expected rate of inflation directly, thus deriv
ing estimates of the real rate of interest indirectly. The
fruitfulness of this approach can be evaluated only by
observing whether the derived estimates of the real
rate of interest seem to make sense.
Typically, this procedure uses some weighted aver
age of current and past inflation rates to estimate the
current expected inflation rate for future periods.
Thus, the procedure involves using an ex post real
interest rate measure to estimate the desired ex ante
real rate. This will yield accurate results only if the
following conditions hold:
15Some examples include Albert E. Burger, “An Explanation of
Movements in Short-Term Interest Rates,” this Review (July
1976), pp. 10-22; John A. Carlson, “Short-Term Interest Rates as
Predictors of Inflation: Comment,” The American Economic Re
view (June 1977), pp. 469-75; Jan Walter Elliott, “Measuring the
Expected Real Rate of Interest: An Exploration of Macroeconomic
Alternatives,” The American Economic Review (June 1977), pp.
429-44; Eugene F. Faina, “Short-Term Interest Rates as Predic
tors of Inflation,” American Economic Review (June 1975), pp.
269-82; Martin Feldstein and Otto Eckstein, “The Fundamental
Determinants of the Interest Rate,” The Review o f Economics and
Statistics (November 1970), pp. 363-75; William P. Yohe and
Denis S. Karnoskv, “Interest Rates and Price Level Changes,
1952-1969,” this Review (December 1969), pp. 18-38.

DECEMBER 1982

Exhibit 1
Estimating the Real Rate When Only
the Expected Happens
Year
1

10%

During this year

During previous year

Nominal interest rate at
beginning of year minus
this year’s inflation rate

Nominal interest rate at
beginning of year minus
last year's inflation rate

Beginning of Year:
Expected inflation rate
for year
Expected real rate
for year
Nominal interest rate
for one-year loans
Measured Inflation Rate:

Estimates of Real Rates:

(a) The expected real rate of interest is constant,
(b) Economic policies, in particular monetary policy,
are unchanged,
(c) There have been no significant “shocks” or structu
ral changes affecting price levels, that is, no OPEC
price changes, no major crop failures or bountiful
harvests, etc.

If any of these conditions is violated, the procedure
can seriously distort the estimate of expected inflation
rate. As a result, estimates of the real rate of interest,
derived by subtracting the expected inflation estimates
from nominal interest rates, will be distorted as well.16
Exhibit 1 depicts a four-year period during which
the three conditions listed above are all met. Since
there are no ex ante real rate changes or other unex
pected “shocks” to price levels, the actual rate of infla
tion is always equal to the expected rate of inflation.
Consequently, estimating the real rate by subtracting
16The reader is warned to reread the admonitions that appear in
footnotes 2 and 7. If future price expectations are not held with
certainty and if interest income is taxed, the use of the Fisher
equation to derive the real rate will not yield the relevant real rate
of interest.
13

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

Exhibit 2
Unreal Estimates of the Real Rate: When the Unexpected Happens
I. Inflation in year 2 is higher than expected due to
unexpected rise in the ex ante real rate during year 2
1

Beginning of Year:
Expected inflation rate
for year
Expected real rate
for year
Nominal interest rate
for one-year loans

II. Inflation in year 2 is higher than expected due to policy
or supply “shocks” which do not affect the ex ante real rate
1

10%

Beginning of Year:
10%
3

10%
3

10%
4

Expected inflation rate
for year
Expected real rate
for year
Nominal interest rate
for one-year loans

During this year

During previous year

Measured Inflation Rate:

Estimates of Real Rates:

Nominal interest rate at
beginning of year minus
this year’s inflation rate

Nominal interest rate at
beginning of year minus
this year's inflation rate

-2

Nominal interest rate at
beginning of year minus
last year’s inflation rate

-2

Nominal interest rate at
beginning of year minus
last year’s inflation rate

-2

-1

either the current or the previous year’s inflation rate
from the nominal interest rate at the beginning of each
year yields identical estimates. Moreover, these esti
mates are, in fact, equal to the actual (though un
observed) ex ante rate of 3 percent.
Consider, however, what happens when the unex
pected occurs; two variations of this are shown in ex
hibit 2. The first example shows the impact on real rate
estimation over a four-year period when the ex ante
real rate unexpectedly rises from 3 percent to 4 percent
at some point during the second year. As explained
earlier, a rise in the real rate will produce a corre
sponding rise in current prices; as a result, the rate of
inflation during year 2 is greater than was expected at
the beginning of the year. Since the price level adjust
m ent to the higher real rate is assumed to have been
completed during year 2 (to simplify the analysis), the
unusual rise in inflation is not expected to persist. As a
result, at the beginning of year 3, the expected infla
tion rate remains equal to 10 percent; the nominal
interest rate rises to 14 percent to reflect the rise in the
real rate.
Notice the difference between the actual ex ante real
rate change (from 3 percent at the start of year 2 to 4
Digitized for 14
FRASER

