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June 1 ,1 984
Factors Influencing long-Term Interest Rates
Since February 1984, long-term interest
rates have started to rise again. Twenty-year
government bond rates, for example, have
climbed by almost 2 percentage points to
13-1/2 percent in mid-May. Short-term interest rates have also increased, but at a much
slower pace-ninety-day
Treasury bill rates
rose by about 1 percentage pointto just over
10 percent in the same period (Chart 1).
While some of this difference may be associated with special factors-such as a temporary decline in the Treasury bill auction- it
suggests that the major force now drivi ng
rates up are long-term considerations.
How long-term interest rates will behave
during the rest of the year is uncertain as
there is considerable disagreement among
financial analysts. Henry Kaufman of
Salomon Brothers currently forecasts that
long-term Treasury bill rates will approach
15 percent by early next year, while Richard
Hoey of A. G. Becker Paribas forecasts that
rates will drop below 12 percent by this
summer. The reason for this diversity of
opinions is that different analysts assign
different weights to each of the various
influences on those rates.
Long-term interest rates are determined in
financial markets that are basically "forward
looking" in the senselhat they incorporate
expectations
about future inflation and other
influences on the supply and demand for
credit over the life of the long-term investment. Experience over the last decade
suggests that three factors, in particular,
have had a major impact on changes in
long-term interest rates: (1)the inflation rate,
which determines the real purchasing
power value of the security at maturity;
(2) the state of the business cycle, which
determines the strength of private credit
demands (the stronger the economy, the
greater the private demands for credit and
the higher the interest rate); and (3) budget
deficits, which determine the government's
demand for credit. (The supply of cred it from
household and corporate savings is also an
important factor in the level of interest rates.
However, the private savings rate has
been remarkably stable for many decades,
and therefore does not appear to be an
important influence on changesin longterm interest rates.)
Inflation expectations
There is a strong tendency for long-term
interest rates to rise and fall with movements
in the actual inflation rate (Chart 2) because
expectations of future inflation are strongly
influenced by experience with actual inflation. Has an increase in inflation expectations been a majorfactor behind the recent
rise in long-term interest rates?
Most forecasters expect inflation in 1 984 to
hover around.5-1/2 percent, up from the
3-1/2 percent experienced in 1983.
Furthermore, there is a general view that
inflation will be higher still in 1985, with the
consensus estimate being about 7 percent.
This suggests that part of the recent rise in
interest rates is related to a rise in inflation
expectations. That is, the financial markets
bel ieve these inflation forecasts for 1 984-85.
5uch a method for evaluating long-term
rates is probably not appropriate, however.
It is not inflation for the next 18 months that
dominates the long-term outlook, but inflation expectations over the next five to ten
years. One of the most authoritative
measures of the financial markets' views of
inflation expectations for that time frame is
prepared byMr. Richard Hoey. Accordingto
his surveys, sophisticated financial executives currently expect inflation to be 6-3/4
percent over the next ten years and these
expectations have not varied more than 1/4
percent from th is value for almost two years.
As long as the actual rate of inflation is equal
to or less than the expected 1O-year inflation
rate, it is unlikely that long-run inflation
Opinions expres::>ed in this new:;letter do not
necessarih ...reflect the
of tht, management
of t;'leh.o.d'f','alResi:::'l"veBank of San
or of the Board of Covernors of thp -Federal
Reserve Svstern.
Those forecasters who saw the first quarter
strength as a temporary response to a surge
in inventories and who expect the economy
to weaken considerably in the remainder of
1 984 are forecasting lower long-term interest rates. They expect slower growth in
private demands forcreditthan that currentIy built into long-term interest rates. How
much the rates would decline depends on
how much one thought the recent rise in
rates was the result of the upward revision in
the business cycle forecast. However, the
maximum decline in rates from this factor
would seem only to put long-term Treasury
bonds at 12 percent at the end of the year,
that is, back at their mid-February level.
expectations have been rising. Thus, inflation factors alone suggest that long-term
interest rates should be stable.
