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O cto b e r 29,1976 Forecasting Interest Rates The textbook theory of money and banking tells us that the Federal Reserve controls the supply of re serves to the banking system and that the Fed may, if it wishes, influ ence the price of these reserves (the Fed funds rate) by changing the reserve supply. If, for example, the Fed injects large additional quantities of reserves into the bank ing system, reserves will be more readily available and the Fed funds rate will come down. For several reasons, interpreting real-world changes in the Fed funds rate by means of the simple text book relationship can be a treach erous endeavor. In particular, the funds rate in the real-world is set in a dynamic environment rather than in a static textbook environment. Within this dynamic environment, both sides of the market are con cerned not just with the present funds rate, but with future interest rates as well. Interest-rate forecasts play an essential role in describing the market for bank reserves, be cause these forecasts can help de termine the behavior both of mem ber banks and of the Federal Re serve itself. Banker’s problem From a banker's point of view, guessing the future path of interest rates is more important than look ing at the present rate. A high pres ent interest rate, even an unexpect edly high rate, is water over the ' dam. The banker's success or failure depends upon his ability to judge the future path of interest rates and to act upon his judgment. In evaluating the future course of interest rates, the banker must be gin by forecasting the path of the economy, including such key vari ables as GNP and inflation, and by judging the impact of these vari ables upon the demand for bank loans and other assets. Going fur ther, he must use this information to form a judgment about the likely response of monetary policy to changes in economic variables. While there is an immense body of literature on forecasting GNP and inflation, and any number of eco nomic consultants available to help in this enterprise, the prediction of the Fed’s response to the economy, in contrast, depends upon a variety of imponderables, such as the abili ty of policymakers to reach their long-run and short-run goals in the current financial and political milieu. In this world of great uncertainty, therefore, the banker must occa sionally grasp at straws. If the funds rate should rise, for example, the banker may form the opinion that this rising trend of rates will con tinue. And if, as has often hap pened, the banker decides in this case to treat the new higher level of rates as though it represented a bargain price for cash—with even (continued on page 2) 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. higher rates yet to come—he may then increase his demand for re serves. This may lead to a turn of events unknown in the money and banking texts. An increase in inter est rates may spawn an expansion in the bank's short-run demand for new cash and, if the expectation of rising rates is shared by the banker's customers, a rise in the demand for bank loans as well. Hazards of forecasting Several recent historical episodes illustrate the effects of these interest-rate forecasts. Few econo mists thought at the time that the high interest rates of mid-1974 would be consistent with the rapid growth in loan demand of that same period. Quite possibly, the loan demand of early 1974 reflected hedging by bank customers, as they stocked up on loans to avoid the higher rates they expected in the last half of the year. By the same token, many economists would have forecast stronger credit de mand in the ensuing two years, as interest rates tumbled to recession ary lows. These episodes suggest a certain pattern of errors in business fore 2 casts of interest rates. If interest rates initially are lower than expect ed, they may remain lower than expected for a considerable period. But when rates start back up again, the effect on market psychology may be sufficient to drive them even higher. Weekly changes in the money sup ply increasingly have come to dom inate the average banker's forecasts of future levels of the funds rate. An unexpected increase in the money supply, for example, inspires an increase in the demand for bank reserves, as bankers persuade themselves that the Fed will tighten policy to keep money-supply growth in check. However, this increase in demand itself works to put upward pressure upon the funds rate, quite apart from any Federal Reserve restrictiveness. In deed, to offset this upward pressure on rates, the Fed may expand the supply of reserves as interest rates move upward. This behavior leads not to a decline in the funds rate, as the textbooks indicate, but rather to a perverse combination of in creasing reserves and money growth along with a rising funds rate. Fed’s problem The dynamics of banker response to changing interest rates creates problems for the Fed as well as for the banking system. The Fed would like to use its supply of reserve assets to influence the economy in a predictable way, through such key transmission mechanisms as the cost of business capital goods and the supply of credit to bank bor rowers. But the central bank’s deci sion to allow interest rates to drift upward may produce any one of a host of possible bank responses, depending upon what the average banker thinks will happen in the future. Financial markets react so dramati cally to changes in interest rates in part because market makers regard such changes as the key indicator of the Fed’s intentions. If bankers did not respond so dramatically to changes in rates, the Fed’s larger role in influencing the pace of eco nomic activity might be easier. In that case, bankers possibly would be less likely to expect each in crease in interest rates to be fol lowed by further increases. Kurt Dew Copies are now available of the summer issue of the Federal Reserve Bank of San Francisco's E c o n o m i c R e v ie w . Under the theme of “ Financial Markets and Uncertainty/' the issue contains analyses of variable-rate home mortgages, the impact of inflation on capital-market efficiency, debt-equity ratios in financial markets, and the shifting relationship of money demand and GNP. This publica tion is designed for financial analysts, college students and teachers. For those not on the mailing list, copies may be obtained from the Public Information Section, Federal Reserve Bank of San Francisco, P.O . Box 7702, San Francisco 94120. 3 u o ;8 u | i | S E / v \ • q e m • u o S s j o • e p e a o n MEM EH . E IU J O p |E 3 • EUOZUV • '1 IIB 3 'O D SI3U EJ-J U BC ZSL ON HWM3d aivd 3D V lSO d s n 1IVW SSV1D ±SdlJ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding 10/13/76 Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities O ther securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Government deposits Time deposits—total* States and political subdivisions Savings deposits O ther time deposits! Large negotiable C D ’s 89,596 68,465 1,574 22,186 20,848 11,530 8,640 12,491 90,938 26,732 310 62,334 5,089 27,956 26,885 11,052 Weekly Averages of Daily Figures W eek ended 10/13/76 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 (-) Change from 10/06/76 - + + - + - + - + - - + 18 0 18 + 3,508 3,210 3,000 156 62 11 193 105 15 554 158 35 65 128 33 56 Change from year ago Dollar Percent + 2,265 + 3,006 247 801 + 1,213 + 1,250 224 517 + 3,319 + 2,009 35 + 1,619 707 + 6,713 3,116 - 4,852 W eek ended 10/06/76 + 2.59 + 4.59 13.56 3.48 + 6.18 + 12.16 2.53 3.97 + 3.79 + 8.13 10.14 + 2.67 12.20 + 31.60 10.39 - 30.51 Comparable year-ago period + 68 0 68 + 40 2 38 424 - 290 + 848 + 1,164 + 752 + 665 ’ Includes items not shown separately, in d iv id u a ls , partnerships and corporations. Editorial comments may be addressed to the editor (William Burke) or to the author. . . . 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) 544-2184. Digitized for F R A S E R . ogEpi B >jSB|V
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