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Are You Protected From Inflation? NANCY AMMON JIANAKOPLOS I f your wage contract had a cost-of-living clause and the income tax structure were tied to a price index, you might believe you were insulated from the effects of inflation. Wrong! Despite these efforts to alleviate the more painful results of inflation, unexpected infla tion could still affect you, increasing wealth in some instances and decreasing it in others. two age groups are such that unanticipated inflation affects them differently. The wealth of almost every household will be affected by unanticipated inflation in a manner similar to one or the other of the house holds used in the examples.2 Too frequently only the most obvious consequences of inflation are considered. It is very easy to recognize a situation where the same number of dollars will purchase fewer goods this week than last week. How ever, inflation can have other, more subtle, effects. Some of these consequences of inflation depend on whether the changes in prices are anticipated or unanticipated. The first case portrays a typical household headed by a person over 65 years old. Column (1 ) of Exhibit I is the balance sheet of this household as of Decem ber 31, 1962. The three categories of items entered on the household’s balance sheet are assets, liabilities, and wealth. Assets are resources which are owned by the household. Liabilities are debts or claims held by others against the household. The difference between assets and liabilities, each valued in 1962 dollars, is the 1962 dollar value of the household’s wealth — in this case $30,684. UNANTICIPATED INFLATION Inflation is an ongoing rise in the general price level. Unanticipated inflation refers to price level increases which are not expected or are larger than expected. One of the effects of unanticipated inflation is a re distribution of wealth in an economy. Wealth (also called net worth or equity) in this context refers to the real or constant dollar net value of the stock of eco nomic goods and claims on economic goods accumu lated by a person, family, or business up to a point in time. Unanticipated inflation can increase or decrease an individual household’s wealth. The following two examples illustrate how one household can gain from unanticipated inflation, while the other loses wealth. The data used in the examples are based on the average December 31, 1962 balance sheets of house holds headed by individuals in two age groups — those over 65 and those under 35 years of age.1 The characteristics of the typical balance sheet of these 1Balance sheet data are based on survey data reported in Dorothy S. Projector and Gertrude S. Weiss, Survey o f Financial Characteristics o f Consumers (Washington, D.C.: Board of Governors of the Federal Beserve System), 1966. This survey of household wealth is one of the most compre hensive available. However, the data are subject to certain limitations. In particular, data relating to currency holdings and ownership of insurance policies by households were not included. Page 2 The Case of a Net Monetary Creditor It is important to distinguish between real and monetary assets and liabilities when considering the effect of unanticipated inflation on the household. Real assets are the household’s claims to specific items whose dollar values change with the general price level. The household’s real assets in this exam ple are claims to a house ( a claim with a 1962 market value of $7,477), a car ($411), a business ($3,727), real estate ($2,767), and stocks ($8,672 — which are claims on the wealth of a business).3 With inflation, the dollar value of these real assets normally increases in about the same proportion as does the price level.4 This occurs because the general price level is a sum-The case of a household’s wealth which is unchanged as a result of unanticipated inflation because its monetary assets exactly equal its monetary liabilities (a net monetary neutral household) is not considered in this discussion. 3The wealth of businesses will also be affected by unantici pated inflation depending on their status as net monetary creditors or debtors. For the sake of simplicity and lack of information pertaining to the monetary status o f firms in which the household owned stock it is assumed that wealth losses and gains of the firms represented by the household’s stock holdings net out on balance. To the extent that this would not actually be the case, the households would have experienced different wealth changes. 