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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 . .. �·�� � . .. . . , ...... . . .. � . . ...,6.... .......,.""•'•"'"'' :: '•""'''"••' ,, . .. .. . . . . .. . . .. . .... . . . . ..... . ... .... . . . .... .. .. .. ·�•. _ ... . . .. .. . .. . . ... . . �# .. � .. ... . .·· . ...... 1-year Rate in 1 Year 7 �; .. the dollar. .... . • 6 5�-----,----�--- Mar Jan Apr Feb Since January 2. 1987 Chart 2 Expected Dollar D epreciation .. . :·· 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. uo�6U!4som !!OmOH 040PI 4o�n O!UJOJ!IO) uo6�JO · opoA�U OUOZ!JI:J O!oiSOII:J Q)SI)UOJ:::J UOS JO �uos aAJasa� IOJapa:::J �uew�Jodea LpJoese� 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
