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Number 94-34, October 7, 1994

The Recent Behavior of Interest Rates
Long-term interest rates have gone up sharply
since the beginning of the year. This rise has
been attributed to a number of factors, including
a stronger U.s. economy, stronger foreign economies, a rise in inflation expectations, as well
as the Fed's moves to increase short-term rates
over this period. ih this Weekly Letter I look at
the recent behavior of interest rates in an effort
to determine how much support the data offer to
each of these factors.

Alternative explanations
As Figure 1 illustrates, rates have risen at all
maturities since the beginning of this year; for
instance, the rate on 3-month Treasury bills over
the first three weeks of September was about 160
basis points higher than in January, the rate on
l-year T-bills was roughly 215 basis points higher,
and the rate on la-year bonds was about 165
basis points higher.
This increase in rates has been attributed to a variety of factors. Foreign rates have risen dramatically over this period. Since financial markets
are becoming increasingly integrated worldwide,
the recent rise in U.s. rates could reflect developments abroad. However, it is quite possible that
the causation worked in the other direction. In
this context, it is worth pointing out that U.S.
long-term rates began to increase prior to rates in
the other G-7 countries, though long-term rates
in some of these countries have risen by more
than u.s. rates since then.
Some have suggested that long-term rates rose in
response to an increase in expected inflation;
this is because higher inflation in the future will
push up short-term rates at that time, and longterm rates today reflect what is expected to happen to short rates in the future. The evidence on
this explanation is mixed. In support of it, analysts point to a run-up in commodity prices, as
well as a fall in the value of the dollar. Contradicting it, however, are surveys of expected inflation that show no signs of an increase large
enough to explain the recent rise in rates; for instance, a survey by the Federal Reserve Bank of
Philadelphia showed that, at 3.5 percent, the

Figure 1
Treasury Term Structure

Weekly Averages

30 Year



Federal Funds

2.00 - " - - - - - - - - - - - - - - - - - Oct- Jan- Apr92



Jan- Apr- Jul94
94 94

rate of inflation expected to prevail over the next
10 years was the same in September as it had
been in December 1993. In'addition, the fall in
the dollar generally has been confined to declines against the yen and the mark; if concerns
about higher inflation were behind the dollar's
decl ine, one wou Id have expected the dollar
to decline against all currencies.
A more likely explanation is that interest rates
rose because of increasing strength in the economy. The economy was growing very rapidly in
late 1993, and this could very well account for
the fact that rates bottomed out around October
1993 (see Figure 1), well before the Fed began increasing short-term rates. The rise in rates in late
1993 serves as a useful reminder of the fact that
interest rates would move over the course of the
business cycle even if the Fed took no action.
Of course, the Fed did raise the federal funds rate
from 3 percent to 4.75 percent in a series of five

moves that began February 4. Since market rates
have risen sharply over this period as well, some
have held the Fed responsible for the rise in rates.
In assessing the validity of this explanation it is
important to remember that the Fed has acted
in response to growing evidence of a robust
economy. Indeed, Barro (1994) argues that the
Fed had little choice but to raise the interest
rate-given a desire to maintain a low and stable
rate of inflation. He points out that " ... real
interest rates are determined by the interplay
between the supply and demand of credit, determined by the willingness of people allover
the world to save, and their desire to invest."
Stronger economic growth means a greater demand for funds to invest, which puts upward
pressure on interest rates. In this situation, the
Fed's unwillingness to raise interest rates would
only lead to higher inflation. Thus, the Fed's
decision to raise rates was really dictated by
its desire to keep inflation low in the face of a
strong economy.
While this explanation appears consistent with
the general trend of interest rates over this period, it does not answer important questions
about the timing of recent changes in interest
rates. Figure 2 plots daily observations on interest rates of different maturities since last October
and highlights the dates of Fed actions to raise
rates. Note that the rise in interest rates (at all
maturities) since the Fed began to raise rates is
substantially greater than the rise in rates beforehand. In addition, rates at maturities of one
year and longer rose sharply when the Fed first
raised rates (on February 4); a similar pattern is
evident when the Fed raised rates the second
ti me. However, rates at the 10- and 30-year maturities have shown little net change immediately
after the last two increases in the funds rate
(though long rates have gone up again recently,
most likely in response to further evidence of a
strong economy).
The response of long-term rates to the Fed's actions provides information that can be used to
distinguish among various hypotheses. First, the
increase in long-term rates immediately after
the initial increase in short rates means that it is
unlikely that inflation expectations are the cause
of the rise in long rates. If anything, the Fed's action was intended to keep inflation from rising. It
is sometimes suggested that markets might interpret the rate increases as a signal that inflation is
likely to go up, on the grounds that the Fed has
superior information about future inflation. How-

Figure 2
Daily Treasury Term Structure





- L - - - I . - - ' _ ' - -_ _- - ' - -

2/4 3/224/18 5/17


ever, it is hard (even as an insider) to point to any
relevant information that the Fed does not make
public. Second, it also suggests that the explanation that relies upon strength in the economy is
incomplete. If the Fed were simply reacting to
widely perceived signs of strength in the economy, there would be no reason for long rates to
rise when short rates were raised.