4Real assets are subject to changes in relative prices which will be ignored in this discussion. F E D E R A L R E S E R V E BA NK OF ST. LO UIS JANUARY Exhibit I U nanticipated Inflation N et M onetary Creditor Col. (1 ) December 31, 19621 Col. (2 ) December 31, 1975 Col. (3 ) December 31, 1 9 7 5 2 ____ (1 9 6 2 Dollars) (1 9 7 5 Dollars) (1 9 6 2 Dollars) $ 7,4 7 7 $ 1 3 ,3 0 2 Real Assets3 House Car 41 1 731 Business4 3 ,7 2 7 6,6 3 0 Real Estate 2,767 4,923 Stocks 8,672 15,427 $ 2 3 ,0 5 4 $ 4 1 ,0 1 3 $ $ M onetary Assets3 Checking Acct. 70 2 70 2 Savings Acct. ( B a n k ) 5 1,934 1,934 Savings Acct. (S&L) 1,484 1,484 U.S. Savin gs Bonds6 M arketable Securities7 M o rtga ge 8 Other TOTAL ASSETS 837 837 1,290 1,290 717 717 1,989 1.989 $ 8,953 $ 8,953 $ 3 2 ,0 0 7 $ 4 9 ,9 6 6 M onetary Liabilities Secured Debt $ 1,169 $ 1,169 Unsecured Debt 154 154 TOTAL LIABILITIES $ 1,323 $ 1,323 $ W EALTH $ 3 0 ,6 8 4 $ 4 8 ,6 4 3 $ 2 7 ,3 4 3 TOTAL LIABILITIES & W EALTH $ 3 2 ,0 0 7 $ 4 9 ,9 6 6 $ 2 8 ,0 8 7 657 87 74 4 S ource: Federal Reserve System. Survey o f Financial Characteristics o / Consumers (1 96 6 ). ’ Data are the average assets and liabilities held by households headed by persons over 65 years old. 2Data are deflated using the annua] average values o f the consum er price index. 3Valued at m arket prices unless otherwise indicated. 4Equity value. The ap p rop ria te measure would be m arket value, but these data were not reported. 5Includes savings not itemized elsewhere. 6Maturity value. 7P ar value. The ap p rop ria te measure would be m arket value, but these data were not reported. 8Dollars outstanding. N O T E : Data m ay differ from origin al due to rounding. mary measure of the dollar values of real assets throughout the economy. Monetary assets, on the other hand, are the house hold’s current or future claims to a fixed number of dollars. In many instances monetary assets earn inter est. The household in Exhibit I had monetary assets totaling $8,953 in December 1962. It held $702 in checking accounts, $1,934 in savings accounts at commercial banks, $1,484 in shares at savings and loan associations, $837 in the form of U.S. savings bonds, $1,290 in the form of marketable securities (for ex ample, U.S. Treasury notes or bills), $717 owed to them on a mortgage, and $1,989 in the form of mis cellaneous monetary assets. When the price level 1977 changes, these monetary assets still rep resent claims for the same number of dollars. This means, for example, that the household has claims on 702 dollars in their checking account, or 837 dollars in savings bonds, irrespective of how many goods and services these dollars can purchase. In contrast, if the market value of the household’s claims on a real asset, for example its house, rose from $7,477 to $8,000, it would still have a claim on the same physical amount of housing services despite any change in the dollar value of those services. Thus, the basic difference between real assets and monetary assets is that the former are claims on a certain quantity of goods and services, whose real value is unaf fected (on average) by inflation, while monetary assets are claims to a number of dollars, whose real value is decreased as a result of inflation. Real liabilities are obligations to de liver a certain physical quantity of goods or services whose dollar value may fluc tuate. An example of a real liability would be a contract to deliver a certain number of hours of labor or a specific volume of potatoes at a prearranged price. An increase in the general price level increases the dollar value of real liabilities in the same proportion. The household in Exhibit I does not have any real liabilities. Monetary liabilities are debts to be paid now or in the future in a fixed number of dollars. A rate of interest to be paid over the course of the debt is generally associated with a monetary liability. The household in Exhibit I has monetary liabilities equalling $1,323. This debt consists of $1,169 of secured debt (such as a mortgage) and $154 of unsecured debt (such as debt incurred by use of a