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April 11,1975 D @© Defied Doldram s )@ jp ir m When the President sent his fiscal 1976 budget message to Congress in January with a $52-billion deficit attached, his message sent small shock waves through the financial community. Now, with the passage of a major tax-cut bill and the pro spective passage of major spending programs, most analysts are think ing in terms of a $73-billion deficit (the House Budget Committee's target) or even of a $100-billion deficit— a startling prospect, when we realize that the entire Federal budget didn't reach $100 billion until the early 1960's. All this, of course, comes on top of a fiscal 1975 deficit which last fall was estimated at about $9 billion but which is now likely to total $45 billion or more. Deficits of this magnitude, aside from creating the specter of future inflation, raise the immediate question of whether private financial markets can ac commodate such demands without severe upward pressures on interest rates. All Federal expenditures in excess of tax receipts must be financed in securities markets, competing with the private sector for the avail able pool of funds. The debt mar kets respond like other markets to the vicissitudes of supply and de mand. Because interest rates vary inversely with securities prices, the larger the supply of Treasury debt coming to market the lower will be the price and the higher the inter est rate if all the securities are to be sold— unless debt issued by other borrowers contracts, or bank funds available for investment expand. 1 Digitized for FRA SER Thus an increased supply of new marketable debt by any sector should place upward pressure on interest rates, short-lived as that pressure may be. Consider the supply situation of the past half-decade. During this period, the Treasury has played a much larger role than during the preceding decade. In the 1970-74 period, the Treasury raised about $13.5 billion annually in net funds in securities markets, compared with the $15.9 billion raised an nually by (domestic and foreign) nonfinancial corporations. During 1965-69, in contrast, the Treasury's annual requirements of $3.8 billion were far below corporate require ments of $11.3 billion. In addition, average net funds raised by Federal agencies, including "off-budget" agencies, have been twice as high in the last five years as in the pre ceding half-decade. Foreign acquisitions Over the past decade, especially since 1970, a sizable part of the Treasury's financing needs has been covered by foreign official institu tions. At the end of 1965, foreign official institutions held about $16.7 billion of Treasury debt. At the end of 1974, they held a whopping $58.4 billion, more than was held by all U.S. commercial banks combined. This sharp increase in debt hold ings reflected the magnitude of the dollar holdings accumulated by foreign official institutions in the course of their dollar-support operations— a dollar "overhang" created by the prolonged series of (continued on page2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. U.S. balance-of-payments deficits. In the past year, of course, reinvest ment of petrodollars by oil-export ing countries added to the total. The foreign role in financing Treasury deficits can be summarized quite simply. Between the end of 1970 and the end of 1974, privately held gross public debt rose by about $41 billion, while foreign offi cial holdings of such debt increased by $38 billion. The foreign role in absorbing large Treasury deficits thus has been.substantial in recent years, and the future course of domestic interest rates and credit flows will remain sensitive to foreign decisions on picking up new T reasury debt. Deficits, interest and prices Larger deficits do not automatically mean rising interest rates, since large deficits and falling rates have gone hand-in-hand in the several recessions since 1960. A sagging economy in itself tends to reduce rates because of lagging private credit demands, at the same time that it generates higher deficits through anticyclical stabilization policy. Also, during a recession the Federal Reserve tends to increase the monetary base (total reserves plus currency) as a part of its expan sionary monetary policy, and this too puts downward pressure on rates. Over longer periods, how ever, the average level of rates has risen with the average level of Fed eral deficits. Between the 1960-66 period and the 1967-74 period, the 2 Digitized for FRA SER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis average deficit rose from less than $1 billion to more than $9 billion annually (national-income basis), while the average three-month Treasury-bill rate rose from 3.36 percent to 5.75 percent. Other fac tors may have been involved here, but a strong correlation exists be tween rising deficits and rising in terest rates. A significant increase in long-run money-supply growth has paral leled these long-run increases in deficits and. in interest rates. (Economists who have long empha sized the relationship between large deficits and rapid monetary growth are tempted to repeat the refrain of the W. H. Auden poem, "Time will say nothing but I told you so.") The