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________ Review_________
Vol. 68, No. 3




M a rch 1986

5 The R esp onse o f Stock Prices to
Changes in Weekly M oney and the
D iscount Hate
15 The E ffects o f Inflation on C o m m ercial
Banks

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F e d e ra l R e se rv e Bank o f St. L ou is
Review
M arch 1986

In This Issue . . .




The efficient m arkets hypothesis suggests th at financial asset p rices reflect the
inform ation available to m arket particip an ts. Consequently, an ticip ated ch an ges
in any factors that influence asset prices, like the m oney stock, should already be
a cco u n te d for in the quoted interest rates and stock p rices. Only u n an ticip ated
ch an ges should lead to ch an ges in interest rates an d stock p rices.
In the first p ap er in this Review, “The R esponse of Stock Prices to C hanges in
Weekly M oney and the D iscount Rate,” R. W. Hafer investigates several a sp ects of
the efficient m arkets h ypothesis: Do stock p rices react only to u n an ticip ated
ch an ges in the m on ey stock? Are the m agnitudes of th ese effects different across
different m on etary policy p ro ced u res? Do different m easu res of stock p rices react
differently to a given u n e x p e cte d ch an ge in M l? Are the different stock p rice
m easures equally responsive to a given ch an ge in the d iscou n t rate? Finally, do
reaction s to d iscou n t rate ch an ges vaiy a cro ss m on etary policy p ro ced u res?
Hafer’s results, b ased on daily d ata from 1977 through 1979, generally do not
reject the efficient m arkets hypothesis. He does find, how ever, that the respon se
to an u n exp ected in crease in M l is different from an u n e x p e cte d d ecrease in M l
for the b ro ad er stock price m easures. Hafer’s evidence also ind icates th at the
resp o n se to discou n t rate ch an ges varies a cro ss stock p rice m easu res and
m on etary policy p roced u res.
*

*

*

While m ost analysts agree that the recen t sh arp red u ction in the rate of
inflation has affected financial institutions, they disagree about the direction of
the effect. Som e people point to the increase in bank failures as evidence that the
sudden drop in inflation h as put a great deal of strain on the w hole credit
stru ctu re. O thers think that banks have gained from re d u ce d inflation an d falling
interest rates. In the se co n d article in this Review, “The Effects of Inflation on
C om m ercial Banks,’’ G. J. Santoni exam ines this issue by analyzing th e relation­
ship betw een inflation an d th e stock p rices of publicly trad ed banks. The a u th o r’s
results indicate that the real sh are prices of banks fall w hen the actu al rate of
inflation is g reater than the an ticip ated rate of inflation. Fu rth erm ore, upw ard
revisions in the anticip ated rate of inflation are associated w ith declines in the
real share p rices of com m ercial banks. Santoni’s evidence suggests that the recent
decline in the rate of inflation has had a favorable im p act on banks and that any
u n exp ected resurgen ce of inflation w ould be harmful to bank stock.

3




The Response of Stock P rices to
Changes in Weekly Money and the
Discount Rate
II. W. Hafer

r

J ONSIPF.RABI.F, research hits been devoted lo an ­
alyzing the effects of weekly ch an ges in the m oney
stock (Ml) on interest rates and exch an ge rates.1 In
general, the results of this research are con sisten t
with the efficient m arkets hypothesis, w hich holds
that only u n exp ected ch an ges in the m oney stock
should significantly affect interest rates and exch an ge
rates.- Few of these studies, however, have investigated
the reaction of stock prices to the weekly m oney
a n n o u n cem en t:1The pu rpose of this article is to p ro­
vide som e evidence on this effect.

R. I/V. Hafer is a research officer at the Federal Reserve Bank of St.
Louis. The author would like to thank Stu Allen, Gikas Hardouvelis,
Scott Hein, Jan Loeys, Doug Pearce, Jim Schmidt and Jim VanderHoff
for their suggestions and comments on earlier drafts of this paper.
Thomas A. Pollmann provided research assistance.
’The surveys by Cornell (1983) and Sheehan (1985) contain numer­
ous references to the literature on this subject.
Alternative evidence is presented in Hein (1985), and Falk and
Orazem (1985).
3Pearce and Roley (1983, 1985) find that stock prices react only to
unanticipated changes in money and, for the most part, show no
statistical relationship to either unanticipated or expected move­
ments of other economic news. Hardouvelis (1985) reports that
stock prices react to unanticipated movements in four monetary
measures (M1, net free reserves, the discount rate and the discount
rate surcharge), as well as three non-monetary measures (trade
deficit, unemployment rate and personal income). Although few
studies have examined the weekly money/stock-price relationship,
numerous studies have studied the longer-term reaction of stock
prices to movements in money. Among others, see Sprinkel (1964),
Rozeff (1974), Sorensen (1982) and Davidson and Froyen (1982).
Various studies also have examined the behavior of stock
prices to announcements of different types of information. For
example, Schwert (1981) examines the reaction of stock prices to
the announcement of inflation data; Fama, et. al. (1969) study the
effects of stock splits; Lloyd-Davies and Canes (1978) investigate
the effects of stock analysts’ published recommendations; and
Niederhoffer (1971) analyses the reaction of stock prices to “world
events."




This p ap er extend s previous research on the re a c­
tion of stock prices to m o n etaiy "n e w s” in several
wavs. First, it covers a broader tim e period, from Sep­
tem ber 1977 through D ecem ber 1984, than most p re­
vious studies. This allows one to test w h eth er the
ch an ges in m o n etaiy policy operating p ro ced u res in
O ctober 1979 an d O ctober 1982 influenced the re­
sp on se of stock prices to ch an ges in the m oney stock
and the discou n t rate.4
Second, unlike previous studies, this study uses
both broad and industiy-specific m easures of stock
prices to determ ine if general m arket effects also o c c u r
uniformilv across in specific ind u stiy groups.'’ As
n oted by King (1966):
“. . . it is intuitively appealing to think of incoming
information as falling into various classes according to
the scope of its effect on the market. There is some
news of a monetaiy nature, for example, which is
bound to have a market-wide impact on security price.
The magnitude of impact need not, however, he the
same for all stocks." (p. 140)
Although n u m erous studies have attem p ted to d e te r­
mine optim al groupings of individual stocks based on
their relative m ovem ents over time, little has been
done to investigate the relative respon se of different
stock groups to the sam e piece of eco n o m ic in­
formation.

4A discussion of the October 1982 change in policy procedures can
be found in Wallich (1984) and Gilbert (1985).
5Most previous research focuses solely on the broad market effects.
For example, Pearce and Roley (1983) use the Dow Jones Indus­
trial Average while Pearce and Roley (1985) use the Standard and
Poor’s 500 index. In an approach similar to that used in this study,
Hardouvelis examines the effect of new information on several
different stock price measures.

5

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

Finally, unlike m ost previous work, w hich p re­
sum ed that the reaction of stock prices wits sym m etric
with respect to unanticipated increases o r d ecreases
in m oney, this p ap er tests for the sep arate effect of
positive and negative u n exp ected ch an ges in M l. This
perm its one to test for market efficiency in a som ew hat
different m an n er than simply testing for the signifi­
ca n c e of e x p e cte d an d u n e x p e cte d ch an g e s in
money.''

the effect of increases in th e rate at w hich th o se flows
are discounted." A large literature ad d resses these
conditions, show ing th at they generally are not
fulfilled.10 Based on th ese studies, w hich ind icate that
stock p rices react negatively to inflation, the exp ected
inflation hypothesis suggests that stock p rices should
fall following the an n o u n cem en t of an u n exp ected
increase in the m oney stock.

THEORETICAL MODELS OF
STOCK PRICE RESPONSE TO
MONETARY NEWS

stock as a signal that alters market p ercep tion s of
future m o n etaiy policy. Presum ing that the ch an g e is
perceived as p erm an en t o r that the Federal Reserve is
slow to respon d to u n exp ected deviations in the
m oney stock aw av from its target level, interest rates
will rise as the public ex p e cts the Fed to offset the
u n exp ected in crease in the m oney stock. C on se­
quently, an u n e x p e cte d increase in the m oney stock
implies g reater future tightening of credit availability,
w hich results in higher interest rates. B ecau se the
higher interest rates red u ce the p resent value of d is­
co u n ted cash flows, stock p rices are hypothesized to
decline.

The efficient m arkets hypothesis suggests that,
w hen exp ected changes in the m oney stock o ccu r,
they have no significant effect on stock p rices b ecau se
they already have been in corporated into security
p rices. Only u n exp ected ch an ges in the m oney stock
affect stock prices accord in g to this h ypothesis.7

Weekly M oney Chanties
Several hyp otheses have been suggested to explain
w hy stock p rices react to u n exp ected ch an ges in the
m oney stock." The e x p e c t e d inflation h y p o th esis sug­
gests that an u n exp ected increase in the m oney stock
increases m arket participants' exp ectatio n s of in­
flation, leading to higher interest rates via the so-called
F isher effect. If the increase in interest rates low ers the
present value of corp oration s' d iscou n ted cash flows,
stock prices will fall w henever investors observe an
u n exp ected increase in the m oney stock. This hypoth­
esized respon se does not o ccu r, how ever, u n d er c e r ­
tain restrictive conditions. Given perfect m arkets and
no taxes, for exam ple, ch an ges in exp ected inflation
w ould have no effect on stock prices, b ecau se e x ­
p e cted in creases in nom inal cash flows w ould offset

6Comell, Pearce and Roley (1985) and Hardouvelis provide no
evidence on this issue as it relates to stock price effects. Pearce and
Roley (1983) present evidence on the response of stock prices
when money deviates from announced long-run target ranges. Their
tests are based on separating unanticipated money into positive
surprises above target, negative surprises below target and all
others. In general, their results indicate that the different surprise
measures are not statistically different in their effect. There is,
however, some evidence of a different effect of positive surprises
across the different policy regimes.
7As Sheehan (1985) notes, the unexpected change in the money
stock provides new information about money stock developments
that already have occurred. That is because the money stock is
announced with a lag. Thus, the announcement causes market
participants to revise their forecasts for future policy actions apart
from previously held expectations only if the announced money
stock change is different from its expected change.
This discussion is based on Cornell and Sheehan.




