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rED iillJTI1 mt1;ll IFJfiillJfM:Ji CD; January 8, 1 982 Real I nterest Rates No one can be certain how long the recession will last, because there are both new and old sources of uncertainty in the outlook. The old elements are summarized by the fact that economists are usually pretty miserable forecasters of economic turning points. The new elements of uncertainty are contained in the fact that the tea leaves at the bottom of the monetary-aggregate teacups are becoming increasingly difficult to read. High interest rates, financial deregulation, and financial innovation have made it difficult to rely on anyone monetary aggregate, and potential shifts in the demand for transaction (checklike) balances have added to the problem. Real interest rates-rates adjusted for inflation -provide an additional element of uncertainty in the outlook. The behavior of real interest rates, indeed, could act as a potentially stabilizing element in the recession and recovery. In years past, economists thought of "automatic stabilizers" almost exclusively as fiscal tools, operating through such elements as unemployment insurance and a progressive income-tax structure. But with the Federal Reserve's move in October 1 979 to de-emphasize control of short-term interest rates, movements in interest rates now have a new role to play. The question is whether this role will be stabilizing or destabilizing. The Fed and interest rates In years past, critics often criticized the Fed for excessive concern with short-term interest rates. In their view, the Fed's reluctance to let interest rates move quickly up or down exacerbated fluctuations in the real economy. For example, the Fed's reluctance to let rates fall quickly enough in a recession led to a money-supply contraction, which in turn led to a deeper -than-necessary decl i ne in the reaI economy. The result, the argument goes, was "pro-cyclical" monetary growth, with money expanding too rapidly in a recovery and too slowly during a recession. Consider, for example, the behavior of M-1 during tne 1 973-75 period. That aggregatecurrency plus bank demand depositsexpanded by 7.3 percent in 1 973 but only by 4.9 and 4.6 percent in 1 974 and 1975, respectively. The critics thus charge that, in an environment of oil-price shock and high inflation, the Fed's interest-rate policy provided too little monetary stimulus and thus aggravated the recession. The economy and real rates After the Federal Reserve moved to its new operating procedures in October 1 979, interest rates soared, to the great surprise of most economists. No one had guessed the heights that interest rates would rise to, or the extreme volatility of rates. Even more surprising was the behavior of real interest rates. The notion of real interest rates goes back at least to the time of Irving Fisher, the early 20th-century Yale economist. The real rate is usually defined as the observed nominal rate less the "anticipated" rate of inflation over an asset's life. Because anticipated inflation is not directly observable, economists often use a proxy in the form of the past inflation rate or, alternatively, the actual inflation rate over the asset's life. The real interest rate was very low, on average, throughout most of the 1 975-79 period (see chart). The rate was calculated by subtracting the deflator for personal consumption expenditures from the three-month commercial-paper rate. In fact, the real commercial-paper rate averaged -.05 percent, or effectively zero, between January 1975 and September 1 979. The economy grew at a rapid rateafterthe 1 975 recession, with annual real growth rates ranging between 3.2 and 5.5 percent, but the real interest rate showed no apparent cycl ical movement during that period. @JIR2. ra@\Jilllk <u>IT S'\''\\ jl\' r(v \;= V ID.l"\ f' !, 1 1.1 Lt :is;'C':r\':,J.J 1:l' Opinions expressed in this ne\.\.!sletter do not necessZlrilv reflE.:ct the of the rnanagernent of th0 Ff,deral Reserve Bank of San or of the Board of Covernors of the Federal Reserve System. interest rates give us a better understanding of the behavior of the economy than do nominal interest rates, providing a better information variable than control variable for the Fed. Real interest rates theoretically should playa stabilizing role in the economy. As the economy softens, real interest rates should fall in an environment of sluggish real aggregate demand, but these low rates shou Id then stimulatedemand and promote a recovery. In the recovery, high real rates conversely should restrain excessive real demand, damping potential inflationary momentum. In theory, real aggregate demand responds to real magnitudes, such as real interest rates, and the economy should perform better if markets have a greater role in determining these real rates. In a recent article in the Journal of Monetary Economics, Professor Frederic Mishkin, of the University of Chicago, finds that the real rate is negatively correlated with inflationas the last half-decade has shown. In addition, he finds that real rates are a better indicator of "tightness" than nominal ratesas was demonstrated by the experience of the Great Depression. During that period, monetary policy appeared "easy" because of the very low level of nominal interest rates. Yet real interest rates ranged between 6 and 10 percent