credit card). When the general price level changes, the dollar value of monetary liabilities remains un changed. This means that despite any change in the purchasing power of the dollar from the time the loan was made, the household has to pay back 1,323 dollars, rather than a certain volume of physical goods. The difference between the 1962 dollar value of this household’s assets (both real and monetary) and its liabilities is the dollar value of its wealth in 1962, which equals $30,684. Exhibit I indicates that this Page 3 F E D E R A L R E S E R V E B A N K OF ST. L O UIS household has more monetary assets ($8,953) than monetary liabilities ($1,323); therefore, it is called a net monetary creditor. A household’s net monetary status is the factor which determines the effect of unanticipated inflation on its wealth. If we now assume that over the thirteen years from December 31, 1962 until December 31, 1975 this household and all others did not expect the price level to change, we can see how unanticipated inflation would have affected the household’s wealth. Over this period, the consumer price index (C P I), used here as a measure of the rate of inflation, actually increased at an average annual rate of 4.5 percent ( a cumulative increase in the price level of 77.9 percent over thir teen years). However, we assume that neither ob served past changes in the price level nor any other events change inflationary expectations, and, there fore, no economic unit takes any actions to change the structure of its balance sheet. Furthermore, any income the household earns is presumed to be used to make interest payments on its monetary liabilities and to purchase goods and services for immediate con sumption. Thus, over thirteen years the household makes no changes in its stocks of real and monetary assets or liabilities. Although these are unrealistic as sumptions, they help to illustrate the impact of un anticipated inflation on the household’s wealth, since everything is being held constant except the price level. Column (2 ) of Exhibit I shows the household’s balance sheet as of December 31, 1975. The CPI in creased by 77.9 percent from 1962 through 1975, rais ing the market value of the household’s real assets by the same percentage. While the household had the same physical claims to a house, car, etc., these real assets are valued at $41,013 in terms of 1975 prices, compared to $23,054 in 1962 prices. On the other hand, the household’s monetary assets totaled $8,953 in both 1962 and 1975. Likewise, the household’s monetary liabilities in 1975 were still obli gations to pay $1,323, the same as in 1962. The 1975 dollar value of the difference between this typical household’s assets ($49,966) and liabilities ($1,323), the household’s wealth, totaled $48,643. Al though the nominal value of the household’s wealth increased by 58.5 percent over the thirteen years, it did not increase as much as the price level (77.9 per cent). In this example, the household’s real wealth actually decreased by 10.9 percent between 1962 and 1975. Page 4 JANUARY 1977 The decline in the household’s wealth is shown more clearly in column (3 ) of Exhibit I. This column pre sents the household’s 1975 balance sheet in terms of 1962 purchasing power. Thus, $1 in column (3 ) has the same purchasing power as $1 in column (1 ). The value of the household’s real assets in constant dollars is identical in 1962 and 1975, since these assets repre sent claims on identical physical units. The purchasing power of the household’s monetary assets in 1975, al though representing the same number of dollars as in 1962, declined to $5,033, compared to their original purchasing power of $8,953. On the other hand, al though the household’s monetary liabilities were obli gations to pay the same number of dollars in 1962 and 1975, only $744 of 1962 purchasing power was owed in 1975, compared to the original debt of $1,323 in 1962. Since the household was a net monetary creditor, having more claims to dollars than obligations to pay dollars, the erosion of the purchasing power of the dollar over the thirteen years reduced the household’s real wealth. Overall, the household’s wealth in 1975 represented only $27,343 of 1962 purchasing power, compared to $30,684 originally — a loss of $3,341. In short, unanticipated inflation