An alternative hypothesis, the p o licy an ticip ation s
h y p othesis, views an u n exp ected ch an ge in the m oney

Finally, the m o n ey d em a n d o r r e a l activity h y p o th e­
sis asserts that m oney an n o u n cem en ts provide infor­
m ation about future m oney d em an d . Suppose that
market participants interpret an u n exp ected increase
in the m oney stock as a signal that there h as been a
perm anent increase in m on ey d em an d . If m oney d e ­
m and d ep en ds on exp ected future outp u t, then the
u n exp ected increase in m oney d em an d ind icates that
future outp u t will be higher than previously ex­
p ected ." Consequently, the in crease in e x p ected cash

9This discussion abstracts from the distinction of net monetary credi­
tors and net monetary debtors. For a discussion of the effects of
changes in inflation expectations on each group, see Kessel and
Alchian (1962). For a more recent study of the effects of inflation on
bank stock prices, used to represent a group of net monetary
creditors, see Santoni (1986).
10For example, Feldstein (1980) discusses the effect of taxes;
Schwert (1981), Fama and Schwert (1977) and Nelson (1976)
examine the inflation-stock price relationship for the United States
while Branch (1974) and Cohn and Lessard (1981) provide evi­
dence from other countries. In general, these studies indicate that
unexpected increases in inflation lower stock prices. Results re­
ported in Kool and Hafer (1986), however, suggest that this result
does not hold for earlier time periods.
"Fama (1981) argues that expected inflation in previous studies
serves as a proxy for expected real activity. Consequently, regress­
ing stock prices on expected inflation without accounting for ex­
pected real activity will yield incorrect estimates. Following this line
of reasoning, several researchers have used available survey data
to study the relationship between expected stock price changes,
expected inflation and expected real activity. See, for example,
Gultekin (1983), Pearce (1984), Hasbrouck (1984) and Coate and
VanderHoff (1985).

FEDERAL RESERVE BANK OF ST. LOUIS

flows p ro d u ces an increase in stock prices.'- This hy­
pothesis thus predicts that stock prices sh ould in­
crease in response to an u n exp ected increase in the
m oney stock.

Discount Rate Changes
Discount rate chan ges m ay lie thought of as an
indication of ch an ges in exp ected future m on etaiy
policy; d iscou nt rate changes, in o th er w ords, affect
financial and stock m arkets primarily through their
effect on interest rates and p ercep tion s of future e co ­
nom ic activity.'1' In general, increases in the discou n t
rate red u ce stock prices b ecause they presage a tight­
ening of m o n etaiy policy.14 The move tow ard tighter
policy is exp ected to in crease interest rates and re­
d u ce real eco n om ic activity and, consequently, future
co rp o rate cash Hows. Stock prices decline b ecau se the
red u ced future cash flows are d iscou n ted at higher
interest rates.
Some argue that the im p act of a d iscou n t rate
change d ep en ds on the Federal Reseive’s cu rren t o p ­
erating p ro ced u re.1' If the Fed is targeting interest
rates, ch an ges in the d iscount rate m ay provide no
inform ation about future policy that is not already

12lt should be noted that attendant increases in the ex ante real rate
are presumably more than offset by expected increases in future
real economic activity.
13Batten and Thornton (1985) and Smirlock and Yawitz (1985), for
example, each attempt to determine "technical” from “non­
technical” changes in the discount rate. Batten and Thornton dichot­
omize discount rate changes into technical or policy-related, based
on Federal Reserve statements. Their procedure assumes that the
change is entirely technical or policy-related.
Smirlock and Yawitz attempt to define technical and non-technical
discount rate changes by regressing rate changes on lagged values
of the spread between the federal funds rate and the discount rate
and lagged values of changes in discount window borrowing. Pre­
dicted values from this equation constitute the technical (or antici­
pated) change, while the regression’s error term constitutes the
non-technical (or unanticipated) change in the discount rate.
Several factors militate against this procedure. First, it does not
capture effects not incorporated in the explanatory variables. Sec­
ond, it may alter the timing of the actual change. Last, it assigns
each discount rate change, which generally is 25, 50 or 100 basis
points, some estimated value that often does not equal the actual
value. In other words, there is always some non-technical change.
Because of the problems surrounding these classifications of
discount rate changes, we take the changes to be unanticipated.
'4There are instances, however, when moves to raise the discount
rate have been received by the market as good news, precipitating
increases in stock prices. This is discussed in the shaded box on the
next page.
'5For example, see Roley and Troll (1984) or Smirlock and Yawitz for
a discussion of this point.




MARCH 1986

in corp orated in interest rates. If the Fed is using a
re se rv e g ro w th o p e ra tin g p ro c e d u re , h ow ev er,
ch an ges in the discount rate influence interest rates.
During the period covered by this study, three differ­
ent operating p ro ced u res w ere used: interest rate tar­
geting (pre-O ctober 1979); nonborrow ed reseives tar­
geting (October 1979 to O ctober 19821; and a borrow ed
reseives proced u re, w hich tends to sm ooth m ove­
m en ts in the funds rate m ore than nonborrow ed re­
serves targeting (post-O ctober 1982). The em pirical
tests below assess the different effects of discou n t rate
changes u n d er different policy p roced u res.

TESTS OF THE BASIC MODEL
The basic equation tested is:
It) ASP, = ct„ + P, UM, + 0 , EM, + p., DR, + p, IJKS, + e„

w hen:
ASP = the fii-st-difference of the logarithm of the
daily stock price index,
UM = the u n exp ected dollar ch an ge in M l,
EM = the exp ected ch an ge in M l,
DR = the ch an ge in the d iscount rate, and
DRS = the ch an ge in th e d iscou n t rate su rch arge."1
The efficient markets hypothesis suggests that the
estim ated coefficient on exp ected m oney ch an g es If},)
should be zero. If d iscou n t rate ch an ges influence
stock prices as hypothesized above, p.. and P4 will be
negative. Finally, the exp ected sign of (3, differs d e ­
pending up on the hypothesis being tested. The policy
anticipations and the exp ected inflation hypotheses
suggest that it will be negative; the m on ey dem and
hypothesis suggests that it will be positive.
Besides investigating the validity of several h yp o th e­
ses regarding the effects of m oney stock an d discou n t
rate ch an ges on stock prices, estim ates of equation 1
can be used to test several o th e r h yp oth eses as well:
Are the effects of the exp lan atoiy variables statistically
equal a cro ss different m o n etaiy policy regim es? Are
the effects sim ilar acro ss stock price ind exes? Are the
effects of m oney stock ch an ges on stock prices sym ­
m etrical, as generally is assu m ed ?

16The discount rate surcharge was used by the Federal Reserve
during the period from March to May 1980 and again during the
period from November 1980 to November 1981. The 1980 imposi­
tion of the surcharge was part of the credit restraint program enacted
by the Carter administration and it was set at 3 percent. During each
period when the surcharge was used, it applied to discount window
borrowings by banks with deposits of $500 million or more that
borrow frequently. Because the surcharge did not apply to all
borrowing, it is included as a separate variable in the regression
equations presented below.

7

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

Timing D iscount Rate Changes
Studies using d iscou n t rate ch an ges often take
the an n ou n cem en t date as the day it becom es
“public." How one tim es the publication of the new
information, however, m ay alter the em pirical
results. F o r exam ple, th ere are o ccasion s on w hich
discount rate ch an ges are an n ou n ced d uring the
trading day and, as su ch , the actu al an n ou n cem en t
day will differ from the day it is rep o rted by the
financial press. B ecause of this, w e en ter the d is­
coun t rate change on the trading day that the
change becom es effective.
To illustrate how sensitive the results are to
ch an ges in the timing, the SP500 equation w as reestim ated for the pre-O ctober 1979 period, defining
the an n ou n cem en t date as that day w hen the dis­
coun t rate ch ange ap p eared in the the Wall S treet
Journal. An exam ination of the d ata revealed that,
on Friday, N ovember 1 ,1 9 7 8 , the d iscou n t rate w as
raised 100 basis points during the trading day. Ac­
co u n ts in the Wall S treet Jo u rn a l on M onday attrib­
ute the stock price rally on Friday to the an n o u n ce ­

To assess these questions, equation 1 w as estim ated
using daily stock price data from Septem ber 23, 1977,
through D ecem b er 31, 1984. T hree zero-on e dum m y
variables w ere u sed to differentiate the periods asso ci­
ated w ith alternative m o n etaiy policy regim es. Thus,
D1 = 1 from S eptem ber 23, 1977, through O ctob er 5,
1979, zero elsew here; D2 = 1 from O ctober 5, 1979,
through O ctober 15, 1982, zero elsew here; and D3 = 1
after O ctober 15, 1982, zero elsew here. Interaction
term s are form ed by multiplying ea ch exp lan atoiy
variable by these dum m y variables.17 F or exam ple,
D1UM rep resents the effect of UM in the first sub p e­
riod, D21IM the effect during the seco n d and so on.
Table 1 p resen ts the results of estim ating equation 1
using th ese interaction term s and the various stock
price in d exes.IS

’'Because the discount rate surcharge variable enters only during the
second subsample, no interaction term is necessary. Also, the
choice of October 15 for the 1982 policy change is arbitrary, since
published accounts of the procedural change do not provide an
exact date.
18Note that equation 1 is estimated without day-of-the-week variables.
Previous analysis by Pearce and Roley (1985) using the same data
finds that the presence or absence of these variables did not
influence their results. Given this evidence and the fact that we are
using the same data, we also omit day-of-the-week variables. Other
evidence on the existence of day-of-the-week effects, much of it

8



m ent, suggesting that the increase in the d iscou n t
rate reaffirmed the m arket’s p ercep tion that the Fed
w as resolved to rein in m oney grow th an d to red u ce
the possibility of future inflation. If w e ch an ge only
this one an n ou n cem en t d ate from the day it b e­
cam e effective (Friday) to the day it ap p eared in the
Wall S treet Jo u rn a l (Monday), the estim ated rela­
tionship b ecom es
ASP500, = 0.04 - 0.098 UM, - 0.872 DR,
(1.14) (2.18)
(2.05)
R2 = 0.015

SE = 0.713

DW = 1.68

Two points should be m ade. First, the use of the
effective day is theoretically preferable to dating the
an n ou n cem en t by its a p p earan ce in the financial
press. Second, the em pirical effects of discou n t rate
ch an ges on stock prices ap p ear to be quite sensitive
to small timing changes. In this exam ple, changing
one observation reverses the sign and significance
of the discou n t rate variable.

