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O ctober 15,1976 Interest Rate Illusions Market watchers have commented frequently about the seeming fail ure of interest rates to display their usual cyclical behavior during the present economic recovery. Nor mally, rates turn upward several months after the cyclical trough. But on this occasion they have trended significantly downward, with the 4-6 month commercialpaper rate falling about 100 basis points (a full percentage point), and the 3-month Treasury-bill rate fall ing about 60 basis points, from the first-quarter 1975 cyclical trough. Every observer has his own favorite explanation for this phenomenon— the sluggishness of business-loan demand, the gradual nature of the recovery, the flush liquidity situa tion of both financial and nonfinan cial corporations, and so on. Yet none of these explanations contains the full story. Indeed, if we take into account the influence of infla tion, we could argue that real inter est rates have not fallen over the past year or so, but have actually risen significantly in line with nor mal cyclical behavior. Interest rate = relative price One of the basic tenets of micro economics is that consumers and business firms respond in their mar ket decisions to “ relative prices'’— the prices of individual goods rela tive to the prices of other goods— rather than to the absolute levels of specific prices. An interest rate is a relative price, but one with a special feature which varies depending on the maturity of the debt contract. In other words, an interest rate can be thought of as the relative price of exchanging money for goods at different points in time, while the typical exchange is between money and goods at a given point in time. Both borrower and lender compare the current value of exchanging money for goods with the value of such an exchange at some future time. The crucial point is this: the debt contract incorporates the fact that the rate of exchange between mon ey and goods may change through time—that is, inflation may occur. Therefore, in the case of an antic ipated rise in prices, the borrower is willing to pay a premium—and the lender will demand a premium— proportional to the rate of inflation. Borrowers and lenders thus will adjust for anticipated inflation, and market interest rates will move pro portionately. We cannot measure anticipated in flation in any exact way, but we can make some rough approximations. For example, in the short-term mar ket, the actual rate of inflation of the past twelve months can be a useful measure of the inflation rate expected over a comparable period in the future. By subtracting this inflation premium from the market interest rate, we get what can be called the real interest rate. Real vs. nominal rates When we make this adjustment, we see a substantial difference be tween the behavior of nominal (continued on page 2) Digitized for F R A S E R 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. short-term interest rates and real short-term rates. Nominal rates, de spite some fluctuations, trended sharply downward in the five quar ters following the cyclical trough of early 1975. Real rates, in contrast, rose sharply during that period, in the sense that they moved from a large minus value to a much smaller minus value. In first-quarter 1975, an 1 1 1 /2percent annual rate of growth of consumer prices greatly overshad owed a 6 V2-percent nominal commercial-paper rate, while in second-quarter 1976, a 6 -percent inflation rate narrowly exceeded a 51/2-percent commercial-paper rate. The real rate on commercial paper thus rose about 4 1/2 percentage points in the five quarters following the trough, offsetting in the process most of the sharp decline in the real rate that had occurred in the pre ceding recession. Moreover, this 41/2-percent increase amounted to more than twice the average in crease in the real rate of the four preceding cyclical recoveries. Thus, despite the decline in nominal mar ket rates, short-term lenders actual ly accrued substantial real gains over the past five quarters from the rise in the real short-term rate of interest. Real short-term rates display certain cyclical patterns, being normally higher at peaks than at troughs. In the four preceding cycles, the real commercial-paper rate ranged, on the average, from about 2 percent at the peak to less than V2 percent at the trough. In this latest cycle, how2 Digitized for F R A S E R ever, the peak rate was only about 1 percent, while the rate at the trough was a negative 5 percent. And despite the sharp rise from the trough, the real rate has remained in minus territory to date this year. This sharp difference in rate behav ior reflected an unusual shift in inflation patterns. In earlier cycles, there was very little cyclical price sensitivity, since the CPI inflation rate (on the average) remained steady between peak and trough. In the last recession, however, the inflation rate rose more than 3 1/2 percentage points between peak and trough, wiping out any real gains that lenders hoped to accrue through short-term investment. The long-term market responded to this inflationary experience in somewhat more stable fashion than the short-term market, indicative perhaps of the much greater error rates found in short-term inflation forecasts. Indeed, the real long term rate hardly declined at all between peak and trough, in con trast to the normal cyclical drop in that rate—and in striking contrast to the sharp fall in real short-term rates during the recession period. Treasury as beneficiary Some market participants actually benefited from that sharp decline in real short-term rates—those who sold debt at low or negative real yields. The U.S. Treasury was an obvious beneficiary of this develop ment, because it sharply increased its sale of short-term marketable debt, at least partly because of cer- tain legislative restrictions on its issuance of long-term securities. Between the cyclical peak and the cyclical trough, the Treasury in creased the amount of marketable debt by $38 billion, and the bulk of that increase ($29 billion) was com posed of issues maturing within one year. been limited, but also reflected the market’s perception of continued relatively low short-term rates. De spite the sharp upturn in real rates since the recession trough, they still remain in minus territory, with the 514-percent Treasury bill rate lag ging behind the CPI inflation rate during the second quarter. More recently, the Treasury has also scored successes in longerterm markets. The Treasury's Au gust offering of 8 percent 10-year notes was a resounding success, with the public tendering subscrip tions of $24 billion for the $4-6 billion originally available. This de velopment reflected the Treasury's ability to exploit a long-term por tion of the maturity spectrum where borrowing previously had While investors may not quote real interest rates in shop-talk about Treasury issues, their actions indi cate that they actually respond to changes in such rates, especially in view of the recent divergence be tween long- and short-term pat terns. With a 5-6 percent inflation rate generally expected over the year ahead, the public may contin ue to respond enthusiastically to high-priced long-term issues. Joseph Bisignano Western Economic Indicators. The mailing list is being revised for this bimonthly publication, which includes incom e, employment, production and financial data for the nine Western states. New subscribers, or old subscribers who have not yet returned subscription reply cards, can be added to the new mailing list by writing the Mail Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco CA 94120. 3 uoiSmqse/vv • qetn • uo8a.io • EpeA3f\| . ogepi M EM EH • E IU J 0 p |E 3 . B U O Z IJy • •}!|B 3 'O J S p U B ij U B § ZSL ON llWlHcl aivd 39V1SOJ s t i HVW SSV1D ISbIJ p K s m p T g d fo Q BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks ' Amount Outstanding 9/29/76 + + Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. T r e a s u r y s e c u r i t i e s Other securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Government deposits Time deposits—total* States and political subdivisions Savings deposits Other time deposits! Large negotiable C D ’s 89,890 68,213 1,461 22,085 20,799 11,507 9,141 12,536 89,459 24,985 552 62,378 5,293 27,525 27,097 11,275 Weekly Averages of Daily Figures W eek ended 9/29/76 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 9/22/76 - + + + - + + - + + + + + + 143 191 73 52 39 53 78 30 716 140 66 572 3 300 275 148 Change from year ago Dollar Percent + 3,139 + 3,239 + 438 - 1,055 + 1,163 + 1,240 + 95 195 + 2,407 + 827 + 324 + 1,352 494 + 6,427 - 3,185 - 5,156 W eek ended 9/22/76 16 0 16 + 3.62 + 4.99 + 42.82 - 4.56 + 5.92 + 12.08 + 1.05 - 1.53 ' + 2.77 + 3.42 +142.11 + 2.22 - 8.54 + 30.46 - 10.52 - 31.38 Comparable year-ago period 15 0 15 - 128 134 6 - 1,570 + 297 + 129 + + 405 + 439 127 ♦Includes items not shown separately. ^Individuals, 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. B > |S E |V