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FRBSF

WEEKLY LETTER

March 15, 1985

Budget Deficits, Interest Rates, and the Dollar
Last fall, short-term interest rates dropped about
3 percentage points, and long-term rates fell
around 2 percentage points. With the rate of
inflation staying low, this translated into equivalent declines in real, or inflation-adjusted,
interest rates. A widely held view is that lower
U.S. real interest rates should depress the real
value of the u.s. dollar, but the real tradeweighted value of the dollar appreciated another
10 percent over the same period. Also puzzling is
the fact that the decline in real interest rates
occurred even though the u.s. federal budget
deficit (on a cyclically adjusted basis) continued
to grow. This Letter argues that the explanation
for these two puzzles is to be found in the
economy's longer-term adjustment to persistently
large federal budget deficits.
Interest rate differentials and the dollar

A widely accepted view of exchange rate determination is the theory of interest parity which
holds that the value of the dollar (or any other
currency) is dominated by the effects of actual
and potential flows of capital. In particular, the
dollar's value will tend to be such that the total
expected return on dollar-denominated assets
just equals the total expected return on foreigncurrency-denominated assets, plus or minus a
premium to compensate for differences in risk.
The expected returns include not only the pure
interest returns, but also the expected capital
gains or losses arising from anticipated changes
in currency values.
The theory of interest parity thus implies that the
value of the dollar should be bid to the point
where its expected future depreciation or appreciation over any given period approximately
equals the difference between the interest yields
on U.S. and foreign investments with maturities
of that same period. When this condition is met,
the total expected return on investments at home
will be approximately the same as that on investments abroad.
In influencing the exchange rate, the differential
between domestic and foreign long-term interest
rates should dominate. The difference between
short-term rates matters only to the extent that it

affects the differential between long-term rates. For
example, if the interest rate on 1-year U.S. bonds
goes up one percentage point and this increase is
expected to be temporary, the interest rate on 10year U.S. bonds should rise only one-tenth of one
percentage point. Given foreign interest rates, the
value of the dollar would then rise one percentage
point to set up an expected depreciation of 1 percent over the followi ng year, and thereby equal ize
total expected returns over all investment periods.
However, if the increase in the 1-year u.s. interest
rate is expected to last for 10 years, the interest rate
on 10-year U.S. bonds would rise by 1 percentage
point; and the value of the dollar would then rise 10
percent to equalize total expected returns.
It is easily shown that an identical relationship
ought to hold between the expected future depreciation or appreciation in the real value of the
dollar and the differential between real long-term
interest rates.
Thus, given an expected real value for the dollar
in the future, the dollar's current real value
should move in the same direction as the differential between domestic and foreign real longterm interest rates. The difference between U.S.
and foreign real long-term interest rates did track
the real value ofthe dollar quite well up until the
end of 1982, as shown in Chart 1. This suggests
that the expected real value of the dollar was
relatively stable until the beginning of 1983,
when the relationship between the long-term
interest rate differential and the dollar's value
began to break down. The real long-term interest
rate differential dropped sharply at that time, but
the real value of the dollar soon reached new
highs.
Another element in the dollar's strength

The continuing appreciation of the dollar, despite
a declining real interest rate differentia" suggests
that the expected real value of the dollar began to
rise significantly after 1982. This development
constitutes a second stage in the adjustment of
the economy to persistently large federal budget
deficits.

FRBSF
From 1979 through early 1982, U.S. real interest
rates rose because of the slowing in monetary
growth required to bring inflation under control.
But then, in late 1982 and 1983, real interest rates
failed to return to normal levels primarily because
of the tax cuts provided over a three year period
by the Economic Recovery and Tax Act of 1981.
These contributed to large budget deficits that put
substantial upward pressure on U.S. credit markets and thus on real interest rates. During the
first stage of adjustment to these large budget
deficits, occurring roughly until mid-1983, high
real interest rates bid the real value of the dollar
high enough above its expected future level to
make the implicit expected depreciation in the
future offset the attraction of the high real interest
returns here relative to those abroad.
In the second and current stage of adjustment,
such a large dollar depreciation is no longerexpected because the persistence of large federal budget
deficits is leading to upward revisions in the market's expectation of the future real value of the
dollar. The market has received new information
indicating thatthe U.S. federal budget deficit will,
at best, be reduced only gradually. Furthermore,
international capital markets are quite efficient,
and, as a resu It, most of the budget deficit has been
financed either directly or indirectly by net capital
inflows. Because the expenditure effects of the
budget deficit are not generating an offsetting
decrease in the trade balance, permanently larger
net capital inflows must lead to an appreciation of
the dollar that will create a larger volume of
imports compared to exports, thereby balancing
the supply and demand for dollars in the market
for foreign exchange. Thus, the expectation that
stronger net capital inflows will continue because
of persistently large federal budget deficits is leading the market to raise its expectation of the real
value of the dollar in the future.
Current indications are that a substantial increase
in the market's expected real value of the dollar
already has occurred. This change in expectations
is one of the key elements in the second stage of
the economy's adjustment to the shift in U.S.
fiscal pol icy towards larger budget deficits. Even
with lower U.S. real interest rates, the total anticipated return on U.S. assets is no lower than in the
first stage because the dollar is now anticipated to
depreciate less in the future.