As the efficient m arkets hyp oth esis predicts, the
exp ected ch an ge in M l (EM) d oes not significantly
affect stock price ch an ges. The results in table 1 indi­
cate that none of the 15 estim ated coefficients on
exp ected m oney is statistically significant at th e 5
p ercen t level of significance. The test results in table 2
also b ear out the efficient m arkets h ypothesis, as the
rep orted F -statistics can n o t reject the hyp oth esis that
the coefficients on the exp ected ch an ge in m oney
togeth er are insignificantly different from zero. Thus,
the hypothesis that the estim ated coefficients on e x ­
p ected m oney are zero a cro ss the different m on eta ry
re g im es is not rejected by the data.
As p red icted by the e x p ected inflation an d policy
anticipations hypotheses, but co u n te r to th e m on ey

conflicting, are reported in French (1980) and Gibbons and Hess
(1981).
Following Pearce and Roley (1985) and Hardouvelis, we also
included several other measures of economic “news” as explana­
tory variables in equation 1. Those results indicated that stock
prices, irrespective of the index, responded to monetary announce­
ments more reliably than the other measures, such as unexpected
inflation, economic activity or unemployment. Because the results of
these tests do not extend the analysis already provided by Pearce
and Roley, we do not report them here.

MARCH 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Table 1
Estimates of Equation 1
Index
Variable

SP500

SP400

SPTRAN

SPUTIL

SPFIN

Constant

0.025
(1.20)

0.025
(1.14)

0.027
(0.98)

0.012
(0.86)

0.018
(0.80)

D1UM

-0.100
(1.81)

-0.104
(181)

-0.164
(2.29)

-0.037
(1.02)

-0.060
(1.03)

D2UM

-0.124
(3.84)

-0.120
(3.58)

-0.067
(1.60)

-0.129
(6.05)

-0.149
(4.37)

D3UM

-0.112
(2.46)

-0.114
(2.41)

-0.091
(1.54)

-0.119
(3.96)

-0.125
(2.60)

D1EM

0.072
(1.14)

0.077
(1.18)

0.105
(1.29)

0.036
(0.87)

0.033
(0.50)

D2EM

0.072
(1.37)

0.073
(1 34)

0.101
(1.49)

0.048
(1.40)

0.031
(0.56)

D3EM

0.034
(0.74)

0.037
(0.77)

-0.021
(0.34)

0.022
(0.72)

0.094
(1.92)

D1DR

0.916
(1.77)

1.038
(1.91)

1.189
(1.76)

0.259
(0.76)

0.944
(1.72)

D2DR

-0.597
(2.35)

-0.599
(2.27)

-0.332
(1.01)

-0.282
(1.69)

-0.448
(1.67)

D3DR

1.208
(1.54)

1.315
(1.61)

1.412
(1.38)

-0.269
(0.52)

0.336
(0.41)

-0.432
(2.66)

-0.421
(2.48)

-0.501
(2.36)

-0.543
(5.08)

- 0.658
(3.83)

DRS
R2

0.020

0.018

0.009

0.039

0.021

SE

0.877

0.913

1.165

0.596

0.952

DW

1.79

1.82

2.00

1.98

2.01

P

—

—

0.19
(8.31)

0.26
(11.36)

0.23
(9.88)

NOTE: Absolute value of t-statistics are reported in parentheses. R2Is the coefficient of determination
adjusted for degrees of freedom; SE is the regression standard error; DW is the Durbin-Watson test
statistic; and p is the estimate of the first-order serial correlation coefficient. The dependent variables are
measured as first-differences of the logarithms of Standard and Poor’s 500 (SP500), 400 stock index
(SP400), the transportation index (SPTRAN), the utility index (SPUTIL) and the financial index (SPFIN).
The right-hand-side measures are unexpected changes (UM) and expected changes in M1 (EM), based
on the Money Market Services, Inc. survey. DR and DRS represent the percentage change in the
Federal Reserve's discount rate and surcharge rate, respectively. The terms D1, D2 and D3 represent
(0,1) dummy variables where D1 = 1 from September 23, 1977, through October 5, 1979,0 elsewhere;
D2 = 1 from October 5, 1979, through October 15, 1982, 0 elsewhere; and D3 = 1 from October 15,
1982, to December 31,1984, 0 elsewhere.

d em and hypothesis, u n an ticipated ch an ges in Ml
(UM) generally have a statistically significant, negative
im pact on stock p rices. F o r instance, an unanticipated
$1 billion increase in M l red u ced the grow th rate of
the SP500 and the SP400 by about 10, 12 and 11 basis
points acro ss the three periods tested . The results in
table 2 provide supporting evidence that un antici­



pated m oney stock ch an ges do affect stock p rices. The
results on line 3 reject th e claim that u n an ticip ated
ch an ges in M l have no effect; the results on line 4,
w hich test the equality of the estim ated coefficients
across the different policy periods, indicate that one
can n ot reject coefficient stability at the 5 p ercen t level.
These results show that only u n exp ected ch an ges in
9

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

Table 2
Hypothesis Test Results
Index/F-statistics
Hypothesis

SP500

SP400

SPTRAN

SPUTIL

SPFIN

D1EM = D2EM = D3EM = 0

1.23
(0.30)

1.24
(0.29)

1.33
(0.26)

1.08
(0.36)

1.41
(0.24)

D1EM = D2EM = D3EM

0.19
(0.83)

0.17
(0.84)

1.20
(0.30)

0.16
(0.85)

0.46
(0.63)

D1UM = D2UM = D3UM = 0

8.04
(0.00)

7.31
(0.00)

3.40
(0.02)

17.81
(0.00)

8.96
(0.00)

D1UM = D2UM = D3UM

0.08
(0.92)

0.03
(0.97)

0.68
(0.51)

2.48
(0.08)

0.88
(0.42)

D1DR = D2DR = D3DR = 0

3.68
(0.01)

3.81
(0.01)

2.00
(0.11)

1.24
(0.29)

1.97
(0.11)

D1DR = D2DR = D3DR

5.15
(0.01)

5.47
(0.00)

2.97
(0.05)

1.03
(0.36)

2.78
(0.06)

NOTE: Marginal significance levels are reported in parentheses. Variable definitions are found in
table 1.

m oney reliably influence the behavior of stock prices
an d that there ap pears to be no statistically significant
change in this resp on se across the different m on etary
policy regim es.19
T h e g en e ra l h y p o th e sis ab o u t d is c o u n t ra te
ch an ges on stock p rices does not fare so well as the
hypothesis about the effects of un an ticip ated ch an ges
in M l. D iscount rate ch an ges generally had a positive
but not statistically significant (5 p ercen t level) effect
on stock p rices before O ctober 1979 an d after O ctob er
1982. This result does not su p p ort the view th at dis­
co u n t rate in creases should negatively influence stock
prices. It does, however, sup p ort the notion that, d u r­
ing periods in w hich m on etary policy em p h asizes the
behavior of the federal funds rate, the discou nt rate
m ay not im part relevant policy inform ation not al­
ready co n tained in, for exam ple, the federal funds
rate.20
The results for the O ctober 1979 to O ctober 1982
period indicate that ch an ges in the d iscount rate
result in stock price m ovem ents generally con sisten t
w ith the hypothesis d escribed above. Changes in the
d iscou n t rate have a significant (one-tailed) negative

19This evidence is in sharp contrast to the results from studies examin­
ing the interest-rate/money relationship over this period.
“ It should be noted that the discount rate changes during the preOctober 1979 period are positive and significant at the 10 percent
level for all of the indexes except SPUTIL. For a possible explana­
tion of this result, see the shaded insert on page 8.

Digitized for10
FRASER


effect on all indexes during this period, e xcep t for the
SPTRAN index. The size of the estim ated coefficients,
however, is low er for the m ore narrow ly defined in­
dexes than it is for th e broad SP500 an d SP400 m ea­
sures. Thus, a 100 basis-point in crease in the d iscount
rate during this period led to a 60 basis-point decline
in the grow th rate of SP500 and SP400, but only a 28
basis-point drop in the grow th rate of the SPUTIL
index.
W hy are the effects of d iscou n t rate ch an ges so
different across the different policy regim es? Prior to
O ctober 1979, m ovem ents in the federal funds rate
directly conveyed inform ation about ch an ges in pol­
icy objectives, thus making the inform ational co n ten t
of d iscou n t rate ch an ges red u n d an t.21 A sim ilar argu­
m ent can be m ade about the p ost-O ctob er 1982 p e ­
riod, since the sw itch from a non b orrow ed to a b or­
row ed reserves targeting p ro ced u re is sim ilar to a
policy that sm ooths m ovem ents in th e federal funds
rate.22 The finding that the estim ated coefficients on
21The evidence in the shaded insert on page 8 and accounts of
discount rate changes in the Wall Street Journal do not support the
gross generality of this view.
“ If a borrowings target (referred to as the borrowings assumption) is
used and the primary determinant of discount window borrowing is
the federal-funds-rate/discount-rate spread, increases in the funds
rate, ceteris paribus, necessitate an increase in reserves since
borrowings will otherwise increase. Thus, reserves are injected, the
funds rate falls and borrowings return to their desired level. This
policy scenario suggests that movements of the federal funds rate
after October 1982 again directly reflect policy objectives. For a
more complete discussion, see Gilbert.

FEDERAL RESERVE BANK OF ST. LOUIS

d iscount rate ch an ges are insignificantly different
from zero during the two different policy regim es
suggests that the m arket's p ercep tion of ch an ges in
the discoun t rate m ay not be any different after O cto­
ber 1982 than it w as before O ctober 1979.
The test results in table 2 indicate that the discount
rate change is an im portant variable in explaining the
behavior of the broad indexes, but is less so for the
m ore specialized groups. In fact, the rep orted Fstatistic for the SPUTIL index indicates that w e can n ot
reject the hypothesis that ch an ges in the d iscou n t rate
together have no significant effect. The test results also
reveal that the effect of discou nt rate chan ges is not
equal acro ss regim es at reasonable levels of signifi­
ca n ce (except for SPUTIL).
Finally, the estim ated coefficient on the discount
rate su rcharge (DRS) is highly significant and negative
for each of the stock p rice indexes tested. The m agni­
tude of the effect on the broad stock price m easures is
sim ilar to that found by Pearce an d Roley (1985); in
addition, all of the stock p rice m easures are affected.
In fact, unlike the results for the discount rate, w hich
tend to have a sm aller effect on the n arrow er indexes,
a ch an ge in the su rcharge rate actually had a larger
im pact on the narrow indexes.
To sum m arize, the hypothesis that only u n an tici­
pated changes in m on ey negatively influence the
m ovem ent of stock p rices can n o t be rejected . This
finding, w hich holds for m ost of the stock price in­
dexes used and tim e periods tested, su p p orts the
efficient m arkets hypothesis, rejects the m oney d e­
m an d hypothesis and corrob orates earlier results
b ased solely on the use of broad stock p rice indexes. It
also show s that the effect of d iscou n t rate changes
varies am ong the p articu lar indexes and over the p eri­
ods tested. Thus, although policy regim e ch an ges do
not ap p ear to influence the m arket ’s reaction to u n an ­
ticipated changes in m oney, the evidence suggests
that the inform ation conveyed through d iscou n t rate
changes varies across policy regim es.