reduced the real wealth of this net monetary creditor. The Case of a Net Monetary Debtor Now consider the balance sheet of the household in Exhibit II. The data represent the average assets and liabilities on December 31, 1962, of a typical house hold headed by a person under 35 years of age. As shown in column (1 ) of Exhibit II, this household had claims on real assets (house, car, etc.) having a 1962 market value of $7,127. The household’s monetary assets (checking account, savings account, etc.) were claims on $2,812. Like the household in Exhibit I, this household does not have any real liabilities. However, monetary liabilities (mortgages, installment loans, etc.) of this household totalled $4,140. Its wealth valued in 1962 dollars totals $5,799. The household’s monetary liabilities exceed its monetary assets, so it is a net monetary debtor. Assume that this household also did not expect any price level changes over the thirteen year period and, therefore, took no actions to change its balance sheet. By December 31, 1975, as shown in column (2 ) of Exhibit I, the market value of the household’s claims on real assets had increased with the price level to $12,679. The household’s monetary assets and liabili- F E D E R A L R E S E R V E B A NK OF ST. LO UIS JANUARY Column (3 ) in Exhibit II illustrates how the wealth was gained. The bal ance sheet in this column presents the value of the 1975 assets and liabilities in terms of 1962 purchasing power. Just as in Exhibit I, $1 in column (3 ) represents the same amount of purchasing power as $1 in column (1 ). The household’s real assets represent the same physical claims in 1962 and 1975 and, thus, have the same real value in both years. The household’s monetary assets and liabili ties, however, represent the same num ber of dollars in 1962 and 1975, but not the same amount of purchasing power. The real value of the household’s mone tary assets in terms of 1962 purchasing power decreased to $1,581 in 1975, com pared to $2,812 originally. Likewise, monetary liabilities in 1975 represented obligations to surrender only $2,327 worth of 1962 purchasing power, com pared to $4,140 originally. Since this household owed more dollars than it had claims on dollars, the inflation reduced the real amount it owed, and the real wealth of the household increased by 10 percent, or $582. Exhibit II Unanticipated Inflation N et M o netary Debtor Col. (1) December 31, 19 6 2 1 Col. (2 ) December 31, 1975 Col. (3) December 3 19752 (1 9 6 2 Dollars) (1 9 7 5 Dollars) (1 9 6 2 Dollar Real Assets3 $ 4,648 $ 8,269 Car House 925 1,645 9 25 Business4 77 0 1,370 77 0 Real Estate 30 8 54 8 308 Stocks 476 847 476 $ 7,1 2 7 $ 1 2 ,6 7 9 $ 7,1 2 7 $ $ $ $ 4,648 M onetary Assets3 Checking Acct. 121 121 68 Savin gs Acct. ( B a n k ) 5 228 228 Savin gs Acct. (S&L) 146 146 82 U.S. Savin gs Bonds6 83 83 47 128 Marketable Securities7 23 23 13 M o rtga ge 8 52 52 29 2,159 2,15 9 1,214 $ 2,812 $ 2,812 $ 1,581 $ 9,9 3 9 $15,491 $ 8,708 $ 2,043 Other TOTAL ASSETS M onetary Liabilities $ 3,6 3 4 $ 3,6 3 4 Unsecured Debt 506 506 284 TOTAL LIABILITIES $ 4,14 0 $ 4,1 4 0 $ 2,327 W EALTH $ 5,7 9 9 $11,351 $ 6,381 TOTAL LIABILITIES & W EALTH $ 9,9 3 9 $15,491 $ 8,708 Secured Debt Source: Federal Reserve System. Survey o f Financial Characteristics of Consumers (1 96 6 ). *Data are the average assets and liabilities held by households headed by persons under 35 years old. 2Data are deflated using the annual average values o f the consum er price index. 3Valued at m arket prices unless otherw ise indicated. 4E quity value. The a p p rop ria te measure would be m arket value, but these data were not reported. 5Includes savings not itemized elsewhere. 6Maturity value. 7P ar value. The a p p rop ria te measure would be m arket value, but these data were not reported. 8Dollars outstanding. N O T E : Data m ay differ from original due to rounding. ties remained fixed claims or obligations of a certain number of dollars. Therefore, the dollar value of monetary assets remained at $2,812, and monetary liabilities were unchanged at $4,140. In December 1975, the household’s wealth equalled $11,351 in 1975 dollars, an increase of 95.7 percent from 1962, exceeding the 77.9 percent increase in the price level. This household’s wealth in 1975 actually represented 10 percent more purchasing power than in 1962. 