Anticipating the Fed's behavior
The timing of the changes in long-term rates
suggests that the Fed's action was a surprise to
market participants; if the action had been anticipated, its effect already would have been incorporated in prevailing long-term rates. The
direction of the response also allows us to infer
something about the nature of the surprise. Long
rates should have fallen if the move provided information about the relative importance the Fed
attaches to inflation. In other words, if markets
interpreted the rise in the funds rate as evidence
that the Fed was more serious about inflation
than they had believed, this move should have
led them to lower their expectations of future
inflation, causing long rates to fall.
Thus, the nature of the response suggests that the
Fed's action did not provide information about a
shift in the weights it attaches to various objectives; instead, it seems to have provided information about the course of action the Fed would
follow in pursuit of those objectives. In other
words, market participants know that the Fed

wants low inflation, but they do not know when
it will perceive a need to act to keep inflation
low. Market participants also know that the Fed
has acted gradually in the past. Thus, a move to
increase the funds rate after a period offal ling or
stable rates signals to markets that the Fed thinks
it needs to act to keep inflation low, and this
move is likely to be followed by further rate increases. Recognizing this, markets react to a shift
in the stance of monetary policy by immediately
raising long-term interest rates by more than the
initial increase in the funds rate.
Support for this explanation can be found in a
variety of sources. For instance, after the Fed's
first move earlier this year, market commentators
pointed out that the central bank would not confine itself to a mere 25-basis point increase in the
funds rate, since such a move would do little to
restrain either aggregate demand or inflation.
Thus, the move on February 4 was likely to be
the first of many such moves. By the second
quarter of this year, a number of private sector
estimates began to circulate on how far the Fed
would move once it began to raise rates. It is not
hard to believe that this information was reflected
in long rates as well.
The fact that long rates did not react much to
funds rate increases after the first two or three
Fed actions also is consistent with this hypothesis. Specifically, it implies that the Fed's actions
to raise rates were no longer much of a surprise,
since the markets already had incorporated a
risingfunds rate in their forecasts by this time.
Indeed, long rates actually declined when the
funds rate increase on May 17 was accompanied
by a statement to the effect that the Fed was unlikely to raise rates again in the near future.

the Fed's action but have risen so much since
then suggests markets were very surprised by
what the Fed did; the extent of this surprise is
In one sense, the puzzle is not new; a number of
studies have documented anomalous behavior at
the long end of the bond market, independent of
what causes short rates to move, or whether short
rates move at all. In the present context, these
studies present evidence suggesting that-even
before the current episode-a signal that the
Fed was going to raise rates in the near future
would cause long rates to go up by more than
would be warranted by expected future short
rates. (See Hardouvelis, for instance.) Unfortunately, while the anomalous behavior of longterm rates has been well-documented, it has not
been explained.

Th is Weekly· Letter has looked at .some of the
hypotheses explaining the recent rise in interest
rates. While part of the rise may be due to an
increase in expected inflation, this explanation
contradicts several key pieces of evidence, and
therefore is unlikely to account for a large portion
of the increase in rates. The rise in rates is more
obviously related to signs of strength in the economy, both directly and indirectly through anticipations of how the Fed will respond in order to
keep inflation in check. Even if one accepts this
explanation, however, the relatively large increase in long rates in response to the Fed's initial moves remains hard to explain.

Bharat Trehan
Research Officer

Some qualifications
This hypothesis leaves some things unexplained
as well. It is hard to argue that the funds rate increase on February 4 caught markets completely
by surprise. Given past patterns of Fed behavior,
the mounting evidence of a strong economy
should have led markets to become more and
more convinced that the Fed would act soon.
This should have begun to push up long-term
rates in advance of the Fed's actions. Thus, the
fact that long rates rose relatively little before


Barra, Robert J. 1994. "What the Fed Can't Do." Wall
Street Journal (August 19) p. A10.
Hardouvelis, Gikas A. 1994. "The Term Structure
Spread and Future Changes in Long and Short
Rates in the G7 Countries: Is There a Puzzle?"
Journal of Monetary Economics (April) pp.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author...• Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

Research Department

Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

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~ ~

Index to Recent Issues of FRBSF Weekly Letter

A 11 r""

'+1 I J



New Measures of the Work Force
Industry Effects: Stock Returns of Banks and Nonfinancial Firms
Monetary Policy in a Low Inflation Regime
Measuring the Gains from International Portfolio Diversification
Interstate Banking in the West
California Banks Playing Catch-up
California Recession and Recovery
just-In-Time Inventory Management: Has It Made a Difference?
GATS and Banking in the Pacific Basin
The Persistence of the Prime Rate
A Market-Based Approach to CRA
Manufacturing Bias in Regional Policy
An "Intermountain Miracle"?
Trade and Growth: Some Recent Evidence
Should the Central Bank Be Responsible for Regional Stabilization?
Interstate Banking and Risk
A Primer on Monetary Policy Part I: Goals and Instruments
A Primer on Monetary Policy Part II: Targets and Indicators
Linkages of National Interest Rates
Regional Income Divergence in the 1980s
Exchange Rate Arrangements in the Pacific Basin
How Bad is the "Bad Loan Problem" in Japan?
Measuring the Cost of "Financial Repression"


The FRBSF Weekly Letter appears on an abbreviated schedule in june, july, August, and December.