Symmetry Hypothesis Tests
Analysts generally assu m e that positive and nega­
tive u n anticipated ch an ges in m oney have sym m etri­
cal influences on stock p rices.-1 To test this hypothe23Little research into the symmetry of the effects is available. Although
Pearce and Roley (1983) and Roley and Troll (1983) test for the
effects on interest rates when money changes are above or below
stated policy targets, this does not directly address the hypothesis.
Also, Pearce and Roley (1983) present similar tests for stock prices.




MARCH 1986

sis, w e again use zero-on e dum m y variables to
generate the ap p rop riate interaction term s that differ­
entiate positive an d negative obseivations of UM.
Table 3 p resen ts the results of this test. Positive
values of UM are d en oted by UM ( + ) ; negative values
by UM ( —).M Negative u n exp ected ch an ges in m on ey
have no statistically significant effect on stock p rices
using the SP500, SP400 and the SPrRAN indexes. In
each case, the rep o rted t-values are quite small, as are
the estim ated coefficients. In tests of the equality of
the coefficients on the positive an d negative values of
UM, w e find that, for th ese three stock p rice m easures,
the t-statistics are large enough to reject equality at
the 5 p ercen t level. It ap p ears that only positive values
of UM have significant effects on ch an g es in these
stock prices; the grow th rates of these indexes fell by
16 basis points for a $1 billion surprise in M l. This
result suggests that m arket efficiency is violated.-'1
The SPUTIL and SPFIN results indicate that both
positive an d negative values of UM have similar, statis­
tically significant effects on the stock p rice ch an ges. In
these instances, the calculated t-statistics to test coef­
ficient equality are well below any accep tab le level of
significance. The sym m etrical resp o n se of utility and
financial stocks to an u n an ticip ated increase o r d e ­
crease in the m oney stock indicates that th ese stocks
are relatively m o re sensitive to interest rate an d p rice
level m ovem ents than o th e r stocks.

SUMMARY
The results of this study generally su p p o rt the ef­
ficient m arkets hypothesis. Based on evidence from
several different stock p rice indexes, u n an ticip ated
ch an ges in m on ey have a statistically significant effect
on stock p rices. E xp ected ch an ges in m oney never
display a statistically significant effect. The estim ated
effect of u n an ticip ated ch an ges in m oney did not
differ across alternative m on etary policy regim es. One

24Values of zero are included in the UM ( + ) data. Discount rate
variables are omitted from the SPUTIL equation, because the evi­
dence in table 2 indicates that they are not significant (Jointly) at any
reasonable level. It should be noted that reestimation of the equa­
tions in table 3 using a seemingly unrelated regression procedure
does not alter the conclusions reached in this section.
25Gikas Hardouvelis, in private correspondence, suggests the fol­
lowing scenario. Consider the median forecaster facing the money
announcement with equal probability that the announced M1 figure
will be above or below the forecast. Given the results in table 3, the
strategy is to sell before the announcement, since a positive sur­
prise in money will lower stock prices while a negative surprise has
no statistical effect. If such response persists, market efficiency is
violated.

11

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

Table 3
Results for Symmetry Test
Index
Variable

SP500

SP400

SPTRAN

SPUTIL

SPFIN

Constant

0.048
(2.18)

0.049
(2.16)

0.067
(1.90)

0.024
(1.20)

0.040
(132)

UM( + )

-0.162
(5.07)

-0.164
(4.93)

-0.166
(4.01)

-0.120
(5.75)

-0.153
(4.56)

UM(-)

-0.046
(1.24)

-0.041
(1.08)

0.006
(0.13)

-0.086
(3.65)

-0.072
(1.89)

D1DR

0.937
(1.81)

1.059
(196)

1.195
(1.77)

0.955
(1.74)

D2DR

- 0.604
(2.39)

-0.607
(2.30)

-0.340
(1.03)

-0.446
(166)

D3DR

1.232
(1.57)

1.341
(1.64)

1.432
(1.40)

0.394
(0.47)

-0.403
(2.49)

-0.391
(2.32)

—0.467
(2.21)

2.48*

2.52*

2.75*

1.07

1.58

DRS
t

-0.551
(5.22)

-0.637
(3.71)

R2

0.022

0.021

0.015

0.039

0.025

SE

0.876

0.912

1.164

0.597

0.952

DW

1.79

1.82

2.00

1.98

2.01

P

—

—

0.19
(8.38)

0.27
(11.73)

0.23
(9.94)

NOTE: The reported t-statistic is based on testing the hypothesis that UM (+) = UM (-). An asterisk
denotes significance at 5 percent level. All other terms are defined in table 1.

result that does not su p port the efficient markets
h ypothesis is the finding that the effects of u n an tici­
pated m on ey ch an ges are asym m etric: only positive
values of u n an ticip ated ch an ges in m oney ap p e a r to
have a significant im p act on the SP500, SP400 and
SPTRAN m easures.
The etfects of discoun t rate ch an ges on stock prices
vaiy with ch an ges in m on etaiy policy p ro ced u res;
their influence also lessened as the stock price index
b ecam e narrow er, fn general, d iscou n t rate ch an ges
have significant negative effects on stock prices only
from O ctober f 979 to O ctober 1982, a period ch a ra c te r­
ized by a m o n etaiy policy that focu sed on controlling
n onborrow ed reserves. Before an d after that period,
discoun t rate ch an ges convey little additional infor­
m ation about policy.
12



REFERENCES
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Interest Rates and Foreign Exchange Rates: An Analysis with
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Branch, Ben. “Common Stock Performance and Inflation: An Inter­
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48-52.
Coate, D., and James VanderHoff. “Stock Returns, Inflation and
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ary 1985), forthcoming Economic Inquiry.
Cohn, Richard A., and Donald R. Lessard. “The Effect of Inflation
on Stock Prices: International Evidence,” Journal of Finance (May
1981), pp. 277-89.
Cornell, Bradford. “The Money Supply Announcements Puzzle:
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ber 1983), pp. 644-57.
Davidson, Lawrence S., and Richard T. Froyen.

“Monetary Policy

MARCH 1986

FEDERAL RESERVE BANK OF ST. LOUIS

and Stock Returns: Are Stock Markets Efficient?” this Review
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Falk, Barry, and Peter F. Orazem. “The Money Supply Announce­
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Fama, Eugene F., and G. William Schwert. “Asset Returns and
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Nelson, Charles R. “Inflation and Rates of Return on Common
Stocks," Journal of Finance (May 1976), pp. 471-82.
Pearce, Douglas K. “An Empirical Analysis of Expected Stock Price
Movements," Journal of Money, Credit and Banking (August 1984),
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Pearce, Douglas K., and V. Vance Roley. “The Reaction of Stock
Prices to Unanticipated Changes in Money: A Note," Journal of
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ness (January 1985), pp. 49-67.

French, Kenneth R. “Stock Returns and the Weekend Effect,”
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Roley, V. Vance, and Rick Troll. “The Impact of New Economic
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Gibbons, Michael R., and Patrick Hess. “Day of the Week Effects
and Asset Returns,” Journal of Business (October 1981), pp. 57996.

_______ _ “The Impact of Discount Rate Changes on Market
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Gilbert, R. Alton. “Operating Procedures for Conducting Monetary
Policy," this Review (February 1985), pp. 13-21.

Rozeff, M. S. “Money and Stock Prices: Market Efficiency and the
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Gultekin, N. Bulent. “Stock Market Returns and Inflation Fore­
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Hardouvelis, Gikas A. “Macroeconomic Information and Stock
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Santoni, G. J. “The Effects of Inflation on Commercial Bank Stock
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Hasbrouck, Joel. “Stock Returns, Inflation, and Economic Activity:
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APPENDIX
Data Definitions
Money
The exp ected change in the m on ey supply (EM) is
the m edian forecast obtained from M oney Market
Services, Inc. (MMS).
Since 1977 this firm has co n d u cted a weekly tele­
phone survey of 50 to 60 governm ent securities dealers
to obtain their forecast of the change in M l. Before
February 8,1980, the survey w as co n d u cted tw ice each



week, initially on Tuesday, with a follow-up call on
Thursday, allowing resp o n d en ts to alter their original
guess. From February 1980 through February 1984,
however, the survey w as co n d u cte d only on Tuesday,
b ecau se of the Federal Reserve’s shift in announcing
the weekly M l figures from T hursday to Friday after­
noon. Beginning February 1984, w hich co rresp on d s to
the change from lagged to co n tem p o ran eo u s reserve
accou n tin g and w ith the an n ou n cem en t day again
being ch an ged from Friday to T h u rsd ay afternoon,
13

FEDERAL RESERVE BANK OF ST. LOUIS

MMS o nce again used two surveys: the initial poll on
the Friday im m ediately following the T hursday m oney
a n n ou n cem ent an d again on the following Tuesday.
F o r this study, w e use the forecasts fr om the Tuesday
survey. The data used here are those from P earce and
Roley (1985) as u p d ated by Doug P earce. We w ould like
to thank him for making th ese as well as the actu al M l
data available.
Actual changes in weekly M l, w hich ap p ear in the
Federal Reserve’s H.6 statistical release, are m easured
as the first an n ou n ced value m inus the first revised
estim ate of the previous w eek’s level. Due to the
changing definition of M l during o u r sam ple, the
following p ro ced u re w as followed to obtain a series
consistent w ith that being forecast by the survey re ­
sp ondents: Until February 1980, w e use the old defini­
tion of M l. From February 1980 through N ovember
1981, w e u se the actual M1B m easure (not the M1B
value that w as “shift-adjusted’’ for the introd uction of
NOW accou n ts). Finally, from November 1981 through
the en d of o u r sam ple, w e u se the cu rren t definition of
M l. Given the actu al an d exp ected series for m oney,
u n an ticip ated changes in M l (UM) are m easured as
actu al less exp ected .

