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February 11, 1983

Exchange Rate Indicators
An unwelcome effect of recent financial
innovations has been to complicate greatly
the interpretation of the traditional monetary
aggregates, M 1 and M2, by blurring the
distinction between checking and savings
accounts. Very likely, these changes have
altered relations between the aggregatesand
the spending, interest rate, and inflation
goals of monetary policy, although by how
much and for how long is quite uncertain. As
a result, authorities are in danger of "flying
blind" over the coming year in setting
money growth targets they cannot be confident will have the same economic effects
they once had.
Naturally, the search has intensified for
alternative measures to help steer monetary
policy. Along with conventional suggestions
-the monetary base, norninal and real
(somehow measured) interest rates-has
come a more novel proposal: to use the
foreign exchange value of the dollar as a
guide to policy. But what guidance could
exchange rates provide that could not be
furnished by purely domestic indicators?

Indicators
The most likely way exchange rates might
be useful in guiding monetary policy is by
serving as indicators of the economic conditions with which policy is concerned.
Exchange rates are affected by certain
domestic economic factors such as real
interest rates and expected inflation that are
not directly measurable, or only imperfectly
so. Thus, movements in exchanges rates
provide "clues," or information, about these
variables that, when used with other available data, may be helpful in the formulation
of policy.
Foreign exchange rates are apt to be most
helpful in interpreting changes in domestic
interest rates, particularly longer-term rates.
Any nominal interest rate is the sum of two
parts: an inflation "premium" (equal to the

inflation anticipated over the life of the
investment) wh ich compensates for the
erosion of the purchasing power of the
principal; and the "real" rate, which is
effectively the amount of additional purchasing power the investor obtains. Both
variables are plainly of concern to policymakers but for different reasons. The real,
rather than the nominal, interest rate most
directly influences real spending and hence
is an indicator of monetary policy's influence on economic activity. The inflation
premium measures the public's anticipation
of future price increases and, thus, is a gauge
of the credibility of the authorities' commitment to contain inflation.
Still, authorities can know only nominal
interest rates with any certainty, since these,
and not their real or expected inflation components, are quoted in financial markets.
There is therefore no way to determine
directly when interest rates vary whether it is
the real rate, or expected inflation, or both
that has changed.
This problem is probably not so serious for
short-term interest rates, since inflation
anticipated over the near-term can often be
gauged from recent inflation trends. Interpreting movements in longer-term interest
rates is much more difficult because inflation expected over the next several years
depends critically upon perceptions of the
future course of monetary policy, which
may not be related in any obvious way to
past developments. However, the longerterm variations in real interest and expected
inflation rates are likely to have the greater
influence on economic decisions, and are
thus generally of greater concern to
policymakers.
Recent experience graphically illustrates the
acute dilemma authorities can face as a
result of this ambiguity. U.S. medium and
long-term interest rates rose by nearly 4

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percentage points from mid-1 980 through
1 981 , yet there was virtually no consensus
among observers as to why. Some argued
that the trend mainly reflected an increase in
real interest rates due to the substantial
slowing of growth in the measured money
aggregates. Others asserted that rising
interest rates reflected increases in expected
future inflation due to fears that prospectivel,' enormous government budget deficits
would lead to higher future money growth.
So, according to the first explanation the
Federal Reserve could lower interest rates by
raising money growth to bring down real
rates; while according to the second it
should slow money growth to calm inflation
concerns (or, perhaps, persuade the administration to reduce the deficit.)

In short, a real increase in U.S. interest rates
relative to abroad raises the spot dollar,
while a rise in our expected inflation lowers
the dollar's forward value (Chart 1). This
reasoning can be applied in reverse. A rise in
U. S. interest rates that is accompanied by a
rise in the spot value of the dollar (relative to
PPP) can' be viewed as an indication that
U.S. longer-term real interest rates have
risen. Alternatively, if interest rates here rise,
while the forward value of the dollar
declines, there is reason to suspect that
long-term expected
inflation has gone
up. ( Of course, a rise in nominal rates could
reflect an increase in both expected inflation
and the real interest rates, and thus could be
accompanied by a spot rate increase and a
forward rate decline).

u.s.

Exchangerate signals
Exchange rates can help in interpreting such
interest rate movements mainly because real
interest rates and expected inflation affect
them quite differently-indeed
in opposite
directions. Ultimately, the dollar's foreign
exchange value must move to keep the
prices of U.S. and foreign products in world
markets at the "competitive" level dictated
by their demands and supplies. In the longrun, then, the dollar's value will vary with
the domestic level of U.S. prices compared
to those abroad-its "purchasing power
parity" (PPP) value-and the competitiveness of U.s. goods.

Viewed in this way, foreign exchange
markets did provide significant "clues" as
to the cause of our interest rate increases in
1 980 and 1 981 . During this period, the
dollar's spot value rose above its PPP level to
an unprecedented degree, while the fiveyear forward value also increased (Chart 2).
This pattern suggests that U.S. real interest
rates increased substantially over this
period, while our expected inflation would
appear to have fallen, at least relative to
expected inflation abroad.
Exchange rates might also have served as an
early warning of impending inflation during
1 976 and early 1 977. Although money
growth accelerated significantly then, interest rates actually fell slightly, while the
ensuing inflation (in consumer prices) did
not become evident until 1 978. However,
the forward (and spot) value of the dollar did
begin to decline rapidly by the end of 1 976,
a trend that, in retrospect, wasa signal of the
inflationary pressures that were building up.