percent at the start of year 3) and the behavior of the
real rate estimates. The first measure suggests that the
real rate declined in year 2; the second measure de
picts a real rate drop in year 3. Moreover, both mea
sures yield negative real rate estimates, an absurd
result for purported estimates of the expected real
interest rate.17 It is evident that estimates of the real
rate obtained using past or current inflation rates are
unreliable when the real rate is changing. Not only is
the direction of movement likely to be misjudged, but
the estimates themselves may turn out to be silly.
Even if the real rate is not changing, typical estima
tion procedures will yield spurious movements in the
purported real rate whenever policy shocks or general
economic shocks occur. These shocks will produce
episodes during which the actual inflation rate is differ
ent from the rate that was expected before the shock.
For example, consider case II in exhibit 2, in which the
1'A number of studies have obtained negative estimates of the real
interest rate. Since we live in a world of productive but scarce
resources, this is nonsensical, especially for the longer-term real
rates. See W. W. Brown and G. J. Santoni, “Unreal Estimates of
the Real Rate of Interest, ” this R eview (January 1981), pp. 18-26,
for an explanation that such results can arise from measurement
errors inherent in current price indexes.

FEDERAL RESERVE BANK OF ST. LOUIS

real rate is constant but some other event (e.g., an
unexpected policy change or an OPEC price increase)
produces higher inflation in the second year than is
anticipated. Once again, as a comparison between the
actual and the different estimates of the real rate indi
cates, the estimation procedure yields results that are
wrong during periods when various shocks are affect
ing prices in unexpected ways.18
In summary, when nothing unexpected happens,
the procedure can be used; when the unexpected
occurs, as it usually does, the procedure yields strange
results over short-run periods.

CAN THE FED CONTROL THE REAL
RATE?
As the above analysis indicates, the interpretation of
real interest rate estimates is extremely troublesome.
This problem has not prevented real rate estimates,
however questionable, from affecting policy discus
sions and debates. Consider, again, the real rate esti
mates in table 1 that were associated with Senate Bill
S.2807. The negative values alone indicate that they
suffer from the estimation problems cited previously.
Nonetheless, these estimates have captured the atten
tion of the public and policymakers alike.
Therefore, whatever qualms we may have about
using these estimates of the real rate, it is clearly of
interest to assess the relationship between Federal
Reserve actions and changes in these estim ates.19
First, however, briefly consider the theoretical argu
ments regarding the relationship between monetary
policy and the “true” real rate of interest.

Theoretical Considerations
There are two contrasting theoretical arguments
concerning the influence of monetary policy on the real
rate. Neither of these, however, is consistent with the
intent of the bills that Congress was considering.
18Of course, additional examples of unreal estimates of the real rate
can be obtained by using some weighted average of past inflation
rates instead of a single year’s rate, by lengthening the adjustment
time during which prices respond to unanticipated events and by
considering the impact of changes in policy that affect the ex
pected rate of inflation. These examples would merely provide
further evidence of the problem with using this approach to esti
mating real rates.
19As a practical matter, if the Federal Reserve is required to target
on the real interest rate, it will, no doubt, link the monetary
growth rate to estimates of the real rate generated by employing a
technique similar to the estimation attempts cited above.