Digitized for
14FRASER


MARCH 1986

Stock Prices
The stock price indexes used in this study are daily
close values of the broad Standard and P oo r’s (SP) 500
and 400 indexes, as well as the industry-specific in­
dexes for transportation (SPTRAN), utilities (SPUTIL)
an d financial institutions (SPFIN). In e a ch instan ce,
the stock p rice ch an ge is m easured as th e difference of
the logarithm s.

Discount Rate
Changes in the Federal Reserve’s d iscou n t rate and
the su rch arge are m easu red in p ercen tage poin ts; that
is, a 100 basis-point ch an ge in eith er rate is m easu red
as 1.0. Our m easu rem en t of th e d iscou n t rate change,
unlike that in som e studies, follows the Federal Re­
serve’s official dating p roced u re, changing w h en one
of th e 12 Federal Reserve Banks h as the approval of the
Federal Reserve Board to ch an ge its rate. The d ata
used h ere is based on the day th e new rate is in effect,
not w hen the new rate is an n o u n ced in the financial
press.

The Effects of Inflation on
Com m ercial Banks
G. J. Santoni

p

■
EOPLE disagree about the effect of the recen t
decline in inflation on U.S. financial institutions.
Som e claim that the "sudden drop in inflation . . . put
the co u n try ’s w hole credit stru ctu re u n d er great
strains that are becom ing increasingly ap p aren t.” 1
One of the m ore im portant indicators of the “strain ,”
accord in g to this argum ent, is th e increase in bank
failures.2 O thers argue that financial institutions have
been the “beneficiaries of disinflation and falling inter­
est rates,” pointing out that com m ercial bank earnings
increased as the inflation rate fell.3
This article d iscu sses the effect of inflation on co m ­
m ercial banks by analyzing the relationship betw een
inflation and the m arket value of bank capital.

INFLATION: A BR IEF EXPLANATION
Inflation is an increase in the general price level,
and is typically exp ressed as an annual p ercen tage
rate of change. F o r exam ple, the GNP deflator (one
index of the general price level) rose from 1.00 in 1982
to 1.038 in 1983, then in creased to 1.081 in 1984. In­
flation averaged 3.8 p ercen t during 19 8 2 -8 3 and about
4.1 p ercen t during 1 983-84. The average annual rate
over the tw o-year interval w as about 3.9 p ercen t.4

G. J. Santoni is a senior economist at the Federal Reserve Bank of St.
Louis. Thomas A. Poiimann provided research assistance.

Inflation d ep reciates the value of m oney. An in­
flation rate of 4.0 p ercen t m ean s that the dollar falls in
value at an annual rate of 4.0 p ercen t in term s of the
goods it will buy.

BANKS AND NOMINAL FINANCIAL
INSTRUMENTS
Inflation is im p ortan t for banks b ecau se they typi­
cally deal in nom inal financial instrum ents, that is,
instrum ents den om in ated in fixed dollar am ounts.
F o r exam ple, w hen a bank m akes a loan, it a cce p ts
nom inal financial instru m en ts (notes, m ortgages,
com m ercial p ap er an d o th e r financial securities) as
evidence of the debtor's obligation to th e bank. W hen a
bank borrow s, it issues nom inal financial instrum ents
to creditors (deposit liabilities, a cce p ta n ce s an d d e­
bentures) as evidence of its obligation.

An Important Characteristic
While nom inal financial in stru m en ts differ from one
an oth er in m any r esp ects, they share one im portant
ch aracteristic: their paym ents are fixed in nom inal
value, that is, in term s of dollars. Nominal instru m en ts
make up the bulk of bank assets and liabilities. F u r­
therm ore, banks are typically net cred itors in nom inal
instrum ents b ecau se their nom inal assets exceed
their nom inal liabilities (see appendix 1 for a theoreti­
cal explanation).’

'See Shaky Credit Structure (1985).
2lbid.
3See Corporate Earnings Uneven (1985).
“There are various methods of computing average annual rates of
change. The method employed in this paper assumes continuous
compounding. The rates are calculated by dividing the difference
between the natural logarithms of the price level at the two points in
time by the number of intervening years and multiplying by 100.




5See Alchian and Kessel (1977a) and Kessel (1956). Of course,
banks have real assets and liabilities as well (land, buildings, office
equipment, equities, etc.). These, however, make up a very small
portion of bank portfolios and are irrelevant in assessing the effect of
inflation on banks.

15

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

Some Balance Sheet Data
Table 1 uses d ata from the con solid ated balance
sh eet of dom estically ch artered com m ercial banks to
illustrate their net position in nom inal instruments.®
Nominal assets are calculated by subtracting the val­
u es of bank prem ises, o th er real estate ow ned, the
equities of o th er firms ow ned, and investm ent in sub­
sidiaries from total assets. T h ese item s are su b tracted
b ecau se the m arket p rices of real assets vaiy directly
with the price level. Nominal liabilities are the sum of
total deposits, subordinated n otes an d debentures,
federal funds p u rch ased, interest-bearing d em an d
n otes, m ortgage indebtedness, all o th er liabilities for
b orrow ed m oney an d the value of preferred stock.
Preferred stock, w hich is sim ilar to a bond, is included
as a nom inal liability b ecau se it is an obligation of the
bank to pay a fixed stream of dollars.
The table 1 d ata indicate that, in the aggregate, the
nom inal assets of these banks exceed th eir nom inal
liabilities. The excess of nom inal assets over nom inal
liabilities am o u n ts to 66.3 p ercen t of bank capital.7

Table 1
Net Nominal Assets of All Commercial
Banks (in billions of dollars)
Nominal assets = total assets - real assets
Total assets
Less real assets:
Equity ownership in other firms
$10.7
Bank premises
39.7
Investment in subsidiaries
1.9
Real estate other than premises
6.9
Nominal assets

59.2
$2,621.8

Nominal liabilities1 = total liabilities + preferred stock
Total liabilities
Preferred stock
Nominal liabilities
Net nominal assets = nominal assets
Nominal assets
Nominal liabilities

$2,681.0

$2,504.5
1.0
$2,505.5

nominal liabilities
$2,621.8
2,505.5

Net nominal assets
Net nominal assets as a percent of equity

$ 116.3
66.3%

ANTICIPATED INFLATION AND BANKS
An increase in an ticip ated inflation raises the n om i­
nal interest rate. This in creases the n u m b er of dollars
that cred itors o r debtors w ho are tran sactin g in nom i­
nal financial instru m en ts exp ect to receive o r pay
w hen loans m atu re (see sh ad ed insert), ff th ese e x p e c­
tations are realized, all nom inal values will be higher
at m aturity. Table 2 show s this effect on the balance
sh eet of a hypothetical bank. The exam ple assu m es
that all of the bank's borrow ing and lending co n tra cts
w ere negotiated with the exp ectatio n that th e rate of
inflation over the next two y ears w ould be 5.0 percen t.
The bank's loan co n tra cts have a tw o-year life. Its
borrow ing co n tracts m atu re at the en d of ea ch y e a r
an d are renegotiated at the existing interest rate.
Reserve requirem ents against all d eposits are 10.0
p ercen t.
F o r simplicity, the real interest rate is assu m ed to be
zero so the nom inal interest rate on bank loans is 5.0
percent." The interest rate on bank deposits is 4.5

6This calculation should be considered as illustrative only, since book
values rather than market values are used.
7As above, capital excludes outstanding preferred stock.
8The assumption about the real rate has no qualitative effect on the
results. See appendix 1.


16


NOTE: Data are as of third quarter 1985.
'All bank liabilities are nominal.
SOURCE: Board of Governors of the Federal Reserve System

p ercen t. The sp read betw een the bank’s borrow ing
an d lending rates is n e ce ssa iy co m p en sation for the
requirem ent to hold n on -in terest-earn in g reserves
(see ap p en dix 1). All assets an d liabilities are valued at
m arket p rices so assets m inus liabilities, o r capital,
rep resen ts the m arket value of the bank, $200, in this
exam ple. The general level of p rices is 1.0 in panel A.
Panel B show s the balan ce sh eet of the bank at the
en d of the first y e a r assum ing th at the an ticip ated
inflation is realized an d that nothing else h as o ccu rre d
to ch an ge th e a cco u n t b alances. Acci-ued interest on
deposit liabilities is $45, while $50 interest h as a ccru e d
on bank loans. A portion of the bank’s interest e a rn ­
ings ($4.50) m u st be ad d ed to reseives to co v er the
increase in deposits. The nom inal value of bank ca p i­
tal has in creased to $210.00, but its real value is u n ­
ch an ged ($200.00).
A sim ilar result o ccu rs in panel C, w hich show s the
balance sheet at the end of the secon d y ear. The
an ticip a te d inflation h as no real effect o n th e
bank’s capital and, therefore, on the w ealth of its
stockholders.

MARCH 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Forecastin g Inflation

Anticipated and Unanticipated
Inflation
Many eco n om ic tran saction s require a co m m it­
m ent to exch an ge m oney at som e future time.
Credit transaction s are a good exam ple of this.
Since inflation red u ces the future value of m oney, it
pays people (both potential b orrow ers and lenders)
to tiy to forecast inflation over the relevant time
period. This forecast is called anticipated inflation.1
As the nam e suggests, anticipated inflation is
forward-looking. It is the rate of ch an ge in the
general price level that people think will o c c u r
during som e specific future tim e period.
Of course, the a ccu ra cy of inflation forecasts d e­
pends on future events an d circu m stan ces that are
unknow n w hen the forecast is m ade. C on se­
quently, these forecasts generally will be “w ron g.”Any difference betw een actu al (or realized) inflation
and anticip ated inflation is called unanticipated
inflation. U nanticipated inflation is known only
with hindsight. B ecause it is known only after the
fact, it plays no role in people's decisions, ft is
im portant, however, in assessing w h eth er the d eci­
sions p rodu ced profits o r losses.