between the fourth quarter of 1931 and the first quarter of 1 933, reflecting the severe deflation of that period. The inflation rate was the same-9 percentat the end as at the beginning of the 1 975-80 business-cycle expansion, and this perhaps could be attributed to the factthat real interest rates failed to respond to real growth over that period. But in actuality, the inflation rate moved cyclically in that span, falling almost to 5 percent in 1 976 but heading steadily upwards after that. It is this rapid upsurge in inflation, of course, which monetary and fiscal policymakers have tried to reverse in the past two years. The post-1 979 record represents a reversal of the experience of the previous half-decade, with real interest rates fluctuating sharply in an environment of decelerating inflation. This could mean the advent-eventually, at least-of a new type of business cycle, in which the economy does not depart for long from its long-run potential growth rate and in which inflation remains within reasonable bounds. In this environment, we may not see four to five years of uninterrupted real growth followed by double-digit inflation. Instead, we may experience a much bumpier period, which will make obsolete the definition of a recession as two successive quarters of negative real growth. The "cycle" may become a lengthy period offluctuating economic activity, but one in which growth becomes more sustainable without accelerating inflation. What do we know? In a recent article in Challenge magazine, Professor Alan Blinder, of Princeton University, argues that the Federal Reserve ought not to ignore the very high real interest rates which have developed since the Fed moved to its new operating procedures. His argument infers that the Fed should target real interest rates rather than monetary aggregates, given the problems in interpreting the aggregates.Apparently, the Fed inadvertently did justthat between 1975 and 1 979, by effectively removing any cyclical movement in real interest rates. Whether this happens will again depend on the behavior of real interest rates. Real rates have behaved in quite unexpected fashion after 1979. The real commercial-paper rate, for example, hit an estimated 1 0 percent in early 1 980, became negative on the heels ofthat spring's "voluntary" credit-restraint program, and then climbed rapidly after the Targeting real rates may not be a good idea, however. First, economists do not have a good understanding of real interest rateshow they are either determ ined or controlled. In theory,'a nominal variable like the Fed's control of reserves cannot control a real variable like interest rates. Nonetheless, real 2 program was suspended in July 1 980. Since that time, high real rates have curtailed aggregate demands considerably. Consequently, the inflation rate has also fallen, with the producer-price index decelerating from a 1 4-percent rate in March 1 980 to 6 percent in November 1981 . If the economy continues to display negative real growth in coming months, real rates could fall rapidly, laying the foundation for a recovery in mid-1 982. numbers in each of the fiscal years 1 982-84. If nominal interest rates rise in response to increased deficits but inflation continues to fall, the recovery could easily be short-lived this year. But whatever else happens, the recovery will almost certainly not display the pattern of uninterrupted growth seen in the 1 976-79 period. Real interest rates now make a difference. JosephBisignano The big uncertainty lies in the prospect of continued Federal deficits in triple-digit Percent 10 8 6 Real Commercial Paper Rate' ... (three-month) 4 _41 -_-- 1975 L _ _ ........_ _ '--_- 1977 L. __ ...I-_..... J1 ..-_.. 1979 *Nominal rate on a given month minus the inflation rate over the life of the note. 3 1981 J !!E'M1?H• 41?ln .. E!UJOj!iEJ • • E'pE'AaN• oyepl EUOZ! JV • e>js1?IV Jl (\» 1l'i\ll@\\I!lJll Jl12i0l@((Jj BANKINGDATA-TWELFTHFEDERAL RESERVE DISTRICT (Dollaramountsin millions) SelectedAssetsandLiabilities LargeCommercial Banks Loans(gross,adjusted) andinvestments'" Loans(gross,adjusted)- total# Commercialandindustrial Realestate Loansto individuals Securities loans U.s. Treasury securities* Othersecurities* Demanddeposits- total# Demanddeposits- adjusted Savingsdeposits- total Timedeposits- total# Individuals,part.& corp. (Largenegotiable CD's) WeeklyAverages of DailyFigures MemberBankReserve Position ExcessReserves (+ )/Defidency(-) Borrowings 'f Netfreereserves (+ )/Net borrowed( -) Amount Outstanding 12/23/81 156,228 135,106 41,273 55,649 23,630 2,258 5,874 15,248 42,506 28,911 29,946 89,506 80,479 36,094 Change from Changefrom yearago Dollar Percent 12/16/81 457 - 537 - 679 9 162 3 37 43 - 4 382 76 696 431 556 - - 8,930 10,138 4,082 5,350 693 762 839 365 4,089 3,597 2,159 15,521 16,379 6,635 Weekended Weekended 12/23/81 12/16/81 85 1 84 44 9 53 - 6.1 8.1 11.0 10.6 2.8 50.9 12.5 2.3 8.8 11.1 7.8 21.0 25.6 22.5 Comparable period 114 125 11 '" Excludes tradmgaccountsecurltles. # Includesitemsnotshownseparately. Editorialcomments maybeaddressed to theeditor(WilliamBurke)or to theauthor.... Freecopiesof this andotherFederal Reserve publications canbeobtained bycallingor writingthePublicInformation Section, FederalReserve Bankof SanFrandsco, P.O.Box7702,SanFrancisco 94120.Phone(415)
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