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lPJ.':9;;:§,<E;$\lfdb Cl::lTI\ ft , §@lill January 28, 1983 How l o w Can Interest RatesBe Pushed? The U.S. economy is in the worst recession in 40 years. While the broadesteconomic measure, real Gross National Product, hit its low point for this recessionin the first quarter of 1982, there has been little sustained recovery since then. As a result of this anemic economic performance the unemployment rate rosethroughout 1982 and stood at 10.8 percent in December,the highest level since 1941. But in spite of the depressedstateof the economy, there were some encouraging signs. These consisted largely of the sharp drop in interest ratessince the middleof 1982 that subsequentlyspurred a strong recovery in the two previously most depressedindustries-housing and automobiles. The economic forecasting fraternity is virtually unanimous in expecting 1983 to be better than 1982. What can the FederalReserve do to aid an economic recovery? Fedpolicy issues The key policy issuesnow facing the Federal Reserveare two: whether interest rateshave declined sufficiently to provide for a sustainable recovery in real output, and whether the recent surge in M1 hasbeen sufficiently large to create concern about reigniting future inflation. With respectto the second issue, the unexpected collapse in the velocity of M1 in 1982 (some 5 percent below its originally forecasted value) and, more recently, the wave of interest rate deregulation hascalled into question the usefulnessof M1 as a guide. to pol icy, at least through the first half of 1983. With M1, the FederalReserve's primary monetary guideline temporarily "out of order", the major focus of policy must be directed toward the broader monetary aggregatesand/or interest rates.This Weekly wi II focus on interest rates. In evaluating the effect of interestrateson the economy, one must consider not only the market rate but the real interestrate. This is the market interest rate adjustedfor the expected rate of inflation. Long-terminterest rates playa key role in influencing the economy, and they probably playa more significant role than short-term interestrates. But, in this Weekly, we will (ocus on shortterm interest ratesfor two reasons.First,the Federal Reserve'sinstrumentsof monetary control, the discount rate and open market operations, have their major impact on shortterm interest rates.The FederalReservehas I ittle or no direct impact on long-term interest rates, which are dependent primarily on the productivity of capital and long-run inflation expectations, Second, it is easier to measure real interest rates in the short-termmarket than in the long-term market becauseshortrun inflation expectations are closely related to the most recent actual inflation rate, while long-run inflation expectations(over the next five to ten years)are not necessarilyrelatedto past inflation. One reasonablemeasureof the real shortterm interest rate is-thedifference between the market interest rate and the inflation rate. In Chart I, we compared the 3-month Treasury bill rate and the inflation rate (measured on a 12-month basis).SinceSeptember1982, the Treasurybill rate has averagedclose to 8 percent and the inflation rate 5% percent, giving a risk-freereal short-term interest rate of about 2V, percent. This is down substantially from the Treasury bill rate of as recent a month asJune 1982 when it was 12% percent. Althat time, the inflation rate was about 6 percent and therefore the risk-free real short-term interestrate was about 6% percent. Indeed, in the 1% yearsthrough June 1982, the real Treasurybill rate had been extraordinarily high, in the 5-7 percent range, and was a major causeof the weaknessin the economy in 1981 and 1982. Alternativeviews Should, then, the Federal Reserveattempt to push the real short-term interest ratesdown If If©\!ill<Cli (G) Opinions expressed in this newsletter do not necessarilv reflect the views of the management of the Federal Reserve Bank of San Franc'isco, or of the Board of Governors of th" Federal Reserve SYstem. between 1955 and 1979. From 1 979-1 983, it rose from 21 percent to 25 percent. The most recent rise is partly due to the relatively weak economy. However, even if G N P grew strongly between now and 1 985 the spending share is expected to decline only modestly. The reason is that in spite of public perceptions to the contrary, the Reagan