Anticipated Inflation and Interest
Rates
The nom inal interest rates quoted in financial
m arkets are form ed in th e p ro cess of con tractin g
betw een borrow ers an d lenders. They indicate the
nu m b er of dollars the b orrow er m ust pay to the
cred itor in the future in exch an ge for a given n u m ­
ber of present dollars. If borrow ers and lenders
exp ect the value of the dollar to d ep reciate in term s
of the goods it will buy over th e life of the loan (i.e., if
they anticipate inflation), the nom inal interest rate
specified in the loan co n tra ct will take a cco u n t of
this. The interest rate will be sufficiently high to
co m p en sate for the e x p e cte d d ep reciation in the
value of the dollar.3
To illustrate, su p p ose the real interest rate is 3
p ercen t and the an ticip ated rate of inflation over
the com ing y e a r is 5 p ercen t. People think that it
wall take $1.05 one y e a r from now to p u rch ase the
goods that $1.00 will buy today. A loan of $1,000 for
one y e a r will require a paym ent of $1,081.50 ( =
$1,000.00 x 1.03 x 1.05) at m aturity. This implies a
nom inal interest rate of 8.15 p ercen t.4 The an tici­
pated real value of this am ou nt at m aturity is $1,030
( = $1,081.50/1.05), w hich is the sum of the principal
($1,0001 and the real retu rn ($30).
3See Fisher (1965), pp. 1-100, who relates the nominal interest
rate, i, to the ex ante real interest rate, r, and the anticipated rate
of inflation, n*, as follows:
i

'See Alchian and Allen (1977), p. 490. They note that “though odd
names are given to inflation (creeping, galloping, runaway, and
hyper-), a critical distinction is between unanticipated and antici­
pated inflation.”
2Economic theory suggests that, although “wrong,” the forecasts
will not consistently over- or underpredict; that is, forecasts will be
unbiased. See Fisher (1954), pp. 36-37; Fisher (1907), p. 213;
and Fama (1970) for discussions of business foresight and effi­
cient markets.

UNANTICIPATED INFLATION
AND BANKS
If the realized rate of inflation exceed s the an tici­
pated rate, the price level h as risen u n exp ectedly. T he
u n exp ected increase in the price level cau ses a p ro ­
portional red u ction in the exch an g e value of both
nom inal financial assets and liabilities in term s of real
goods. B ecause banks are typically net cred itors in
nom inal instrum ents, bank ow ners lose w ealth w hen



= r+

it*

+ (r)(iT*).

Fisher’s hypothesis regarding the formation of the nominal inter­
est rate is an approximation to the "true” relationship; it ignores
risk premiums and the effect of taxes on interest income and
assumes that the anticipated rate of inflation is held with certainty.
See Darby (1975) and Kochin (1981). The ex ante real rate is the
premium in terms of real goods that creditors expect to receive
(and borrowers expect to pay) expressed as a percentage of the
principal of the loan. See Fisher (1954) and Santoni and Stone
(1981) for discussions of the real rate of interest.
48.15 = [($1,081.50/$1,000.00)-1]100.

there is unan ticip ated inflation (that is, w hen bank
capital declines) *
Table 3 p resen ts a n um erical exam ple of this effect.
The assu m p tions in table 3 are the sam e as those in
table 2 excep t that people are surp rised by a 10 p er­
cen t increase in the p rice level in the first y ear. The
exam ple assu m es that the surprise is interp reted as a

9See Keynes (1923), pp. 18-19, and Alchian and Kessel (1977b).

17

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

T a b le 2

The Effect of an Anticipated Inflation of 5.0 Percent
Panel A: The current balance sheet. The price level is 1.0.

Assets:
Reserves
Loans and securities
Premises

$ 100.00
1,000.00
100.00

Liabilities:
Deposits
Capital:

$1,000.00
200.00
$1,200.00

$1,200.00

Panel B: The balance sheet one year hence. The price level is 1.05.

Assets:
Reserves
Loans and securities
Premises

$ 104.50
1,045.50
105.00

Liabilities:
Deposits
Capital:

$1,045.00

210.00
$1,255.00

$1,255.00

Real value of capital = $210/1.05 = $200

Panel C: The balance sheet two years hence. The price evel is 1.1025.

Assets:
Reserves
Loans and securities
Premises

$ 109.20
1,093.07
110.25

Liabilities:
Deposits
Capital:

$1,092.02
220.50
$1,312.52

$1,312.52

Real value of capital = $220.5/1.1025 = $200

one-tim e-only deviation in the p rice level so that the
inflation forecast for the secon d y e a r rem ains at 5.0
percent.
Panel B show s the effect of the un an ticip ated in­
flation. The bank’s nom inal assets an d liabilities are
unaffected by the inflationaiv surprise. The increase
in these dollar values is fixed by co n tract. In co n trast,
the nom inal value of the bank’s real assets, th e p rem ­
ises, increases by the realized rate of inflation, 10.0
p ercen t. The nom inal value of capital increases from
$200 to $215. The value of the bank in term s of the real
goods for w hich it can be exchanged, however, d e ­
clines to $195.45. The u n anticip ated inflation cau ses
the real value of the bank to fall by $4.55."'

10An unanticipated decrease in the price level produces symmetrical
results in that the real wealth of bank owners is increased.

18



Panel C show s the bank’s b alan ce sheet at the en d of
the seco n d y ear. The real value of the bank rem ains at
$195.45, indicating that th e one-tim e inflationary su r­
prise p ro d u ces a p erm an en t red u ction in the real
value of the bank even though th e rate of inflation in
subsequent y ears retu rn s to 5.0 p ercen t.

THE INTEREST RATE AND INFLATION
A bank’s nom inal financial assets an d liabilities typi­
cally m atu re at different dates. At any given m om ent,
the m aturity dates of a bank’s assets generally extend
beyond those of its liabilities." In o th e r w ords, an

"More precisely, the duration of the bank’s receipt stream exceeds
the duration of its payment stream. For discussions of duration, see
Samuelson (1945), p. 19; Bierwag, Kaufman and Toevs (1983);
Maisel and Jacobson (1978); and Santoni (1984).

MARCH 1986

FEDERAL RESERVE BANK OF ST. LOUIS

T a b le 3

The Effect of an Unanticipated Inflation
Panel A: The current balance sheet. The price level is 1.0.

Assets:
Reserves
Loans and securities
Premises

Liabilities:
Deposits
Capital:

$ 100.00
1,000.00
100.00

$1,000.00
200.00
$1,200.00

$1,200.00

Nominal assets - nominal liabilities = ($100 + $1,000)
- $1,000 = $100
Real value of capital = $200/1.0 = $200

Panel B: The balance sheet one year hence. The price level is 1.10.

Assets:
Reserves
Loans and securities
Premises

$ 104.50
1,045.50
110.00

Liabilities:
Deposits
Capital:

$1,045.00
215.00
$1,260.00

$1,260.00

Real value of capital = $215/1.10 = $195.45

Panel C: The balance sheet two years hence. The price level is 1.155.

Assets:
Reserves
Loans and securities
Premises

$ 109.20
1,093.07
115.50

Liabilities:
Deposits
Capital:

$1,092.02
225.75
$1,317.77

$1,317.77

Real value of capital = $225.75/1.155 = $195.45

interest rate change affects the paym ent stream obli­
gated by the bank’s liabilities before it affects the
bank's receip t stream . Consequently, an increase in
the interest rate red u ces the exp ected net stream of
dollar receip ts as the bank’s cred ito rs renegotiate for
the higher interest rate, while the interest rate earn ed
by the bank on its existing loans is locked up. Of
cou rse, the loans eventually m atu re and are renegoti­
ated at the higher nom inal rate, but the bank’s capital
is red u ced nonetheless.

An Illustration
Table 4 illustrates the effect of a ch an ge in the



nom inal interest rate on bank capital. The exam ple
assu m es the interest rate in creases b ecau se antici­
pated inflation in creases. The qualitative effect illus­
trated by the exam ple, however, results from the
change in the interest rate, regardless of w hat p ro­
d u ced the change.
In this exam ple, an ticip ated inflation at the tim e the
bank initially co n tra cts with its cred itors an d debtor's
is 5.0 p ercen t. The bank’s co n tra cts with its creditors
m atu re in one year, while its loans m atu re at the end
of the secon d y e a r and can n o t be renegotiated before
maturity.
As in the previous exam ples, the bank’s loans and
19

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

T a b le 4

The Effect of a Change in Anticipated Inflation
Panel A: The current balance sheet. The price level is 1.0.

Assets:
Reserves
Loans and securities
Premises

$ 100.00
1,000.00
100.00

Liabilities:
Deposits
Capital:

$1,000.00
200.00
$1,200.00

$1,200.00

Panel B: The balance sheet one year hence. The price level is 1.05.

Assets:
Reserves
Loans and securities
Premises

$ 104.50
1,045.50
105.00

Liabilities:
Deposits
Capital:

$1,045.00
210.00
$1,255.00

$1,255.00

Real value of capital = $210.00/1.05 = $200.00

Panel C: The balance sheet two years hence. The price level is 1.155.

Assets:
Reserves
Loans and securities
Premises

$ 113.90
1,090.65
115.50

Liabilities:
Deposits
Capital:

$1,139.05
181.00
$1,320.05

$1,320.05

Real value of capital = $181.00/1.155 = $156.71

deposits are $1,000. The lending rate is 5.0 percent,
an d th e borrow ing rate is 4.5 p ercen t. Panel A show s
the bank’s initial balance sheet. Panel B show s the
balance sheet at the end of th e first y e a r assum ing that
the realized rate of inflation during the first y e a r w as
5.0 p ercen t, the sam e as the an ticip ated rate.
Panel C show s the b alance sh eet at the en d of the
secon d y e a r assum ing that the anticip ated rate of
inflation w as revised upw ard to 10.0 p ercen t at the
beginning of the secon d year, just before th e bank
renegotiated its co n tra cts with d e p o s ito r . The ex a m ­
ple assu m es that the realized rate of inflation during
the seco n d y e a r m atch es the an ticip ated rate.
The in crease in an ticipated inflation cau se s the
nom inal interest rate to rise to 10.0 p ercen t during the
secon d year, while the interest rate on bank deposits
Digitized for20
FRASER


in creases to 9.0 p ercen t. At th e en d of th e secon d year,
these deposits will am ou nt to $1,139.05 ( = $1,045.00 x
1.09). T he bank, how ever, is prevented from raising the
interest rate on its existing loans ( = $1,000) by the
term s of its co n tra ct. T h ese loans co n tin u e to yield 5.0
p ercen t in the se co n d year, a ccn jin g earnings of
$50.00 during th e y e a r. Of co u rse, th e bank ca n m ake
new loans of $45.50 at the beginning of the secon d
y ear. These new loans, w hich result from th e net
interest earnings th e bank obtained the first y ear, are
m ad e at the h igher interest rate (10.0 percen t) and
a ccru e earnings of $4.55 ( = $45.50 X .10) at y ear-en d .
Since bank deposits in creased during the secon d
year, som e of th e bank’s interest earnings m u st be
used to in crease reserves. The in crease in bank d e­
posits am o u n ts to $94.05 ( = $1,139.05 — $1,045.00), so