money supply (Mi) grew at a 2.9-percent average rate in the low-deficit period of 1960-66, but at a 6.2-percent average rate during the high-deficit period of 1967-74. Moreover, a significant long-run increase in the inflation rate has paralleled this long-run increase in money-supply growth, with the consumer-price index rising at a 1.6-percent average rate in the 1960-66 period but at a 5.4-percent average rate in the 1967-74 period. While money and price growth can diverge by wide margins for several years at a time, in the economist's version of the long-run, Auden's lament returns to haunt us. Sustained money growth in excess of real-output growth can only result in increased average growth of prices— and meanwhile, in creased price expectations get imbedded into interest rates. Borrowers and lenders are both aware that the real cost of a loan is its nominal interest cost less the rate of price inflation on some aggregate bundle of commodities. Hence, a lender who anticipates that prices will rise over the course of the debt contract will incor porate his price expectations in his demand for a nominal interestrate return. Similarly, a borrower will be willing to absorb these increased nominal interest costs if he shares the lender's price expec tations. The inflation premium is dependent on the length of the debt contract. Expectations of a 10-percent rate of inflation over a one-year period but a 6-percent rate of inflation over a ten-year period thus will often result in short-term interest rates exceeding long-term yields. This helps explain the "humpbacked" yield curve typical of many inflationary boom periods. Last August, for example, the average rate on three-month Treasury bills was 8.96 percent, while the average yield on Treasury bonds with ten years to maturity was 8.04 percent. Conflicting rate pressures The situation has changed drasti cally in recent months, of course, as the recession and an easier mon etary policy together have pro duced a much lower level as well as a more typical pattern of rates. But the question now facing the financial community is the effect on rates of a combined deficit of perhaps $120 billion for the two fiscal years 1975-76. The soft econ omy, reduced private demands for short-term credit (especially bank credit), and reduced price expecta tions argue for lower levels of inter est rates. However, the unparalleled Treasury demands on securities markets are expectedTo.continue into next year, at a time when the business recovery should be boost ing private credit demands and thereby putting upward pressure on rates. In addition, the behavior of the Federal Reserve will influence the level and pattern of interest rates. Large purchases of Treasury securities by the Fed, adding to bank reserves, could cushion the blow that Treasury demands will exert on the markets. Some observers suggest that if the economy remains weak, the Fed should undertake whatever rate of growth in money and credit is re quired to insure that all borrowing requirements (Federal and private) are met at stable or declining inter est rates. But this leaves unan swered the question of how much debt the Fed can safely purchase in carrying out its anti-recession func tion without at the same time con tributing to the long-term problem of inflation. Joseph Bisignano 3 Digitized for FRA SER ucnSuiqseM • i|Etn • uo§aJO • epBAaN . oqepi UBMBH • B|UJOp|B3 *l!le3 zsi • EUOZJjy • B>jSB| V '03SI3UBJJ UBS on iiWHid aivd 3DVlSOd s n 1IVW SSV1D ISiilJ BANKING DATA— TWELFTH FEDERAL RESERVE DISTRICT (D o llar amounts in m illions) Change from year ago D o llar Percent Am ount Outstanding 3/26/75 Change from 3 /19/75 Loans (gross, adjusted) and investments* Loans (gross, adjusted)— total Security loans Com m ercial and industrial Real estate Consum er instalm ent U.S. Treasury securities O ther securities Deposits (less cash items)— total* Demand deposits (adjusted) U.S. Governm ent deposits Tim e deposits— total* States and political subdivisions Savings deposits O ther tim e depositst Large negotiable CD 's 85,006 65,165 1,439 24,028 19,669 9,794 7,446 12,395 84,172 22,703 370 59,976 6,630 19,279 30,337 17,199 78 372 — 241 — 143 — 42 8 + 567 — 117 568 — 274 — 445 + 250 — 13 + 140 — 136 + 213 Weekly Averages of Daily Figures W eek ended 3/26/75 W eek ended 3/19/75 35 15 20 17 20 3 Selected Assets and Liabilities Large Commercial Banks Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( - ) Federal Funds— Seven Large Banks Interbank Federal fund transactions Net purchases ( + ) / Net sales ( - ) Transactions of U.S. security dealers Net loans ( + ) / Net borrowings ( —) + + + + + + + + — + + — + + + + + + - - 1,740 1,515 5.83 6.28 36.92 10.15 5.14 6.93 27.78 5.98 11.87 4.59 47.44 16.13 4.91 6.00 22.80 48.32 Com parable year-ago period - 2,111 715 + + + + + + + — + + — + + + + + 4,682 3,851 388 2,214 961 635 1,619 788 8,932 997 334 8,332 310 1,092 5,632 5,642 65 310 245 1,884 - 7 * Includes items not shown separately. ^Individuals, partnerships and corporations. Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 397-1137. Digitized for FRA SER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis
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