administration did not reduce the trend in government spending; it only changed the mix of spending. Thus, with the continued rise in the ratio of government spending to GN P, the cost to the economy of financing government has continued to rise. further to stimulate growth? There are two approaches to answering this question. The first is that, given the depths of the recession, we should allow real interest rates to become negative, that is, market interest rates should be pushed below the inflation rate to encourage a recovery. Once the economy had started to show a sustained recovery, the appropriate policy would be to raise the interest rate above the inflation rate to ensure thatthe growth in aggregate demand was not excessive, that is, did not reignite inflation. Experience indicates that this flexible approach to interest rates is particularly important. In the 1 974-75 recession, the Treasury bill rate fell below the inflation rate and the real interest rate was minus 2-3 percent. FollOWing the 1 974-75 recession, however, the Treasury-bill rate never rose above the inflation rate, and the real interest rate was kept close to zero for four years (mid-1 975 to mid1 979) as the economy grew rapidly and added 11 million people to the employment roles. (The reluctance to raise the real interest rate in this expansion period was probably due to the unemployment rate, which remained well above 6 percent.) There are only three ways in which increased government spending can be financed: first, by higher tax receipts; second, by the in, creased issuance of government bonds, which the public can be induced to hold only with higher real interest rates; and third, by printing money, which i ncreasesthe inflation rate. Cutting taxes without cutting government spend ing does not reduce the cost of the government, it merely redistributes it from one source of financing to another. In the 1 960 s, the rise in the trend of government spending was financed by tax revenues generated by a rapidly growing real economy. In the period from 1 960-69, we had the longest continuous period of economic expansion in our history (real growth averaged 4.3 percent per year) and this generated tax receipts that financed the growth in government spending even when tax rates were reduced. The alternative approach argues that we cannot now let interest rates fall much below current levels because government deficits are more dangerous than they were in 1 974-75. The recent deficits require a higher real interest rate to finance. In 1 974-75, government deficits were largely induced by the business cycle. In that recession, the decline in tax receipts increased the deficit, while the subsequent economic expansion increased receipts and reduced the deficit. In 1 982-83, the business cycle deficit has, superimposed on it, a structural deficit that will not disappear when the economy and tax receipts increase. In the 1970s, the continued growth in government spending as a share of GN P was financed by a higher inflation rate. Real GN P did not grow very rapidly (averaging 2.9 percent per year), but nominal income, because of inflation, grew at an average rate of 1 0 percent per year, which pushed most people into higher tax brackets. This form of "inflation tax" financed the increased government spending. Roleof deficits To understand this consideration, it is useful to review the history of government spending and structural deficits (Chart 2). The government spending share of GN P moved gradually from about 1 7 percent to 21 percent In the 1 980s the Reagan administration has cut tax rates sufficiently to stop "bracket 2 Chart 1 Percent Chart 2 16 14 Percent '·iV. ... .I Treasury bill 12 . 10 30 . GovernmentSpending as Share 01<?NP 25 \ 20 15 \ 10 Deficit as Share of GNP 5 0 4 o'1973\974 '1976I \978 ' '1980! -5 1955 '1982' "'" 1965 1970 1975 1980 1985 creep" (and thus tax receiptsas a percentage of GNP will stabilize around 20 flercent in 1984, down modestly from 20.5 percent in 1980). The Federal Reservehas cut the inflation rate from over 10 percent in 1980 to 5 percent in 1982. If thesegains are not to be reversed, the only method left of financing the continued rise in govemment spendingas a share of GNP is to increasethe govemment issuing of bonds. This is the primary sourceof what has been called the structuraldeficits. In the Reaganadministration, it looks as if the