FEDERAL RESERVE BANK OF ST. LOUIS

reseives m ust increase to $113.90 o r by $9.40 ( = $94.05
X .10). As a result, the bank’s loan a cc o u n t aty e a r-e n d
is $1,090.65 ( = $1,000.00 + $50.00 + $45.50 + $4.55 $9.40). Bank prem ises in crease in nom inal value by the
realized rate of inflation and am ou nt to $115.50 ( =
$105.00 x 1.10) a ty e a r-e n d . Note that both the nom i­
nal an d real value of capital decline. The real value of
capital falls by $43.29 to $156.71 ( = $181.00/1.155).
As th e table 4 exam ple show s, a ch an ge in the
interest rate can have a fairly substantial effect on the
bank w hen the m aturities of the bank’s assets and
liabilities differ. In this p articu lar exam ple, the real
value of capital declined by about 22.0 p ercen t w hen
the interest rate doubled.
An in crease in an ticip ated inflation affects banks in
a w ay that is qualitatively the sam e as u n an ticip ated
inflation. This is b ecau se the upw ard revision in an tic­
ipated inflation that o ccu rs at the end of the first y e a r
w as not forecast at the beginning of the y ear. If people
had anticipated inflation of 5.0 p ercen t the first y e a r
an d 10.0 p ercen t the seco n d y ear, the rate of interest
on tw o-year loans w ould not have been 5.0 percen t.
Rather, it w ould have been higher to reflect the fact
that an ticip ated inflation averages 7.2 p ercen t acro ss
the tw o y ears. U nanticipated inflation and ch an ges in
anticip ated inflation have sim ilar effects b ecau se both
reflect a m isguess about inflation.
To recap the main points so far, th e previous d iscu s­
sion suggests that inflation affects the real capital
value of banks through two chann els. First, capital
value falls w hen the actu al rate of inflation exceed s the
anticip ated rate. This is called u n an ticip ated inflation.
Second, capital value falls w hen the an ticip ated rate of
inflation is revised upw ard, b ecau se this cau ses nom i­
nal interest rates to rise u n exp ectedly. The reverse
o ccu rs if the actu al rate of inflation falls short of the:
anticip ated rate o r if the anticip ated rate of inflation is
revised dow nw ard.

SOME ESTIMATES
These im plications can be exam ined by observing
the effect of inflation on various indexes of the stock
p rices of publicly trad ed banks. Stock p rices are used
as a proxy for the capital value of banks b ecau se they
rep resent the m arket’s assessm en t of the p resent
value of the future net receip ts banks aie exp ected to
generate.
The relationship betw een ch an g es in the real stock
prices of banks and the o th er variables is assu m ed to
take the form show n in equation 1:



MARCH 1986

(1) ALnlV/P), = C + aALny, + (iALnli
+ Sir* +

it*),

+ -yir;'

e AL t]tt*,

w here
V/P
C
y
(i —tt*)

=
=
=
=

the real p rice of bank stock,
a con stan t,
real incom e,
the nom inal interest rate less an ticip ated
inflation,
tt" = unan ticip ated inflation, w hich is th e dif­
ference betw een realized inflation, tt, and
anticipated inflation, tt*. tt“^U.

Equation 1 exp resses real stock p rices, real incom e,
the interest rate residual an d the ch an ge in an tici­
pated inflation in term s of annualized p ercen tage
ch an ges. The u n an ticip ated rate of inflation is the
difference betw een two annualized p ercen tage rates
of ch an ge: the realized rate of inflation an d th e an tici­
p ated rate. The estim ates use quarterly data from the
first quarter of 1962 through the fourth q u arter of 1984.

Anticipated and Unanticipated Inflation
M easuring an ticip ated inflation is a problem . Since
w e only observe actu al inflation, various analysts have
used different m eth od s to estim ate an ticip ated in­
flation.
This study estim ates an ticip ated inflation o ne quar­
ter ah ead by em ploying a tim e-series forecast of in­
flation. This m ethod gen erates pred iction s of inflation
solely on the basis of its past behavior.13The difference
betw een the actual rate of inflation and the rate fore­
cast by the model is interp reted as the em pirical
co u n terp art of u n an ticip ated inflation, t t " . B ecau se the
real price of bank stock is e x p ected to be inversely
related to unan ticip ated inflation, the coefficient of tt"
should be negative.
A nticipated inflation, tt*, an d ch an ges in the real
p rice of bank stock are theoretically u n related ; co n se ­
quently, the coefficient of this variable sh ou ld be zero.
C hanges in anticip ated inflation ch an ge interest rates,

12See Hafer and Hein (1985).
13Roughly, the technique accounts for the past pattern of inflation by
estimating a model that provides a description of the process that
generated the observed series. Past observations of inflation are
then used along with the information contained in the time-series
model to forecast inflation one period ahead. For further discussion
of time-series models and their properties, see Pindyck and Rubinfeld (1981), pp. 469-573, especially pp. 469-70 and 493-97. For
further discussion of the model employed here, see appendix 2.

21

FEDERAL RESERVE BANK OF ST. LOUIS

however, and these interest rate ch an ges are exp ected
to be inversely related to ch an g es in stock prices.
E stim ates of the ch an ges in anticip ated inflation are
obtained directly from the inflation fo recasts.14

MARCH 1986

an d ch an ges in the difference betw een the nom inal
rate an d the estim ate of an ticip ated inflation, A(i —-it*),
ca n be includ ed separately in the regression eq u a­
tion .1'’ The e x p e cte d sign of ea ch of th ese term s is
negative.

The Business Cycle
Real incom e grow th w as included as an explanatory
variable to con trol for the effect of the business cycle
on bank earnings. Business exp an sion s increase the
real quantity of bank loans, secu rities an d deposits,
w hich is thought to have a positive im p act on the
exp ected earnings stream . The em pirical co u n terp art
of real incom e used in the regressions is gross national
p ro d u ct (GNP) divided by the GNP deflator. The e x ­
p e cted sign of the coefficient of this term is positive.

The Interest Rate
The p rices of bank stocks are exp ected to be related
to ch an ges in the interest rate. The interest rate will
vary with chan ges in the cx ante real interest rate,
ch an ges in incom e tax laws, ch an ges in risk prem ium s
an d ch an ges in an ticip ated inflation. Since the interest
rate includes all of these factors, ch an g es in it can n o t
be readily attributed to the effect of any one of them .
The qualitative effect of a ch an ge in the interest rate on
stock prices, however, is the sam e regardless of the
so u rce. The exp ected sign of the coefficient of interest
rate ch an ges is negative.
Since this p ap er focu ses on the effect of inflation,
the following estim ates attem p t to isolate the effect of
a ch an ge in an ticip ated inflation. As m en tioned above,
an estim ate of anticip ated inflation, -it*, is p ro d u ced by
the tim e-series forecast of inflation. W hen this esti­
m ate is su b tracted from the nom inal interest rate, the
residual is an estim ate of the nom inal interest rate
e x c lu d in g a n tic ip a te d in flatio n . C o n s e q u e n tly ,
ch an ges in the estim ate of an ticip ated inflation, Att*,

’“Changes in the interest rate are expected to be positively related to
changes in anticipated inflation. To check this, changes in the Aaa
bond rate, AR, and changes in the 3-month Treasury bill rate, ARS,
were regressed on the estimate of the change in inflation expecta­
tions. The results are presented below.
AR, = .09 + .13Air*,
(1.93) (3.03)*

ARS, = .06 + .36 Air*,
(.58) (3.71)*

DW = 1.65

DW = 1.79

R2 = .10

R2 = .14

Although both coefficients are less than one, they are both positive
and significantly different from zero. The estimated coefficient of
Air* is larger in the equation for the short-term interest rate, which
suggests that the inflation forecast used here is a better estimate of
short-run expectations.

Digitized for 22
FRASER


Controlling f o r Problem Loans
In addition to the above variables, th e estim ated
equations include a d u m m y variable to con trol for the
effect that re ce n t Latin A m erican loan problem s have
had on bank stock p rices. D uring th e early p art of 1982,
it b ecam e ap p aren t that certain Latin A m erican co u n ­
tries w ould have difficulty h onoring th eir obligations
to U.S. banks. In O ctob er an d November 1982, the
cen tral bank of Brazil began borrow ing heavily from
the E xch an ge Stabilization F u n d of the U.S. Treasu ry;
M exico began draw ing heavily on its sw ap arran ge­
m en t w ith the Federal Reserve System in April of the
sam e y ear. News rep o rts on the exten t of the problem
co n tin u ed to su rface for about three qu arters. The
period du m m ied begins in the first q u arter of 1982 and
exten d s throu gh the third q u arter of 1982, w hen it
b ecam e evident th at the U.S. governm ent w ould take
an active role in resolving th e problem ."1Th e e x p e cte d
sign of the du m m y is negative.

The Estimates
Table 5 p resen ts the regression results. E stim ate 1
exam ines the effect of inflation on an ind ex of th e real
sh are p rices of banks located outside New York City.
Estim ate 2 d oes th e sam e thing for New York City
banks.17
Th e signs of the estim ated coefficients are as e x ­
p ected . The estim ates indicate th at u n an ticip ated in­
flation an d ch an ges in the an ticip ated rate of inflation
are inversely related to ch an g es in the real p rice of
bank stock. As exp ected , the estim ated coefficient of
an ticip ated inflation is not significantly different from
zero in a statistical sense.

15Actually, the data entry is one plus the difference between the
nominal rate and anticipated inflation. This is necessary because
the difference is negative in some quarters during 1971, 1975 and
1976. See Brown and Santoni (1981) for a discussion of some
problems associated with this method of separating the nominal rate
into its various components.
,6On February 2, 1983, the chairman of the Federal Reserve Board
addressed the House Committee on Banking, Finance and Urban
Affairs regarding the problem and measures to deal with it. See
Volcker (1983).
'This was done because Standard and Poor’s reports the data this
way.

