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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




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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.




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