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FRBSF WEEKLY LETTER

June 5, 1987

Interest Rates and Exchange Rates
During the last several weeks, asset prices,
seemingly driven by developments in foreign
exchange markets, have fluctuated widely in
U.S. financial markets. In particular, bond prices
have responded strongly, and in the same direc­
tion, to fluctuations in the dollar/yen exchange
rate. A puzzling aspect of these movements is
the extent to which rates on bonds with matu­
rities as long as 30 years have been affected by
the dollar/yen rate.
Three alternative hypotheses have been sug­
gested to account for these recent exchange rate
and interest rate movements. The first posits an
increase in the expected rate of U.S. inflation as
the primary factor at work. The second views
recent asset price changes as reflecting an
increase in the risk premium foreign (predomi­
nantly Japanese) investors are requiring to hold
U.S. dollar-denominated assets. Finally, the third
view cites revisions in market participants'
expectations about the longer run value of the
dollar required to turn the U.S. trade balance
around.
As will be shown, forward interest rates implied
by the term structure of interest rates and
expected future dollar depreciation as implied
by forward exchange rates can be analyzed to
help discriminate among these alternative
explanations. Our conclusions are that the
strong recent response of interest rates to
exchange rates seems best explained by the
probable impact recent declines in the dollar
have had on expectations of future U.S. infla­
tion, while the dollar declines themselves may
be due to a downward revision in market par­
ticipants' views of the longer run value of the
dollar required to correct the U.S. current
account deficit.

survey; the consensus inflation rate expected
over the next 12 months rose from 3.5 percent
in December to 4.0 percent in March, and the
rate expected over the next ten years rose from
5.0 percent to 5.5 percent over the same period.
These increases in expected inflation rates
apparently were based on two factors. First, oil
prices will no longer make a negative contribu­
tion to inflation during 1987 because they are
not expected to fall significantly (they actually
rose from December to March), and, second, the
continued fall in the value of the dollar will add
to inflation as it causes the prices of imported
goods to rise.
The interest rate increases that have accom­
panied declines in the value of the dollar suggest
that financial markets may be focusing on the
inflationary implications of further declines in
the dollar. Based on historical relationships
between changes in the dollar and changes in
U.S. inflation, exchange rate movements should
have their major impact on inflation over the
next two to three years.
The behavior of nominal interest rates on bonds
of different terms to maturity- the term struc­
ture of interest rates- can shed light on this
issue. According to the expectations theory of
the term structure, interest rates on long-term
bonds should be approximately equal to the
average of expected future short-term rates over
the life of the bond. The observed term structure
can therefore be used to derive estimates of
expected future short-term rates. Evidence that
expected short-term rates way out on the term
structure have not risen would be consistent
with the hypothesis that increases in expecta­
tions of inflation over the next few years are
responsible for the rise in both short-term and
long-term interest rates.

Expected inflation

The most recent Decision Makers Poll by Drexel
Burnham Lambert indicated that expectations of
inflation rose approximately one-half of one per­
centage point between December 1986 and
March 1987. This increase seems to have
occurred over all time horizons covered by the

Chart 1 shows the pattern of the current 1-year
rate and two forward rates- the implied one­
year rate expected in one year and the implied
five-year rate expected in five years- since Jan­
uary 2, 1987 based on daily observations. (The
forward rates were calculated from the term

FRBSF
structure of interest rates using a duration-cor­
rected linear approximation to estimate the
implied expected future rates.)
As Chart 1 shows, since mid-March, both for­
ward rates have risen relative to the current one­
year rate. However, since the middle of April,
the one-year rate expected to occur in one year
has continued to rise while the other two rates
have been relatively flat. This suggests markets
recently have come to expect higher interest
rates one year from now relative to both current
rates and rates five years into the future.
Although not shown in the chart, the current
five-year rate also has risen during the last two
months relative to the five-year rate expected in
five years, indicating a greater expected increase
in market rates over the next five years than over
the period five to ten years from now.
According to the Decision Makers Poll,
expected inflation rose about 0.3 percentage
points between January and March. This would
imply that a rise in nominal interest rates of
around 40 basis points would be consistent with
unchanged expected after-tax real rates. The
actual rise in rates from January to March was
between 30 and 40 basis points, suggesting little
change over this period in expected real rates.
The increase in long-run rates during April, par­
ticularly the implied 1-5 year rates, is consistent
with a further 0.3-0.4 percentage point rise in
expected inflation concentrated within the next
few years.
This evidence does seem consistent with the
expected inflation story. The recent decline in
the dollar. should have a significant impac:t on
actual inflation with a lag, so the rise in rates
one or two years out on the term structure may
reflect the impact of dollar depreciation on
expected inflation. However, since a real dollar
depreciation- a fall in the price of U.S. goods
relative to that of foreign goods- produces a
rise in the equilibrium price /eve/, it is hard to
attribute the 90 basis point rise from March 2 to
April 30 in the expected twenty year rate, ten
years forward, to expected inflation within the
next few years. Nevertheless, such difficult-to­
explain movements in long-term interest rates
and forward rates are not unusual. For example,
during 1980-82, long-term rates seemed to
respond excessively to the weekly money supply
announcements.