1977 On balance, unanticipated inflation re distributes wealth from net monetary creditors, who lose part of the real value of their money-fixed assets to net mone tary debtors, who gain through a reduc tion in the real value of their monetary liabilities. For the economy as a whole some households gain wealth while others lose. However, the redistribution is not based on changes in productivity or explicit legislation (a progressive tax structure, for example). Thus, this effect of unanticipated inflation could be char acterized as redistribution without repre sentation and without merit. ANTICIPATED INFLATION The assumption that these two households did not expect any inflation over the thirteen years, and, therefore, did not alter the structure of their balance sheets is unjustified. More likely, a typical household, at least during the latter part of the period, would have expected some of the inflation, although perhaps not the exact pace of price level increase. Page 5 F E D E R A L R E S E R V E B A N K OF ST. L O UIS Consider the case when the two households from Exhibits I and II and all other economic units in the economy know the rate of inflation beforehand, a case of perfectly anticipated inflation. In this instance the households know that the price level will increase at an average annual rate of 4.5 percent. With perfect foresight and no institutional barriers, the interest rate structure will incorporate the expected inflation and eliminate wealth redistribution. However, given current institutional arrangements, households might not be able to prevent wealth re distribution. In order to demonstrate that correctly anticipating the rate of inflation theoretically allows households to avoid the wealth redistribution, it is necessary to assume that no external limits are placed on interest rates which can be paid. In particular, this implies that the household could earn interest on its checking account balances and currency that it holds. Unless all assets held by the household can earn an appropriate interest rate, wealth redistribution will not be avoided. The key difference in this instance is that house holds know there will be inflation and they know what the rate of inflation will be. Since they de.sire to avoid any loss in real wealth, purchasers of monetary assets will seek to protect the value of their assets. They can do this by demanding a rate of return on their monetary assets above the interest rate they would have originally agreed to in the absence of inflation. This increment to the interest rate, or “infla tion premium,” must equal the rate of price increase in order to provide the real yields the household would have received in the absence of inflation.5 In this case, since the household knows the price level will increase at an average 4.5 percent annual rate over the thirteen years, they will demand that their monetary assets earn a rate of interest 4.5 per centage points above what the assets would have otherwise earned. For example, if households would have originally agreed to lend money to the Govern ment by purchasing a Treasury bill earning a 2 per cent rate of interest in the absence of expected infla tion, they will now demand a 6.5 percent rate of return in order to maintain the bill’s real value. Thus, a correctly anticipated “inflation premium” protects net monetary creditors from wealth loss. Borrowers will be willing to pay the inflation pre mium since they know that they will be repaying the loan with “cheaper” dollars as a result of future infla 5The effect of taxes on interest earnings is ignored in this discussion. Digitized for Page FRASER 6 JANUARY 1977 tion. The extra interest paid by net monetary debtors as a result of the inflation premiums incorporated in interest rates offsets the wealth gain which would have occurred if inflation were unanticipated. Exhibit III illustrates how the net monetary creditor household from Exhibit I maintains the real value of its 1962 balance sheet given anticipated inflation and the assumptions set out. Column (1 ) of Exhibit III is the household’s original balance sheet as of Decem ber 31, 1962. Column (2 ) shows the household’s 1975 balance sheet. Real assets are assumed to have in creased, in proportion to the increase in the price level, from $23,054 