DECEMBER 1982

One major argument, term ed the “neutrality of
money doctrine,” states that real economic variables—
such as output, employment, economic growth and the
real rate of interest—are not influenced permanently
by money growth and, therefore, are essentially un
affected by monetary policy. Instead, money growth
affects only nominal variables— the price level, the
rate of inflation, and nominal interest rates (via the
expected rate of inflation). Given this argument, the
Federal Reserve has no perm anent influence over the
real rate of interest whatsoever.
A different theoretical argument, usually called the
Mundell effect, states that permanently faster money
growth will reduce the real rate of interest, at least
temporarily.20 This occurs because the permanently
higher rate of inflation accompanying accelerated
money growth initially reduces people’s wealth. As a
result of this loss, they decide to save more in an
attem pt to mitigate the wealth-reducing consequences
of higher inflation. The increased supply of savings
then results in a reduction in the real interest rate.
It is clear that neither of these theoretical arguments
support the notion that the Federal Reserve can re
duce the real rate of interest in a manner compatible
with the purpose of the congressional bills. If the
neutrality argument is valid, the Federal Reserve has
no ability to control the real rate of interest at all.
Attempts on the part of the Fed to do so would be, at
best, unsuccessful; at worst, such attempts may be
counterproductive to its anti-inflation efforts.
If the “Mundell effect” is valid, the Fed can reduce
the real rate only by permanently increasing the rate of
inflation and lowering the general level of wealth. Not
only is this presumably not the intent of Congress, it
directly conflicts with those parts of the bills that would
make a lower real rate target subordinate to the goal of
reducing inflation.

Empirical Considerations
There are several ways to assess the relationship
between Federal Reserve actions and estimates of the
real rate. Table 3 presents evidence on the correlation
between M l growth and the various estimates of the
real rates that appear in table 1.
Two different correlation comparisons are shown in
table 3. The second column shows the correlation coef20Robert A. Mundell, “Inflation and Real Interest,” Journal of
Political Economy (June 1963), pp. 280-83.
15

DECEMBER 1982

FEDERAL RESERVE BANK OF ST. LOUIS

Table 3
Correlation Coefficients for Estimates of the Real Interest
Rate and M1 Growth: Annual Data_________________________
Correlation Between

Estimated Real
Interest Rate

Real Rate Estimates
and M1 Growth1

Changes in Real Rate
Estimates and Changes
in M1 Growth2

.100

.008

Federal funds rate
90-day Treasury bill rate

-.1 1 0

.075

Aaa corporate bond rate

-.1 8 3

.023

.000

-.1 4 5

-.1 0 5

.001

Prime rate
Mortgage rate

11960 to 1981, except for mortgage rate (1963-1981)
21961 to 1981, except for mortgage rate (1964-1981)

Table 4
Influence of Monthly M1 Growth on an Aaa Bond Real Interest
Rate Measure: February 1951 to November 1982
11
r = constant + S a, M1t-j
i= 0
October 1979 to
November 1982

February 1951 to
September 1979

a 5

a7
a8
a9
a io
a i1
£

Coefficient

Itl

1.48851
- .00088
.00171
.00170
.00233
- .00249
-.0 0 1 6 0
.00292
.00253
.00000
.00074
.00016
.00025

2.068
.388
.510
.423
.542
.553
.348
.631
.556
.001
.181
.045
.107

1.0360
.00840
.039601
.03112
.02719
.00901
.01940
.02411
.01446
- .00036
- .00499
-.0 1 1 2 6
-.0 0 1 7 8

.801
1.014
3.419
2.003
1.502
.423
.863
1.056
.666
.019
.301
.888
.211

.00737

.221

.926

.8662
2.04

D-W

2.07

RH01

1.271

24.536

RH02

- .281

5.410

1.401

9.838
3.373

NOB

344

SER

.1548

.3899

'Significantly different from zero at the .05 level.

Digitized for 16
FRASER

.1549

.9826

a 3

Itl

Coefficient

FEDERAL RESERVE BANK OF ST. LOUIS

ficients between the levels of the estimated real rates
and the growth of M 1; they range from —. 183 to . 100.
The third column displays the correlation coefficients
betw een changes in the estim ated real rates and
changes in the growth of M l; they range from —. 145
to .075.
Nothing in table 3 demonstrates that the Federal
Reserve can influence these estimates of the real rate
by varying the growth of money on a year-to-year basis.
Not only are the estimated correlation coefficients
small, they are statistically indistinguishable from
zero. There is no discernibly significant relationship
between either the level of real rates and the growth of
M l or changes in real rates and changes in the growth
of M l. If these real rate estimates actually were indica
tive of the “true” ex ante real rate, the results in table 3
could be interpreted as supporting the “neutrality of
money” hypothesis.
A different test of the Federal Reserve’s influence on
real interest rate estimates (if not on the real rate itself)
can be obtained by looking at the relationship between
M l growth and monthly estimates of the real interest
rate. By doing so, we can assess the Federal Reserve’s
short-run ability to influence estimates of the real in
terest rate.21
Table 4 presents the results of assessing the impact
of the current and past 11 months’ M l growth on one
measure of real interest rates. The specific monthly
real interest series used is one that this Bank utilized in
the early 1970s until it became apparent that the esti
mates were questionable in the sense discussed ear
lier.22 It is derived by subtracting the average annual
rate of change in the seasonally adjusted consumer
price index over the prior 36 months from Moody’s
Index of Aaa bond yields. As constructed, it represents
an estimate of long-term expected real interest rates.
21Because there is some question about the Fed’s ability to control
M l growth on a month-to-month basis, the regression rela
tionship in table 4 was estimated using the monetary base
growth in place of M1 growth. The results were virtually identical.
For recent articles discussing the relationship between the
monetary base and the money stock, see Anatol B. Balbach, “How
Controllable Is Money Growth?” this Review (April 1981), pp.
3-12 and K. W. Hafer, “Much Ado About M2,” this Review
(October 1981), pp. 13-18.
"This Bank discontinued the use of these estimates in 1975 because
the “series suggests that real (interest) rates have fallen substan
tially in recent months. There is no supporting evidence that this
has happened.” Internal memo, Denis S. Karnosky, Research
Department, Federal Reserve Bank of St. Louis, 1975.

