The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Percent October 1979 14 12 ,10 reflect Ot' oi the Fioi1rd (II inti', i the Covernors i'ip'l;vsleH er do not of ifH' t 4 of thp Federal related, as we can see (Chart 1) from comparing current stock and bond yields. (Seeour Weekly Letter of June 5,1 981 .) The stock yield, because it need not incorporate an explicit inflation premi"um, is in effect a real rate of return. And the real returns on stocks and bonds, while certainly not identical, have historically moved together over the business cycle. Thus the unusual stability in the stock yield for the past four years provides strong, if indirect, evidence of the stability of the non-inflation component of the bond yield. money supply and inflation on the basis of announced money targets, they would have been too low because the Federal Reserve overshot some of its targets in each of these years. But investors wou Id have been about right if they had forecast money growth on the basis of growth in the national debt, because the two series have almost always moved together. Wall Streeters see the Reagan budget program as implying rapid growth in the national debt for the next four years, and so they forecast rapid growth in money and inflation. They are not convinced by the fact that the (M-1 B) money supply has fallen below target so far this year, because it did the same in the comparable period of 1 980 and yet overshot the top of its target range for the year as a whole. Inflation will affect the bond yield not only because of a rise in inflation expectations, but also because of a rise in inflation risk, which is related to the degree of uncertainty with which future inflation premiums are incorporated into the bond yield. If inflation expectations turn out to be too low (a common problem in the last ten years), then the investor runs the risk of suffering a loss on his bond investments. This risk is one-sided if inflation is less than expected and the bond can be "called" back by the corporation. Because high rates of inflation are associated with variable inflation, inflation premiums and inflation risks have tended to move together. The recent rise in long-term bond yields may be more than proportional to the rise in inflation expectations, because bond purchasers face additional risks if their inflation forecast turns out to be too low. On the other side of the market, large corporate borrowers may be reluctant without a "call provision" to pay an interest rate which includes an inflation premium largerthan the expected rate of inflation. Moreover, bond dealers may find the cost of holding inventories excessively risky, so thatthe bond market becomes thinner and more volatile in the wake of any reduction of inventories. Indeed, as a result of high bond rates and a thin bond market, many corporate borrowers have (at least temporarily) shifted to the short-term end of the market, especially to bank loans. One can only speculate about the reasons for the major rise in inflation expectations and risk in the last two years. Certainly the actual rate of inflation has not risen dramaticallyjust the reverse. As measured by the consumer-price index, the inflation rate declined from 13.3 percent in 1 979 to 1 2.4 percent in 1 980, and then to an 8.5-percent annual rate in the first half of 1 981 . However, the inflation-induced rise in bond yields may reflect a perceived lack of Federal Reserve "credibility" with respect to achieving longrun money-growth targets. (See our Weekly Letter of June 5, 1981 .) Bank loans and short-term rates Over the last 15 years, bank loans have averaged 22 percent of total funds raised by corporations. However, the proportion has varied considerably over time, because many corporations consider banks as their residual source of funds. Yet unlike other suppliers of shorter-term funds, banks have the unique ability to increase the money supply because they increase deposits, at least temporarily, as they service loans. This factor has had Investors seem to forecast future inflation on the basis of what they expect to happen in the future growth of the money supply. If, over the past four years, investors had forecast the 2 Pre ·June October 1979 Percent Chart 2 Percent Percent October 1979 10 92 60 6 100 94 8 90 40 2 0 0 -2 -20 -4 6 88 20 -40 86 4 2 0 -2 -60 -6 -4 -80 *Detrended 3-month bill rate **Ratio, deviation from mean ----------------_ •.•... _--------------_._----------------_._._----------------_.--_ .... , _._------_.-_.--, "- --,- ..,----... return for buying dollar assets, and therefore no capital inflow to affect exchange rates. Since October 1979, much of the movement in the dollar's exchange value C<;in be explained by the unusual variation in U.s. real short-term interest rates (see Chart 3). different consequences before and after the October 1 979 shift in Federal Reserve operating procedures (see chart 2). Prior to October 1979, the Federal Reserve tried to keep the Fed funds rate within a narrow target range, so that an unexpected increase in bank loans, deposits and the money supply would be accommodated by an increase in bank reserves. This accommodation meant that short-term interest rates could not respond quickly to changes in bank loans. However, the resulting increase in money would eventually stimulate the economy, and raise interest rates after a year or so. Summary: policy dilemma In summary, tour factors help explain the phenomenon of a weak bond market and a strong dollar. First, long-run inflation expectations are not based on Federal Reserve money-supply targets, but rather on an expected growth rate of the national debt. Second, market participants widely expect thatthe national debt will increase, leadingto future increases in the money supply. The resulting rise in long-run inflation expectations and inflation risks reduces the viability of the bond market as a source of long-term funds, and increases the share of funds raised in the form of bank loans. Third, banks provide a unique link between credit and money markets, because an increase in bank loans induces increases in deposits and the money supply. The Fed must resist this credit-induced increase in money if it is to stay within its long-run money targets. Fourth, the resulting rise in real short-term interest rates leads to a temporary rise in the value of the dollar in the foreign-exchange market. After October 1979, the Fed has focused instead on short-run control of bank reserves, so that an increase in bank loans and deposits would not be accommodated to the same extent as before by an increase in bank reserves. Interest rates thus have moved immediately to equate the supply and demand for bank loans, with the size of that response depending upon the strength of corporate preference to meet their short-run needs from banks. If corporations see substantial advantages to the use of bank loans, then a relatively large increase in rates will be needed to discourage them from borrowing. Consequently, Federal Reserve attempts to control money via bank reserves will lead to a rather sharp movement in short-term rates when corporations decide (for whatever reason) to increase the share of funds raised in the form of bank loans. When will interest rates come down? The pressure will be relieved when the market begins to forecast money growth and inflation on the basis of the Fed's targets, or alternatively when the market sees a reduction in the size of the government deficit. That eventuality would reduce inflation expectations, and would revive the bond market as a viable source of long-term financing. The resulting reduction in corporate demand for bank loans would then make it possible for the Fed to hit its moneysupply targets without involving such high short-term interest rates. Exchangerates and interest rates A rise in the real interest rate, and not in the nominal interest rate, affects the exchange value of the dollar (see the Weekly Letter of September 12, 1980). Only a rise in real interest rates induces foreigners to purchase more dollar-denominated assets. If the rise in rates is due to inflation expectations, there is no higher real rate of Michael W. Keran 3