in 1962 to $41,013 in 1975. Column (3 ) shows the 1962 purchasing power of the 1975 dol lars reported in column (2 ). The real value of real assets is the same in both periods just as in Exhibit I. Monetary assets in 1962 equalled $8,953. In order to offset losses in purchasing power the household is as sumed to have demanded an inflation premium aver aging 4.5 percentage points per annum incorporated in the interest rates of its monetary assets.6 This re sults in an addition to monetary assets totaling $6,974 over the course of the thirteen years. Thus, the house hold’s monetary assets increased from $8,953 in 1962 to $15,927 in 1975. Column (3 ) shows that the real value of the household’s monetary assets in 1975 is the same as in 1962. An inflation premium of 4.5 percentage points per annum is also assumed to be associated with the household’s monetary liabilities. As a consequence, over the course of thirteen years the household would have incurred $1,031 additional dollars of monetary liabilities, raising its total monetary liabilities to $2,354 in 1975. Again, this is the same real value as in 1962. The household’s 1975 wealth in this case amounts to $54,586 in 1975. In terms of 1962 purchasing power the household’s real wealth is unchanged and, there fore, it has avoided any wealth loss. Exhibit IV shows the case of the net monetary debtor in the instance of perfectly anticipated infla tion. Column (1 ) is the original 1962 balance sheet. Real assets increased in proportion to the price level, as indicated in column (2 ), but maintain the same real value, as shown in column (3 ). Monetary assets, which incorporate an inflation premium, earn annual incre ments to principal which total $2,190 so that their real value remains unchanged. Likewise, monetary liabili®As in the earlier examples, interest which would have been earned when no inflation was expected is assumed to be spent by the household. The incremental interest earned as a result of the inflation premium incorporated in interest rates is assumed to be added to the principal annually. F E D E R A L R E S E R V E B A NK OF ST. L O UIS JANUARY 1977 the components of their balance sheets, economizing on those monetary assets which did not earn a high enough rate of return and holding larger amounts of those assets whose interest rates were high enough to compensate for the losses in purchasing power. Exhibit III Anticipated Inflation N et M onetary Creditor Col. (1 ) December 31, 1962* Col. (2 ) December 31, 1975 Col. (3 ) December 31, 19752 (1 9 6 2 Dollars) (1 9 7 5 Dollars) (1 9 6 2 Dollars) Nevertheless, in order to carry out day-to-day transactions, most households M one tary Assets 15,927* 8,953 will find it necessaiy to maintain at least $ 5 6 ,9 4 0 $ 3 2 ,0 0 7 Total Assets $ 3 2 ,0 0 7 some assets in noninterest or low-interest $ 2 ,3 5 4 ‘ $ 1,323 M onetary Liabilities $ 1,323 earning forms, such as cash and check 3 0 ,6 8 4 3 0 ,6 8 4 5 4 ,5 8 6 W ealth ing accounts (money). Inflation makes $ 3 2 ,0 0 7 W ealth & Total Liabilities $ 3 2 ,0 0 7 $ 5 6 ,9 4 0 it more expensive to use money since it loses purchasing power. Households will, S ource: Federal Reserve System. Survey o f Financial Characteristics of Consumers (1 96 6 ). therefore, cut down on their holdings *Data are the average assets and liabilities held by households headed by persons over 65 years old. and use of money. However, in econo 2Data are deflated using the annual average values o f the consum er price index (C P I ). mizing on their money balances, house 3Assumed to have increased in p rop ortion to the CPI. 4Assumed to have earned or incurred a 4.5 percentage per annum rate o f return (n et o f holds will lose some of the services of taxes) above the rate o f interest contracted assum ing no inflation. N O T E : Data m ay differ from origin al due to rounding. money. Money facilitates transactions and enhances economic efficiency. The higher cost of holding money will lead the economy ties incur an additional 4.5 percentage point average annual interest charge from which the annual incre to devote otherwise productive resources to the production of money substitutes. ments to principal total $3,225 over thirteen years. The real value of monetary liabilities is unchanged. Loss of money’s services can result in economic The