In this way, increases in our expected inflation tend mainly to lower the forward value
of the dollar, reflecting the market's perception of its future level. In the short-run,
though, the dollar may be,pushed away from
its PPP value by real interest fluctuations
(relative to those abroad), arising from
temporary fluctuations in credit markets,
that attract or repel international capital
from our shore. Increases in U.s. real interest
rates, then, tend to raise the spot value of the
dollar, both absolutely and relative to its PPP
level. But, given the temporary nature of
such fluctuations, real interest rates tend to

Caution
Still, the signals provided by exchange rate
indicators are farirom unambiguous. After

2

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1974 197$ 1976 1971 1916 1m

1960 1961 1982 1963

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index: foreign wholesalepricesto U.s.
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**Trade-weighted value of the u.s. ollar in termsof the
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currencies 9f 15 trading pMners.

*Spot and 5-yeiJrforward ratesare DM/$. The interestrate
is the S-year Eurodollarrilte.

1981 were signaling a rise in our real interest
rates only because the dollar was much
further above its PPPlevel than it had been
in recent experience. Again, not every
movement in exchange .rates is fraught with
significance.

all, the foreign exchange value of the dollar
reflects conditions abroad, as well as those
in the U.S. The implications of exchange
rate trends thus can easily be misread unless
foreign conditions are taken into account.

u.s.

Forexample, although
interest rates fell
considerably during 1982, the dollar has
remained remarkably strong. Viewed alone,
this pattern might suggest a substantial drop
in our expected inflation, but little if any
drop in our real interest rates. However,
foreign interest rates also fell sharply during
this period, in some cases by nearly as much
as our own. The Swiss five-year rate, for
example, declined by nearly S percentage
points last year. Moreover, recent inflation
trends in Switzerland do not point to any
dramatic improvement in its longer-term
inflation outlook, suggesting that Swiss real
interest rates have fallen sharply. If so, then
real interest rates must also have declined considerably, for otherwise the dollar
would have soared much further against the
Swiss franc last year.

Still useful
Nonetheless, these ambiguities (which
are shared to some degree by nearly all
economic indicators) mean'simply that
exchange rate indicators must be used with
considerable care; they do not render them
useless as guides to policy. At the least,
though, authorities will have to evaluate
current and prospective economic conditions abroad, as well as factors that might
have altered the international competitiveness of U.S. products, in interpreting
exchange rate movements. Clearly, these
signals will be easiest to read when foreign
economic conditions are relatively stable,
and very difficult to interpret when they are
highly volatile.

u.s.

More important, though, exchange rates are
only one source of information available to
authorities, so policy must be guided as well
by the signals from domestic indicators such
as the money-aggregates, real growth, and
inflation trends. Exchange rates are best
viewed as supplements to the conventional
measures that have guided policy in the
past. And, possibly, once the adjustment to
financial innovations is complete, the
money aggregates (perhaps revised) may
once again provide a reasonably clear indication of the economy's direction, reducing
the need to rely on the exchange rate or
other less conventional indicators. Still, as
past experience has shown, exchange rates
are likely to continue to be useful to policy
makers, if only as "alarms" signaling that
public perceptions about the ultimate
courSe of policy may be diverging dangerously from official intentions.

This experience also suggeststhat exchange
rate trends generally will provide the
clearest indicators of U.S. conditions when
foreign conditions are most stable and predictable. Thus, movements in the dollar
versus the Swiss franc, given Switzerland's
comparatively stable inflation record, are
apt to be more informative to our own
policymakers than the dollar's fluctuations
against currencies issued by nations with
less enviable performances.
Similarly, many factors can alter the longrun competitiveness of the U.S. dollar,
causing it to deviate persistently from PPP.
Not all departures from PPP,therefore,
mean that real interest rates have changed.
In fact, there is substantial evidence to
suggestthat real interest rates varied little
prior to 1979, so that departures from PPP
mainly reflected shifts in competitiveness.
We could be confident that exchange rate
trends during the last half of 1 980 and during

CharlesPigott

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BANKINGDATA-TWELFTH
FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)

Selected
Assets liabilities
and
LargeCommercialBanks
Loans
(gross,
adjusted) investments*"
and
Loans(gr05s,
adjusted)- total#
Commercial industrial
and
Realestate
loans to individuals
Securities
loans
U.S.Treasury
securities'"
Othersecurities*"
Demand
deposits total#
Demand
deposits adjusted
Savings
deposits- total
Timedeposits total#
Individuals,
part.& corp.
(largenegotiable
CD's)
WeeklyAverages

of DailyFigures
MemberBankReserve
Position
Excess
Reserves )jDeficiency(-)
(+
Borrowings
Net freereserves+ )jNet borrowed(
(
-)

1jI1ill'@C[JI

Amount
Outstanding
1/26/83

163,582
142,496
45,106
57,368
23,841
2,754
7,561
13,525
37,668
27,092
57,518
77,385
68,391
26,317
Weekended
1/26/83
163
4

'159

Changefrom
Change
from
year ago
Dollar
Percent
1/19/83
- 26
6,368
4.0
6,770
5.0
- 31
- 229
3,473
83
991
1.8
- 55
49
252
1.1
836
44.0
299
1,385
22.4
116
91
- 1,787 - 11.7
-2,553
787
2.0
- 836
406
- 15
1,504
27,193
89.7
- 13,837
- 15.2
-1,810
-1,630
- 13,809
- 16.8
- 534
- 10,060
- 2.9
Comparable
Weekended
period
1/19/83

67

198

o

198

171

-

104

* Excludes
tradingaccount
securities.
# Includesitemsnotshownseparately.
Editorial
comments beaddressedtheeditor(Gregory
may
to
Tong) to theauthor. ... Free
or
copies this
of
andother Federal
Reserve
publications beobtained callingor writing thePublic
can
by
Infonnation
Section,
federalReserve
Bank Sanfrancisco,
of
P.O.Box7702,SanFrancisco
94120.
Phone
(415)