MARCH 1986

FEDERAL RESERVE BANK OF ST. LOUIS

Table 5
Estimating the Effect of Inflation on the Price of Bank Shares,
Sample Period: I/1962-IV/1985
Estimate 1:

ALnBK/P = -4.29 + 1.79ALny - 4.72ALn(1 + i (.47) (2.21)*
(3.91)*

it*)

- 1.48-ir1' + .05ir* -,12ALmr* - 11.75 DUM
(3.19)*
(.15) (3.01)*
(2.64)*

RSQ = .34
DW = 1.68
Estimate 2:

ALnBKNY/P = 5.94 + 1.10ALny - 5.51 ALn(1 + i-n*)
(. 64 ) ( 1.33 )
(4 . 44 )*

1 .34 t t " + ,35n* - ,12ALmr*
(. 99 )
(2 . 97 )*

(2 .81 )*

6.05 DUM
( 1 .32 )

RSQ = .31
DW = 1.74
where:
BK/P
BKNY/P
y
i
ir“
ir*
DUM

=
=
=
=
=

the Standard and Poor’s index of the real share prices of banks located outside New York City
the Standard and Poor’s index of the real share prices of New York City banks
Real Gross National Product
the corporate Aaa bond rate
unanticipated inflation
anticipated inflation
= 1 during 1/1982-111/1982 and zero otherwise

NOTE: Absolute values of t-scores appear in parentheses. * = significantly different from zero at the 5 percent level.

The coefficient of the d u m m y variable has the e x ­
p ected sign in both estim ates but is not significant in
estim ate 2. In the ca se of estim ate 1, th e coefficient is
significant an d its point estim ate is fairly large, sug­
gesting that the grow th in real stock prices w as about
12 p ercen t lower, on average, during the first three
quarters of 1982, o th e r things th e sam e. This m ay be
som ew hat m isleading since the con fiden ce interval
for this coefficient ranges from —2.9 to —20.7.

Implications f o r Banks
The average forecast of inflation (tt*) g enerated by
the tim e-series m odel during 1984 w as about 4.0 per­
cen t. This fell to about 3.5 p ercen t during 1985, result­
ing in a 13.5 p ercen t d rop in an ticip ated inflation
(ALmr*). The table 5 estim ates suggest that this raised
the real stock p rices of the banks in the sam ple bv
about 1.6 p ercen t ( = —13.5 X — .12). In addition, the
decline in the actual rate of inflation exceed ed the
decline in an ticip ated inflation. As a result, u n an tici­
p ated inflation averaged about —.85 p ercen t in 1985,
raising the real stock prices of banks by an additional
1.2 p ercen t ( = — .85 X
1.4). In sum , the real stock



p rices of banks in creased by about 3.0 p ercen t, ceteris
paribus, as a co n seq u en ce of the fall in anticipated
inflation in 1985 and b ecau se th e actu al rate of in­
flation in 1985 w as even low er than an ticip ated.

CONCLUSION
This p ap er exam ines the effect that inflation has on
the share p rices of co m m ercial banks. The results
indicate that the real sh are p rices of banks are in­
versely related to both u n an ticip ated inflation — that
is, deviations in the realized rate of inflation from its
anticip ated rate — and ch an g es in an ticip ated in­
flation. C ontrary to som e claim s, this evidence indi­
ca te s that bank shareh old ers have benefited from the
recen t decline in the rate of inflation an d that any
u n exp ected resurgen ce of inflation w ould be harmful.

REFERENCES
Alchian, Armen A., and William R. Allen. Exchange and Production:
Competition, Coordination and Control, 2nd ed. (Wadsworth Pub­
lishing Company, Inc., 1977), pp. 490 - 94 .

23

FEDERAL RESERVE BANK OF ST. LOUIS
Alchian, Armen A., and Reuben A. Kessel. "Effects of Inflation,”
Economic Forces at Work (Liberty Press, 1977a), pp. 363-96.
_______ and_______ _ “Redistribution of Wealth Through Infla­
tion,” Economic Forces at Work (Liberty Press, 1977b), pp. 397412.
Bierwag, G. O., George G. Kaufman and Alden Toevs. “Duration:
Its Development and Use in Bond Portfolio Management,” Finan­
cial Analysts Journal (July/August 1983), pp. 15-35.
Brown, W. W., and G. J. Santoni. “Unreal Estimates of the Real
Rate of Interest,” this Review (January 1981), pp. 18-26.
“Corporate Earnings Uneven,”

New York Times, November 4,1985.

Darby, Michael R. “The Financial and Tax Effects of Monetary
Policy on Interest Rates,” Economic Inquiry (June 1975), pp. 26676.
Fama, Eugene F. "Efficient Capital Markets: A Review of Theory
and Empirical Work,” Journal of Finance, Papers and Proceedings
(May 1970), pp. 383-417.
Fisher, Irving.
pp. 1-100.

Appreciation and Interest (Augustus M. Kelley, 1965),

MARCH 1986
Kessel, Reuben A. “Inflation-Caused Wealth Redistribution: A Test
of a Hypothesis,” American Economic Review (March 1956), pp.
128-41.
Keynes, J. M. A Tract on Monetary Reform (Macmillan and Com­
pany, 1923).
Kochin, Levis. 'The Term Structure of Interest Rates and Uncertain
Inflation" (University of Washington, 1981; processed).
Maisel, Sherman J., and Robert Jacobson. “Interest Rate Changes
and Commercial Bank Revenues and Costs,” Journal of Financial
and Quantitative Analysis (November 1978), pp. 687-700.
Pindyck, Robert S., and Daniel L. Rubinfeld. Econometric Models
and Economic Forecasts, 2nd ed. (McGraw-Hill Book Company,
1981), pp. 469-573.
Samuelson, Paul A. “The Effect of Interest Rate Increases on the
Banking System,” American Economic Review (March 1945), pp.
16-27.
Santoni, G. J. “Interest Rate Risk and the Stock Prices of Financial
Institutions,” this Review (August/September 1984), pp. 12-20.

________ The Theory of Interest (Kelley and Millman, 1954).

_______ , and Courtenay C. Stone. “Navigating Through the In­
terest Rate Morass: Some Basic Principles,” this Review (March
1981), pp. 11-18.

_______ _

“The Shaky Credit Structure.”

The Rate of Interest (The Macmillan Company, 1907).

Hafer, R. W., and Scott E. Hein. “On the Accuracy of Time-Series,
Interest Rate, and Survey Forecasts of Inflation," The Journal of
Business (October 1985), pp. 377-98.

24



Washington Post, November 4,1985.

Volcker, Paul A. Statement Before the Committee on Banking, Fi­
nance and Urban Affairs, House of Representatives, February 2,
1983.

FEDERAL RESERVE BANK OF ST. LOUIS

MARCH 1986

APPENDIX 1
Some Banking Arithm etic
In large part, a bank’s exp ected stream of net reve­
nue is generated by its holdings of nom inal assets and
liabilities. These are its loans, L, w hich earn the market
interest rate, i„„ and its deposits, D, on w hich interest,
i„, is paid. In addition, ow ners have invested capital, I,
of w hich a fraction, a , m ust be held as non-interestearning reserves against deposits, and the rem aining
fraction, (1 — a), is held in eith er nom inal o r real assets
that are exp ected to yield the m arket rate, i,„. The
following assu m es that this rem ain der is held entirely
in net real assets. The exp ected stream of net revenue,
R, is given in equation 1:
(II R = i„,L — i„D + i„,(l — all.
If the required reserve ratio is p, required reseives
are pD = a l. The quantity of loans and d eposits the
bank ca n generate are L = □ = al/p. In equilibrium,
the exp ected revenue stream of the bank m ust equal
the alternative stream of earnings that could be ob­
tained by investing the capital at the m arket interest
rate. This is show n in equation 2:
(2) R = i,„L — i„D + i,„(l — all = i,„cd + i,„(l — all.
The capital value of the bank, K, is show n in equation
3:
(31 K = — = a l + (1 - all = I.
i,„

Equation 3 exp resses the capital value of the bank as
the p resent value of the stream of exp ected revenue. In
equilibrium, K = I. If K wore g reater than I, resou rces
w ould be attracted to banking sin ce the capital value
of forming a bank w ould e x ceed the opportunity cost.
If K w ere less than I, resou rces w ould leave the industiv.

The Equilibrium Interest Rate on Bank
Deposits
Substituting pD for a l in equation 2 and noting that
D = L, the equilibrium interest rati; on bank deposits
is given in equation 4:
14) i„ = (1 — p!i,„.

Banks as Net Creditors in Nominal
Assets
Net nom inal assets, NNA, are nom inal assets m inus
nom inal liabilities. The bank’s nom inal assets are the
sum of its loans and reserves, while the bank’s d e­
posits are its nom inal liabilities. Assum ing equilib­
rium, these are given in equation 5:
(5) NNA = L + pD - D = pD.
Under these assum ptions, the bank is a net cred ito r in
nom inal assets to the extent of its reserve holdings.

APPENDIX 2
A Tim e-Series F o re ca st of Inflation
While the initial obseivation for the regressions re ­
ported in the text is first q u arter 1962, the d ata period
used to develop the forecast of inflation (as m easured
by the GNP deflator) extend s back to first q u arter 1948.
A backw ard extension is n ecessaiy to get th e fo recast­
ing model started.
Since the period covered is quite long, a rough
ch eck of the data w as m ade to d eterm ine if the p ro­
cess that generated the tim e series ch an ged materially



over the period I/1948-IV/1985. To do so, a m odel was
first estim ated for I/1948-IV/1965 an d these results
w ere co m p ared with the results obtained from esti­
m ates for I/1966TV/1985. The GNP deflator ap p ears to
be a seco n d -o rd er h om ogeneou s p ro cess that can be
m odeled as ARIMA (0, 2, 1). The estim ated m odels for
the two periods are rep orted below. C alculated tstatistics ap p ear in p aren th eses, and B is a backward
shift operator, i.e., (1-B) X, = X, — X,_,.

FEDERAL RESERVE BANK OF ST. LOUIS

III948-IV/l 965
AT.nP, = - .107 + (1 - .49B)e,
(.58)
(4.73)
Chi-square (2, 24) = 16.07

HI966-IV/l 985
A-LnP, = .003 + (1 - .48B)e,
(.03)
(4.70)
C hi-square (2, 24) = 26.63


26


MARCH 1986

A m odel w as then estim ated for th e period I/1948-IV/
1961, and a forecast of inflation for 1/1962 w as m ade.
The difference betw een the realized inflation rate for 1/
1962 and this forecast is in terp reted as th e em pirical
co u n terp art of tt".
The forecast for the next quarter, 11/1962, is g en er­
ated by adding the realized inflation rate for 1/1962 to
the d ata an d re-estim ating the m odel throu gh 1/1962
an d proceed in g as above. The p ro cess w as rep eated
for each q u arter through IV/1985.