household’s wealth increases to $10,316, which dislocation. For example, a worker may want to be represents the same amount of purchasing power as paid at the end of each day instead of at the end of in 1962. the week or month, so that he can spend the money By incorporating an appropriate inflation premium before it loses more purchasing power. The loss of money’s services will cause people to alter their pro in their interest rates based on accurate expectations duction patterns in order to protect themselves against of future price level changes, households can theoreti lost purchasing power. This will involve more frecally avoid an inflationary redistribution of wealth. However, over the period from 1962 through 1975, there were barriers which Exhibit tv would have prevented households from Anticipated Inflation totally avoiding the redistribution. Real Assets $ 2 3 ,0 5 4 $ 41 ,0133 $ 2 3 ,0 5 4 8,953 N et M on etary Debtor Owners of monetary assets and liabili ties were not free to contract interest rates which fully incorporated an ade quate inflation premium. For example, over this period banks were not allowed to pay any interest on checking accounts. Interest rates on savings accounts were regulated and, therefore, households would not have been able to earn 4.5 percentage points in addition to the in terest rate they would “normally” re quire. These interest rate restrictions hindered households from protecting the real value of their balance sheet. How ever, in order to maintain the value of real wealth, households could rearrange Col. (1 ) December 31, 19621 (1 9 6 2 Dollars) Real Assets M onetary Assets Total Assets M on e tary Liabilities W ealth W ealth Total Liabilities Col. (2 ) December 3 1, 1975 (1 9 7 5 Dollars) Col. (3 ) December 31, 197 5* (1 9 6 2 Dollars) $ 7,1 2 7 $1 2 ,6 7 9 3 $ 7,1 2 7 2,812 5 ,0 0 2 4 2,812 9,9 3 9 $ 9,939 $17,681 $ 4,1 4 0 $ 7,365* 4 ,1 4 0 5,7 9 9 10,316 5 ,7 9 9 $ 9,9 3 9 $17,681 $ 9 ,9 3 9 S ource: Federal Reserve System. Survey o f Financial Characteristics of Consumers (1 96 6 ). *Data are the average assets and liabilities held by households headed by persons under 35 years old. 2Data are deflated using the annual average values o f the consum er price index ( C P I ) . 3Assumed to have increased in p rop ortion to the CPI. 4Assumed to have earned or incurred a 4.5 percentage per annum rate o f return (n et o f taxes) above the rate o f interest contracted assum ing n o inflation. N O T E : Data m ay differ fro m original due to rounding. Page 7 F E D E R A L R E S E R V E B A N K OF ST. L O UIS JANUARY 1977 quent trips to the bank and greater use of nonmoney transactions (barter). These attempts to prevent wealth loss will use up productive resources, lowering the productive capacity of the whole economy. tion leads to a loss in money’s services and a loss to the whole economy in terms of lower efficiency and production. Just as there are institutional barriers preventing households from fully protecting themselves against wealth redistribution, it is probable that households, although anticipating inflation, will not accurately anticipate the pace of price increase. Past rates of inflation have varied from year to year and, thus, have increased uncertainty about future rates of inflation. Expectations of future inflation, but at an uncertain rate, can decrease households’ desires to hold long term investment assets since they will have a better idea of the rate of inflation one year from now than ten years from now. Long-term investments will in volve greater risks when the future rate of inflation is uncertain. If a smaller amount of long-term funds is available, the price of long-term borrowing by indus try to expand plants or households to build houses, for example, would increase. Thus, a possible conse quence of increased uncertainty about future inflation is a reduction in the rate of growth of the economy’s capital stock and a lowering of the society’s welfare. CONCLUSION If households have accurate expectations of future price level changes reflected in the interest rate structure, it is theoretically possible to avoid infla tionary wealth redistribution.7 However, current insti tutional arrangements, which hinder households from fully adjusting their portfolios, make some wealth re distribution inevitable. In addition, anticipated infla 7However, even perfectly anticipated inflation involves costs. For a discussion of these costs, see John A. Tatom, “The Welfare Cost of Inflation,” this Review (November 1976), pp. 9-22. 