Another factor adding strength to the dollar is
indicated in Chart 2, which shows that at the
same time that the U.S. budget was moving into
deficit, government budgets in the other major
GECD countries were moving toward surpluses.
This sustained shift in foreign fiscal policies is
generating permanently higher levels of national
saving abroad, which also contribute to expectations of persistently higher net capital inflows into
the United States, lending even more strength to
the dollar.
Implication for real interest rates
The other key element in the economy's longerrun adjustment to budget deficits is the lag in the
response of exports and imports to the real value
of the dollar. As shown in Chart 3, during the first
stage of adjustment in 1982 and 1983, the structural budget deficit grew faster than the excess of
imports over exports. This, along with the recovery from the 1981-82 recession, kept real interest
rates relatively high. At that stage, the dollar was
strengthened mainly by a high real interest rate
differential in favor of the United States that offset
an expected dollar depreciation. But because it
takes over a year for the exchange rate to make its
full impact felt on net exports, there was relatively little drag on overall aggregate demand
from a larger deficit in the foreign sector. The
pressure on real interest rates from the budget
deficits was therefore large in comparison to that
occurring in the second stage of adjustment.

During the second stage, beginning in mid-1983,
net exports fell faster than the structu ral budget
deficit grew, as the stronger dollar took its fu II
effect. The deterioration in the foreign sector
contributed importantly to the slowdown in real
economic growth during the last half of 1984,
which, in turn, caused real interest rates to
decline. Also, the value of the dollar at this stage
came to be strengthened more by heightened
expectations of the effects of continued budget
deficits on international capital flows, than by
high real interest rates.
Conclusion
In summary, so far there have been two distinct
stages in the adjustment of the economy to
persistently large federal budget deficits. During
the first stage, up until around mid-1983, large
budget deficits were perceived to be relatively

Chart 2
Cyclically Adjusted
General Government
Budget Balances

Chart 1
Real Trade·Weighted Value
of U.S. Dollar and Real Long·Term
Interest Rate Differential*
1980·1982 Avg.
Percent

=100

5

140

130

Real Long-Term Interest
Rate Differential"

120

1\,'

"

1\1

110

I:

\

\

\

.'. ~

,

'v' \.. ../

Percent
of GNP

1972 $
billions

2.------------

60 .-----:-:-:---:-::-----c-------=-::--:---:-,
High Employment Deficit,..---

,'\ ,,"""""
,\

~

,,, .. ~
\

Chart 3
Real High Employment
Federal Budget Deficit
and Real Net Exports

I

3

\

...

-2

,,

\

I

,

I

" ... /

01------''''''''';::-------1

.\

100

40

4

2

--

_.. .,.,... ...

-_

20

......

Ol------------\c----j

"i;'er Major OECD Nations

-20

I

1981

.. u.s. real

1982

1983

1984

1985

-4L-_.L-_...l...-_...l-_--L._--J

1981

1982

1983

1984

1985

1981

1982

1983

1984

rate minus trade-weighted foreign real rate.

temporary, and the dollar's strength at that time
resulted mainly from higher real interest rates that
counterbalanced an expected dollar depreciation.
The economy could withstand these high real
interest rates because their depressing effect on
aggregate demand was being offset by the stimulus from the budget deficit itself, and also
because the strong dollar had not yet fully
affected net exports.
In the second stage, which we are still in, the
dollar has remained strong despite a reduction in
the differential between domestic and foreign real
long-term interest rates because of an increased
market perception that persistently large budget
deficits at home and smaller ones abroad will
generate permanently larger net capital inflows.
These larger capital inflows will necessitate a
strongerdollarto create an offsetting decline in net
exports, thereby balancing the supply and
demand for dollars. As the market's expectation of
the real value of the dollar in the future rises, the

current real value is pulled along. Also, as the
effect of the strong dollar on net exports, and
hence on overall aggregate demand, becomes
more fully felt, real interest rates must decline.
Foreign investors eventually might come to feel
relatively satiated with dollar-denominated
investments and require a substantially higher
real interest rate differential. As the perceived risk
premium for investing in dollar assets rises, the
differential in total returns (i.e., including the risk
premium) would fall, thus tending to weaken the
real value of the dollar and raise U.S. real interest
rates. Such a development would constitute yet a
third stage in the economy's adjustment to persistently large U.S. budget deficits. However, current indications are that this stage is at least
several years off. In the meantime, there is good
reason to believe that the dollar will remain
strong despite substantially reduced levels ofreal
interest rates.

Adrian W. Throop

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (- )
Borrowings
Net free reserves (+ )/Net borrowed( -)

Amount
Outstanding

Change
from

02/27/85

02/20/85

188,322
170,622
52,760
62,252
32,716
5,275
10,584
7,076
192,331
43,689
28,851
12,755
135,886

145
578
311
20
174
6
- 426
7
-2,291
-2,335
625
168
211

43,783
39,173
21,049

-

Change from

02/29/84
Dollar

5.9
8.2
12.3
4.3
21.0
5.3
- 13.4
- 10.7
3.4
1.2
.5
6.0
4.7

69

3,410

8.4

207
1,094

1,012
737

2.6
3.6

-

Period ended

Period ended

02/25/85

02/11/85

111
84
27

31
21
10

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
1

2

Percentl

10,517
13,011
5,805
2,598
5,683
268
1,635
855
6,298
526
153
732
6,097