DECEMBER 1982

The relationship in table 4 was estimated over two
different time periods.23 The first regression estima
tion assesses the impact of money growth on the
monthly real rate series from February 1951 through
September 1979. The second estimation assesses the
relationship between money growth and the monthly
real rate estimate since October 1979, the month in
which the Fed announced that it would focus more
attention on money growth in implementing monetary
policy. The two periods were analyzed separately to
determine whether the Federal Reserve’s action on
October 6, 1979, has resulted in any significant change
in the relationship between money growth and these
estimates of the real interest rate.
The results shown for the February 1951 to Septem
ber 1979 period indicate that current and lagged
money growth have no discernible effect on the real
interest rate measure. While the R2, which measures
the proportion of the variation in the real rate “ex
plained ’ by the regression equation (adjusted for the
number of regressors used), is close to one, the “ex
planatory power” of the equation is derived from the
rho coefficients that adjust for the existence of first- and
second-order autocorrelation and from the constant
term. None of the individual coefficients on M 1 growth
(which range from —. 00249 to . 00292) differs statisti
cally from zero. Moreover, the sum of the coefficients
on M l growth, which is an estimate of the net impact of
money growth over a 12-month period, is not statisti
cally different from zero. Thus, during this period, the
real rate was not affected discernibly by short-run
money growth.
The second set of estimates, for the period since
October 1979, yields results that are virtually identical
to those from the earlier period. The “explanatory
power” of the estimated equation is derived chiefly
from the autocorrelation coefficients alone: the con
stant term is not statistically different from zero. Once
again, money growth has essentially no effect on the
real rate of interest. Although a!, the coefficient that
measures the impact of last month’s money growth on
this month’s real interest rate is statistically signifi
cant—and positive at that— the sum of the money
growth coefficients is not significantly different from
zero. There is no net impact of short-run money
growth on the real rate.
2iThe procedure used was generalized-least-squares regression.
The equation was estimated correcting for first-order and secondorder autocorrelation using a maximum-likelihood grid search
procedure.
17

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

The overall impression that emerges from the re
sults shown in table 4 is that the Federal Reserve is
unlikely to be able to influence month-to-month move
ments in estimates of the real interest rate by varying
money growth over short-run periods.24 Money

growth had no significant impact on these estimates
prior to October 1979 and has had virtually none since
then.

24The results reported here are similar to those derived recently
from two alternative approaches to assessing the impact of mone
tary policy on quarterly real interest rates. R. W. Hafer and Scott
E. Hein, in “Monetary Policy and Short-Term Real Rates of
Interest,” this Review (March 1982), pp. 13—19, looked at the
relationship between quarterly estimates of the ex post real threemonth Treasury bill rate and current and lagged levels of the
“real” money stock (measured by the “real” monetary base). They
found that an increase in the real money stock reduced their real
rate measure in the same quarter but raised it in the next quarter
by virtually the same amount with no subsequent impact. Thus,
they conclude “there is no evidence of a long-run effect running
from changes in real money balances to changes in real interest
rates.”
Keith M. Carlson, in “The Mix of Monetary and Fiscal Policies:
Conventional Wisdom Vs. Empirical Reality, this Review (Octo
ber 1982), pp. 7-21, finds that in general “monetary and fiscal
actions do little to explain the movement of the real rate as
measured bv the Aaa bond rate minus inflation.” W hen he as
sessed the impact of current and lagged growth in M l (up to
20-quarter lags) on quarterly estimates of the Aaa real rate, he
found that the monetary growth coefficients were positive and
significant for the period from II/1959 to IV/1981; however, the R"
was small (from .04 to .06). As Carlson notes, the positive rela
tionship “should probably not be taken too seriously, however,
because of the problems inherent in measuring the real rate.