Risk premium

Great concern has been expressed about the
willingness of Japanese investors to continue to
accumulate dollar-denominated assets. Some
reports have been fearful of a coordinated move
by Japanese investors to withdraw funds from
the U.S. bond market, perhaps in retaliation for
U.S. trade sanctions against Japan. These con­
cerns can be thought of as producing a change
in the implicit risk premium between dollar and
yen assets. A risk premium change is an alterna­
tive explanation for recent exchange rate and
interest rate movements.
The interest parity condition linking expected
real returns on dollar assets and foreign assets
states that arbitrage will force risk-adjusted
expected real returns on dollar and yen
securities to be equal. A rise in the risk premium
Japanese investors require to purchase dollar­
denominated assets generates an incipient capi­
tal outflow in the U.S. Equilibrium is restored by
some combination of a rise in the U.S. real inter­
est rates and a fall in the exchange rate sufficient
to generate a smaller expected future
depreciation.
It seems difficult, however, to reconcile this
explanation with the behavior of the term struc­
ture discussed earlier. A rise in the risk premium
should have its main effect on short-term interest
rates, not long-term rates. Since the U.S. econ­
omy is much larger than Japan's, the main long­
run adjustment should work through a fall in
Japanese interest rates, not a rise in U.S. rates.
Thus, while all rates might rise, the yield curve
should become flatter, or even downward slop­
ing, as short rates rise relative to long rates.
However, one-year rates expected in one to two
years are the ones that have risen the most.
The risk premium argument implies that the dol­
lar must fall in order to generate an increase in
the expected rate of future appreciation or at
least a smaller expected rate of depreciation.
This means that the spot exchange rate for the
dollar should decline more than the expected
future value of the dollar. Forward exchange
rates can be used to test this implication.
Chart 2 presents the expected rate of deprecia­
tion of the dollar versus the yen as implied by
the 6-month and 12-month forward rates, i.e.,
the rates expected over the next 6 months and

Chart 1
Current and Forward Rates

Percent
10
9

5-year Rate in 5 Years
8

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the dollar.

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Since January 2. 1987

Chart 2
Expected Dollar D epreciation
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The recent focus on the bilateral trade deficit
with Japan may have lowered the market's esti­
mate of the value of the dollar necessary to elim­
inate the U.S. trade deficit. A fall in the expected
equilibrium exchange rate will produce an
approximately equal fall in the current exchange
rate. It could also generate expectations of fur­
ther depreciation and depress bond and stock
prices in the U.S.
This explanation might also be consistent with
the evidence from the forward exchange mar­
kets, which suggests that less depreciation was
expected over the next six months than over the
six months after that. This would also seem to fit
with the term structure evidence since interest
rates would be expected to rise to offset the
expected greater depreciation. However, the
explanation does not seem consistent with the
observed rise in interest rates on 20-year and 30year bonds.
Conclusion

Jan
Since January 2, 1987

over the 6-month period after the next six
months. Contrary to the risk premium story, for­
ward rates have fallen more than the spot rate,
producing an increase in the expected rate of
depreciation beyond six months. Of particular
interest is the fact that the rate of depreciation
expected over the next six months has risen less
than the rate expected over the period from six
to twelve months ahead. This seems most con­
sistent with an expected rise in future inflation as
prices adjusted with a lag to recent dollar
declines.
Equilibrium exchange rates

John Campbell and Richard Clarida have
recently argued that exchange rate fluctuations
tend to be predominantly fluctuations in the
longcrun equilibrium expected exchange rate.
Thus, a possible explanation for the recent
decline in the value of the dollar is that the
decline reflects a fall in market participants'
assessment of the long-run equilibrium value of

An examination of the forward interest rates
implied by the term structure and the expected
change in the value of the dollar implied by the
forward exchange market yields two findings:
1) while interest rates across the term structure
have risen, the greatest increases appear to be
concentrated in the one-year rates expected one
and two years in the future, and 2) during March
and April, the expected rate of depreciation
expected over the next six months increased less
than did the rate of depreciation expected over
the following six months.
These forward interest rate and expected
exchange rate movements seem most consistent
with the hypothesis that recent dollar declines
are expected to produce a rise in the rate of
inflation, particularly over the next one to two
years. A rise in expected inflation due to the dol­
lar decline cannot, however, explain why the
dollar has fallen. One explanation that appears
consistent with the observed asset price move­
ments attributes the fall in the value of the dollar
to a fall in market participants' expectations of
the long-run equilibrium value of the dollar
resulting from the unexpectedly persistent U.S.
current account deficit.
Carl E. Walsh

Opini?ns expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Franc1sco, or of the Board of Governors of the Federal Reserve System.
Editorial co -:nments may be ad�ressed to the editor (Gregory Tong) or to the author ....Free copies of Federal Reserve publications
can be obtamed from the Pubhc Information Department, Federal Reserve Bank of San Francisco, P.O.Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDE RAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and lnvestments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities'
Other Securities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
T ime Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed Moneys
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+)/Deficiency (-)
Borrowings
Net free reserves (+)/Net borrowed(-)

Amount
Outstanding

5/13/87

204,136
181,518
53,206
68,053
37,289
5,411
15,318
7,300
204,463
51,905
48,109
19,171
133,387

5/6/87

-

Period ended

5/4/87
19
104
84

690
718
359
283
89
2
36
9
1,696
1,618
1,010
390
311

-

-

-

258
3,270
342
1,456
3,404
230
4,095
568
1,243
1,718
1,891
3,469
3,943

0

-

0
31,607
22,985

Change from 5114/86
Dollar
Percent7

Change
from

-

46,013

213
274

-

5,475
2,813

-

-

Period ended

4/20/87
89
72
17

1 Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

2
3
4
s
6
7

-

-

0.1
1.7
0.6
2.1
8.3
4.0
36.4
7.2
0.6
3.4
4.0
22.0
2.8

- 100.0
-

14.7
10.9