deficits will averageclose to 5 percent of GNP, the highest in our history outside of a major war. Conclusion This country has had no experiencewith deficits of this size, and therefore,no clear idea of how high real interestratesmustgo to finance them. In the 1960s the Treasurybill rate was approximately 1 to 1h percent above the inflation rate, which suggeststhat a real interest rate of 1-1h percentwas necessary to fi nance the much lower deficits that accrued in those years without inflation financing. The current real Treasurybill rate of 2 h percent may be about as low as that interest rate can go and still finance the much larger deficits that are currently being produced without inflation financing. Deficits and savings To focus more closely on the effectsof deficits on interestratesand financial markets, we must look at deficits as a shareof net private savingsof the economy. Net private savings equals grossprivate savingslessdepreciation allowances to maintain the existing capital stock. In the 1960s, the deficit averaged about 10 percent of net private savings,leaving 90 percent available for private use. In the 1970s,the deficits varied from year to year, but averagedjust over 20 percent of net private savings.In 1982, deficits consumed 80 percent of net private savings. While this analysis is rather speculative,one thing is clear, further reductions in short-term interest rates would require the Federal Reserveto increase the rate of growth of the money supply. The San FranciscoBank's money market model estimatesthat for every 1 percent reduction in interestrates,M1 will need to grow 5 percent faster(atannual rates) than it otherwise would have over the next three months. If the financial markets interpret further reductions in short-term interestratesas an attempt by the Fed indirectly to print money to finance the deficit, long-run inflation expectations and long-term interestratesmay rise. Should policymakers decide that the recession is suffiCiently severeto warrant further reductions in short-term interestrates, they should consider the effect it would have on the long-term bond markets.A rise in long-term interest rates is a signal that the financial markets perceive monetary policy to be too easy. Most analystsdo not expect things to change significantly in the yearsahead. In 1983, the cashdeficitwill consumebetween 70 and 90 percent of net savings.The range depends upon whether the tax incentives for savings substantially increasesavingsor not. By 1985, the deficit is not expected to decline significantly, but the economy is assumedto grow rapidly, reducing the deficit's shareof • net private savingsto between 60 and 70 percent. Michael Keran 3 S S"' O .LSl:lI:l !!E'Ml?H 41?ln• uoSaJO• epeA<3N • oyepl E'!UJoJ!leJ • euozpv • e>jSl?JV Jr 'Mle::> IO:>spUI?J:I lIeS lS" 'ON OIVd39VlS Od's-n llVWSS VUlS BU OUB09Bd :tJ1\lJ@\\lill:tJ ollW!<dl@<1 J] '"lI;:))ollW!@\B@(ill BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollar amountsin millions) SelectedAssetsand Liabilities large Commercial8anks Loans(gross,adjusted) andinvestments* loans(gross,adjusted)- total# Commercialand industrial Realestate loansto individuals Securitiesloans U.S.Treasury securities* Othersecurities" Demanddeposits- total# Demanddeposits- adjusted Savingsdeposits- total Time deposfts,- total# Individuals,part.& corp. (large negotiableCO's) WeeklyAverages of Daily Figures MemberBankReserve Position ExcessReserves(+ )/Deficiency (-) Borrowings Netfreereserves (+ l/Net borrowed( -) -* Amount Outstanding 1/12/83 163,305 142,480 57,586 23,973 2,597 7,395 13,430 41,153 28,951 53,395 82,186 72,656 28,215 Change from 1/5/83 Changefrom yearago Dollar -1,137 -1,076 - 907 1 44 - 154 - 9 52 -3,689 -1,178 3,577 -2,638 -2,514 - 926 - Percent 6,124 6,544 3,124 1,317 288 515 1,550 1,970 844 1,070 22,247 7,714 8,265 7,366 3.9 4.8 7.5 2.3 1.2 24.7 26.5 12.8 2.0 3.6 71.4 8.6 10.2 20.7 - - Weekended Weekended Comparable 1/12/83 1/5/83 year-agoperiod 108 33 75 144 20 124 68 131 63 Excludes tradingaccountsecurities. # Includesitemsnotshownseparately. Editorialcommentsmaybeaddressed to theeditor(GregoryTong)or to theauthor.••• Freecopiesof this andotherFederalReserve publications canbeobtainedbycallingor writingthePublicInformationSection, FederalReserve Bankof SanFrancisco, P.O.80x 7702,SanFrancisco 94120. Phone(415)974 2246. M
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