Business cycle revisions
Long-term interest rates at any time
incorporate some forecast of the business
cycle and therefore of private demands for
credit over the next few years. Only when
there is an upward revision in the forecast of
business cycle expansion, and consequently
a revision in the forecast of private demands
for credit, would there be an increase in
long-term interest rates.
The timing of the rise in the long-term rates
in 1 983-84 suggests that it was related to
upward revisions in the forecast of the
business cycle. For example, the rise in longterm Treasury bonds from 1 0-1 /2 percentto
12 percent between May and August 1 983
paralleled the release of economic statistics
that started to show a recovery in real G N P
that was much stronger than what had
previously been expected. Forexample, real
G N P growth for the second quarter of 1983
was revised upward from a May flash report
of 6.5 percent to the August report of 9.3
percent. This contributed to an upward
revision in the forecast for 1983 as a whole
from a below-average 3.4 percent to an
average 6 percent-plus growth for the first
year of the business cycle expansion. It also
caused an upward revision of the level of
GN P forecasted for subsequent years.
The resulting increase in the forecast of
future private credit demands led to a rise
in long-term interest rates.
Budget deficits
The expectations of greater budget deficits
over the next ten years will raise long-term
interest rates because they imply an increase
in the government's demand for credit over
that period. Thus, the major impact on longterm interest rates of the approximately
$200 billion in structural budget deficits that
first materialized in 1983 actually occurred
earlier- in 1981 when the legislation
responsible for those deficits was enacted.
In other words, the expectation of deficits,
not their actual occurrence, caused longterm interest rates to rise.
As indicated in Chart 2, long-term interest
rates rose substantially in 1981 despite a
declining inflation rate and the start of a
business cycle recession. (A period of tight
monetary policy started in late 1979.
However, the liquidity effects of tight money
on long-term interest rates are not considered sufficiently large to explain a significant
increase in rates.) Treasury bonds rose from
12 percent in January to 13.5 percent in June
and 15.5 percent in September 1 981 -the
highest in this century.
Rates were stable between August 1983
and January 1 984 as real GN P moved
closely in line with market expectations.
Then, in February and March, there was
another spurt in theeconomic statistics, with
the first quarter estimates of GN Pmuch
stronger than previously expected. This led
to a further upward revision in estimates
both of the strength of the business cycle and
of private credit demands down the road.
With government spending promising to rise
at the same rate in the four years of the
Reagan administration as in the Carter
administration, and with a major cut in tax
rates, it became clear to financial markets
2
percent as forecast by Mr. Kaufman of
Salomon Brothers probably depends upon
whether the markets expect any legislative
action on deficits next year, that is, 1985.
If Congress can take the minimal actions this
year to keep future deficits from rising above
$200 billion, it probably would bring
long-term government bond rates back to
their mid-April level of 12.5 percent from
their mid-May level of 13.5 percent. Only a
major cut in deficits below the $200 billion
level could lead to a substantial fall in
long-term interest rates.
during 1981 that future government deficits
would be substantially higher than they had
expected. Most forecasts were. for deficits
about $200 billion per year. The historic
peak in long-term interest rates at 15-1/2
percent in September 1981 came just seven
weeks after the largesttax cut in U.S. history
became law. By the same token, about one
percentage p Ointofthefall in long-term interest rates in 1982 occurred in the week following the tax increase in August of that year.
There have been no substantial legislative
moves to deal with the deficit since August
1982. Thus, until recently, financial markets
embedded in long-term interest rates
expectations of budget deficits close to $200
billion in each of the nextten years.
Now independent budget analysts estimate
that if no action whatsoever is taken by
Congress and the Administration, deficits
would grow to $300 billion by the year
1990. One could interpret the rise in longterm interest rates in April and early Mayas
market concerns that even the minimal
action necessary to keep this from
happening will probably not materialize.
