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May 14,1982 I n terest Rates: H ow M u ch Is Reai?(I) Proper implementation of monetary policy requires an evaluation of whether private markets perceive policy as being too tight, too easy, or about right. For example, what does the current environment of exceptionally high nominal interest rates imply about monetary pol icy? If those high rates are due to high and rising inflation expectations, the markets may believe that monetary policy is too easy. On the other hand, if high market rates are due to high real rates, monetary policy may be too tight. In this and next week's Weekly Letters, we evaluate developments in the stock and bond markets in an attempt to determine how financial markets view high long-term interest rates-in terms of high inflation expectations or high real rates. For the purpose of this analysis, we will define the real interest rate as equal to the market interest rate when the expected rate of inflation is zero. If the expected inflation rate is positive, then the real interest rate would equal the nominal rate when the principal (and coupon) value ofthe underlying security is indexed to the price level. On this basis, the real interest rate would equal the market rate less the expected inflation rate-the latter including any risk factors resulting from the failure to realize the expected inflation rate. Inflation risk is not symmetrical between suppliers and demanders of corporate debt. Corporations who sell bonds face the risk that the actual rate of inflation will be less than they had expected, so thatthey may pay too high a rate. They have some protection against this risk from the "ca"" provision, i.e. repaying debt before maturity. But bond purchasers, unlike sellers, face the potential risk thatthe actual rate of inflation will exceed the expected rate, so that they may receive too Iowan interest rate in compensation. There is no para"el to the seller's call provision to protect buyers from this risk. As a result, the demand for corporate bonds tends to fall with a rise in inflation risk, which simultaneously raises the inflation-risk premium in interest rates and reduces the volume of transactions. Inflation risk should be added to the inflation premium rather than the real interest rate because ·it has opposite implications for monetary policy. If real interest rates go up because of a shortage of liquidity or increased business-cycle risk, monetary policy may be too tight and probably shou Id be eased. On the other hand, if interest rates'go up because of rising inflation risk, monetary policy may be too easy and probably should be tightened. Short-term rates... Short-term real interest rates are relatively easy to determine because of the relative ease of measuring short-run (6 to 12 month) inflation expectations. • The actual inflation rate of the last 6 to 12 months is a good proxy forthe expected inflation rate over the next 6 to 12 months. • Because of the lags between monetarypolicy changes and inflation, past money growth will be the dominant factor in influencing inflation over the next 6-1 2 months. Ct Major supply-side shocks,such as sharp oil-price increases, can affect the general price level relatively predictably over the subsequent 6-1 2 months. . .. and long-term rates Real interest rates on long-term securitiesour primary focus here-are more difficult to measure because of the lack of any clear-cut way to measure long-run inflation expectations. First, there is no necessary link between past inflation and the expected inflation rate over the next 5 to 15 years. Second, futurenot past-monetary policy wi" determine the rate of inflation over periods of that length. Given the substantial theoretical and empirical problems involved in measuring long-run inflation expectations, it may be useful to measure real long-term interest rates more ITi)(?i\ &\lffi CG) ' r;::::::::' vir©\lC\\(C·Jl (C , 0 Opinions expressed in til!:; newsletter do not necessa rilv refiect the views of the rnanagement of the Federal Reserve Bank of San Francisco, en of the Board of Cc}V(?rnors of the Federa! Reserve -- ..-".-,,-- ---.- .....-..-. -, -- ........... ..... -.... , directly-perhaps through the stock yield (current dividend divided by current stock price). In the economics literature, the stock yield is sometimes used for this purpose because stock ownership is a claim on a corporation's real property. Generally, however, financial analysts believe it is inappropriate to compare stock and bond yields, because bond yields measure the total return to'bonds" while stock yields measure only a part of the total return to stocks, the remainder including growth expectations for future earnings and dividends. But yield comparisons would be valid if we could treat stock yields as a proxy for real yields, in the same way that bond yields measure normal market yieJds. That would be reasonable where changes in the expected inflation rate lead to proportional changes in the expected growth of dividends. When the value of an investor's holdings is roughly indexed to inflation, the current stock yield would not need to rise with inflation expectations or inflation risk. mid-1 950's and then fluctuated in a narrow range around 3 percent until 1973. However, the utility-stock yield generally moved closely in line with the industrial-stock yield until 1 965 -a period of low and stable expected inflation -but then moved with the bond yield as the expected inflation rate rose after 1965. This divergent behavior on the part of the two stock yields reflects the