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October 1979



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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

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

Pre ·June
October 1979


Chart 2


October 1979
























*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
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

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