Conclusion
The wide diversity of financial analysts'
forecasts about the course of interest rates in
1984 means that the analysts give different
weights to the likely outcome of the inflation, business cycle, and deficit factors
discussed above. Those who expect interest
rates to come down tend to emphasize that
there will be a substantial weakening in
business cycle demands for credit and that
Congress and the Administration wi II take at
least minimal action to keep future deficits
from rising above current levels. Those who
forecast interest rates to rise substantially
from current levels either consider that the
business cycle expansion will be stronger
than usual or that fiscal actions will not be
taken to prevent deficits from rising in the
future. Changes in long-term inflation expectations do not seem to be a major factor
in the current rise of long-term interest rates.
The conventional political wisdom is that if
no legislative action is taken to cut deficits
before the summer recess, Congress will
take no action at all in this election year.
If the financial markets become concerned
about this, long-term interest rates would
probably rise further this year. Whether
long-term government bonds rise to 15
Michael Keran
Chart 1
Long- and Short-Term Interest Rates
(Weekly)
Pa,,,onl
Chart 2
Long-Term Rates and Inflation
POfcenl
14.0
13.5
11.0
13.0
(Quarterly)
11.5
1o.s
h.".nl
16
14
12.5
.....30·Yaar Trea.sury Bond ',..,....,.
...
,
..........
12.0
11.5
,,'
12
10
10.0
1 .....
• .... • ..
8
9.5
6
........... " 3·Month Treasury Bills ..
.........
11.0 '-::::JAN
9.0
...... : : : ...... _
FEB
_
MAR
' --
....
".
...
.......
",
""
.."
• .....
......... Consumer
'" ·u.
Inflatlon'
8.5
: ......
APR
\
1976
MAY
1984
1978
1980
'Per"enl change COver yo., oarll.r
one
3
1982
'.'
1984:1
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\llJ;»
BANKING DATA-TWELfTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsand liabilities
large Commercial Banks
Loans,Leases Investments 2
and
1
loans and Leases 6
1
Commercial and Industrial
Real estate
Loansto Individuals
Leases
U.S. Treasury and Agency Securities2
2
Other Securities
TotalDeposits
Demand Deposits
Demand Deposits Adjusted 3
4
Other Transaction
Balances
6
Total
Balances
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
WeeklyAverages
of Daily Figures
Reserve
Position,All ReportingBanks
Excess Reserves (+ )/Deficiency (- l
Borrowings
Net free reserves (+ l/Net borrowed{ -)
Amount
Outstanding
5/16/84
180.187
160,639
48,520
59,834
28,017
5,019
12,000
7,548
187,914
45,410
29,316
12,131
130,374
Change
from 12/28/83
Percent
Change
from
5/09/84
496
652
99
114
111
6
- 106
50
2,574
2,358
289
- 165
382
Dollar
-
4,162
5,284
2,557
935
1,366
44
507
615
3,083
3,827
2,015
644
1,389
39,337
-
33
-
260
39,027
18,675
275
-3,717
-
862
4,332
Annualized
-
-
-
6.1
8.8
14.4
4.1
13.3
2.2
10.5
19.5
4.1
20.2
16.7
13.1
2.7
1.7
5.8
- 48.9
Weekended
05/07/84
04/23/84
89
32
120
102
236
33
Includes loss reserves, unearned income, excludes Interbank loans
Excludes trading account securities
Excludes U.s. government and depository institution deposits and cash items
ATS, N OW, Super N OW and savings accounts with telephone transfers
5 Includes borrowing via FRS, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
Editorialcomments
maybeaddressed theeditor(Gregory
to
Tong) to the author.... Free
or
copies
of
FederalReserve
publicationscanbeobtainedfrom the PublicInformationSection,Federal
Reserve
Bankof SanFrancisco,
Box7702,SanFrancisco
94120.Phone
(415)974M2246.
@(QJ