CONCLUSION

The expected real rate of interest is an important
economic variable that, although directly unobserv
able, has a pervasive influence on the allocation of
resources and on the distribution of wealth. W hether
the Federal Reserve can control or influence the actual
real rate is an unsettled issue. W hat is clear, however,
is that discussions about the real rate and the Fed’s
influence on it have been misdirected. Because the
most commonly used estimates of the real rate are
subject to substantial errors, it would be a serious
mistake to base policy actions on them.
In addition, the Federal Reserve cannot affect esti
mates of the real interest rate, whatever their validity.
Thus, the passage of any bill requiring the Fed to set
policy on the basis of real rate estimates would inevi
tably send it in pursuit of some monetary will-o’-thewisp.

FEDERAL RESERVE BANK OF ST. LOUIS

DECEMBER 1982

FEDERAL RESERVE BANK OF ST. LOUIS
REVIEW INDEX 1982
JANUARY

JUNE/JULY

John A. Tatom, “ Potential Output and the Recent Pro
ductivity Decline”

Daniel L. Thornton, “The Discount Rate and Market
Interest Rates: What’s the Connection?”

R. W. Hafer, “The Role of Fiscal Policy in the St. Louis
Equation”

Lawrence S. Davidson, “ Inflation Misinformation and
Monetary Policy”

Clifton B. Luttrell, “ Food and Agriculture — Current
Situation and Prospects for 1982”

Scott E. Hein, “ Short-Run Money Growth Volatility: Evi
dence of Misbehaving Money Demand?”
AUGUST/SEPTEMBER

FEBRUARY
Norman N. Bowsher, “The Three-Year Experience with
the Community Reinvestment Act”
R. W. Hafer and Scott E. Hein, “The Shift in Money
Demand: What Really Happened?”

MARCH
Lawrence S. Davidson and Richard T. Froyen, “ Mone
tary Policy and Stock Returns: Are Stock Markets
Efficient?”
R. \N. Hafer and Scott E. Hein, “ Monetary Policy and
Short-Term Real Rates of Interest”
Dallas S. Batten, “Central Banks’ Demand for Foreign
Reserves Under Fixed and Floating Exchange Rates”

APRIL
Daniel L. Thornton, “The FOMC in 1981: Monetary Con
trol in a Changing Financial Environment”
John A. Tatom, “ Recent Financial Innovations: Have
They Distorted the Meaning of M1?”

MAY
Keith M. Carlson, “A Monetary Analysis of the Adminis
tration’s Budget and Economic Projections”
Dallas S. Batten and R. \N. Hafer, “ Short-Run Monetary
Growth Fluctuations and Real Economic Activity: Some
Implications for Monetary Targeting”
Mack Ott, “ Money, Credit and Velocity”

Dallas S. Batten and James E. Kamphoefner, “The
Strong U.S. Dollar: A Dilemma for Foreign Monetary
Authorities”
Michael D. Bordo and Ehsan U. Choudhri, “The Link
Between Money and Prices in an Open Economy: The
Canadian Evidence from 1971 to 1980”
Dallas S. Batten and Clifton B. Luttrell, “ Does ‘Tight’
Monetary Policy Hurt U.S. Exports?”
Zalman F. Shiffer, “ Money and Inflation in Israel: The
Transition of an Economy to High Inflation”
OCTOBER
Lawrence K. Roos, “ Is It Time To Give Up the Fight
Against Inflation?”
Keith M. Carlson, “The Mix of Monetary and Fiscal
Policies: Conventional Wisdom Vs. Empirical Reality”
Daniel L. Thornton, “Simple Analytics of the Money
Supply Process and Monetary Control”
NOVEMBER
R. Alton Gilbert, “The Puzzling Behavior of Business
Loans in the Current Recession”
Clifton B. Luttrell, “ Good Intentions, Cheap Food and
Counterpart Funds”
Mack Ott and John A. Tatom, “A Perspective on the
Economics of Natural Gas Decontrol”
DECEMBER
R. Alton Gilbert and Michael E. Trebing, “The New
System of Contemporaneous Reserve Requirements”
G. J. Santoni and Courtenay C. Stone, “The Fed and
the Real Rate of Interest”
19