money illusion exhibited by public-utility commissions at least until 1973. (Seeour article in the Spring 1 976 issue of the Bell Journal of Economics.) When the expected inflation rate went up, commissions refused to permit regulated utilities to obtain higher growth of nominal earnings and dividends. As a result, utility stocks behaved just like bonds, with a parallel drop in prices and parallel rise in yields to reflect higher inflation expectations. The typical, unregulated industrial corporation did not suffer from this problem, however, so that industrial-stock yields as a group did not incorporate an inflation premium. Dividendsand inflation Second, if a stock yield is free of inflation expectations, it measures the real return on equity and thus moves roughly in line with the real return on other securities. We find evidence of this in the significant degree of correlation between monthly changes in stock yields and the real Treasury-bill rate during the 1970's. Expected dividend growth reflects, first, expected real growth, i.e., the volume of real sales projected in the future. Second, it reflects the price at which those sales will be transacted, i.e., the expected inflation rate. For the economy as a whole, the expected real growth rate is relatively stable and changes only slowly. However, inflation expectations are high and can change rapidly, so we can assume that changes in dividend expectations will be dominated by changes in inflation expectations. Three separate pieces of evidence support the proposition that they move proportionally, which means that the stock yield is a real yield. Third, we have at least indirect evidence of a parallel movement in dividend expectations and inflation expectations. Actual dividend growth has moved in line with the actual inflation rate since inflation started to accelerate in 1965. Furthermore, the return to equity multiplied by earnings retention (earnings minus dividends)-a good measure of i nterna Ily-generated earn i ngs growth -has risen roughly in line with the inflation rate over time. On this basis, the total return to stocks (current yield plus expected dividend growth) has increased from about 7 percent in the first half of the 1960's, when the inflation rate was low and stable, to almost 18 percent in the early 1 980's, when the inflation rate reached double digits. The divergence between industrial and utility stock yields during the recent period of inflation strongly supports this thesis (see chart). The S&P bond yield increased from 3 percent to 4 percent in the mid-1 950's, remained relatively stable unti I 1 965, and then gradually rose again with the actual and expected rate of inflation. The industrial-stock yield declined from 4 percent to 3 percent in the 2 Measureof real rates Our analysis thus suggeststhat (1) changes in stock yields are a good indication of changes in real interest rates and of changes in business-cycle risk, and (2) changes in bond yields relative to stock yields are a good indication of changes in inflation expectations and inflation risk. In our next Weekly Letter,we will evaluate the information content of current stock and bond yields to determine what the financial markets see as the major current risks in the economy. All of these tests independently make the same point: stock yields are a measure of real rates, just as bond yields are a measure of nominal rates. This does not mean that stock . yields will always move in line with real bond yields, because stock yields are more sensitive to business-cycle risks and probably have a higher average value than real bond yields. However, relative stability in stock yields would suggest parallel stability in the real yields on bonds. MichaelW.Keran Percent 8 STOCK AND BOND YIELD S 7 High-grade bonds .. ( Composite) 6 5 4 1 \ 3 \-.) I ' Industrial stocks" 1 955 1 958 1961 1 964 3 1967 1970 1973 SS'V,:> .lSl:U:I U018U!ljSPM.ljPln • uo8aJO • ppPt\aN • oljPPI !!PMPH • P!UJoJ!IP:) • PUOZ! N • P>jsPIV Jrd[ (CJ) 'J!lI?J IO:lSpUI?J:I UI?S lS'L 'ON IIWH:Id OIVd :I!)V IS ad 's'n ll VW SSV1J ISHI:I BANKIN G DATA-TWE LfTH FEDERALRESERVE DISTRICT I (Dollar amountsin millions) Selected Assetsand Liabilities Large Commercial Banks Loans(gross,adjusted)and investments* Loans(gross,adjusted)- total# Commercialand industrial Realestate Loansto individuals Securitiesloans U.s. Treasurysecurities* Other securities* Demanddeposits- total# Demanddeposits- adjusted Savingsdeposits- total Time deposits- total# Individuals,part.& corp. (LargenegotiableCD's) Weekly Averages of Daily Figures Amount Outstanding Changefrom yearago Dollar Percent Change from 4/28/82 4/21/82 159,543 138,559 42,653 57,132 23,504 2,346 6,014 14,970 37,262 26,694 30,401 91,945 82,587 33,887 313 678 164 27 77 203 352 13 -2,310 -1,388 - 994 1,191 1,168 840 - - - Weekended Weekended 4/28/82 4/21/82 102 105 3 35 198 163 11,281 12,590 5,338 5,139 559 854 540 748 3,336 2,276 91 14,719 14,433 3,625 7.6 10.0 14.3 9.9 2.4 57.2 f8.2 "- 4.8 "- 8.2 "- 7.9 0.3 19.1 21.2 12.0 Comparable year-agoperiod Member Bank ReservePosition ExcessReserves (+)/Deficiency(-) Borrowings ." Net freereserves(+)/Net borrowed(- ) * Excludestradingaccountsecurities. # Includesitemsnot shownseparately. - - 32 330 298 . Editorial comments may beaddressedto the editor (William Burlce)or to the author .... Freecopiesof this andother FederalReservepublications can be obtained by calling or writing the Public Information Section, Federal ReserveBankof SanFrancisco,P.O. Box 7702, SanFrancisco94120. Phone(415) 544-2184.
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