8 Digitized for Page FRASER Certain consequences of inflation depend on whether the rate of inflation is anticipated or unanti cipated. Inflation is not likely to be perfectly antici pated nor totally unexpected. To the extent that inflation is unanticipated, redistribution of wealth occurs. Net monetary creditors lose wealth, while net monetary debtors gain wealth. Households gain or lose depending on the composition of their balance sheets. The government sector is a net monetary debtor to the rest of the economy and, thus, benefits as a result of unanticipated inflation. Nevertheless, unanticipated inflation transfers wealth (control over resources) from private decisionmakers to public control without necessitating higher taxes and, therefore, without requiring explicit authorization by a majority of the citizens. As a consequence of this positive wealth transfer, which is a relatively attractive method of raising revenue, the government has less incentive to control inflation. Even if households perfectly anticipate inflation, institutional arrangements prevent households from fully protecting themselves against wealth losses. Especially to the extent that households hold money during periods of inflation, they will lose wealth. And the economy as a whole will lose welfare as house holds hold less money and benefit less from the ser vices of money as a result of adjustments to expected inflation and increased uncertainty. The 1975-76 Federal Deficits and the Credit Market R IC H A R D T H E possible effects on credit markets of the fiscal 1975 and 1976 U.S. Government deficits were of con siderable concern in late 1974 and early 1975. Projec tions of these deficits ran from $50 to $80 billion or more. A number of analysts outlined certain condi tions under which the financing of such large deficits by Treasury borrowing would have adverse effects on credit markets, pushing short-term interest rates into the double-digit range again and crowding out private borrowing for capital formation. If these conditions developed, it was suggested that the Federal Reserve might attempt to keep interest rates from rising by increasing its rate of purchase of Government securi ties. As a result, there would be a large increase in the growth of the money stock, which eventually would lead to a new inflationary spiral that would push interest rates higher due to increased inflationary expectations.1 The concern for credit markets was based on the assumption that the increased Government demand for credit would overwhelm any decrease in the private demand for credit as well as any increase in the supply of credit. Other analysts maintained that although Government borrowing would increase, pri vate borrowing would decrease substantially during the recession. This decrease in the private demand for funds was expected to largely offset the increased Government demand, with the result that the larger deficits would have little effect on either interest rates or the total quantity of credit.2 The deficits in fiscal 1975 and 1976 were $43.6 billion and $65.6 billion, respectively, while the largest deficit in the previous ten fiscal years was $25.2 billion (see Table I ).3 Thus, relative to recent historical 1This possibility was expressed in this Review in a number of different articles. See, for example, Darryl R. Francis, “ How and W hy Fiscal Actions Matter to a Monetarist,” this Review (M ay 1974), p. 7; W . Philip Gramm, “ Inflation: Its Cause and Cure,” this Review (February 1975), pp. 5-6; or Susan R. Roesch, “ The Monetary-Fiscal Mix Through Mid-1976,” this Review (August 1975), pp. 2-7. -This point of view was clearly expressed by James L. Pierce, “ Interest Rates and Their Prospect in the Recovery,” B rook ings Papers on Econom ic Activity (1 :1 9 7 5 ), pp. 89-112. 3Using the unified budget data as reported in the Federal Reserve Bulletin. W. LANG Table I Fiscal Y e a r Surplus or Deficit Fiscal _Year Surplus ( + ) or Deficit ( - ) (In Billions of Dollars) 1 96 5 - 1.6 1 96 6 - 3.8 8.7 1967 - 1 968 -2 5 .2 1969 + 3.2 1 97 0 - 1971 -2 3 .0 1 97 2 -2 3 .2 1 97 3 -1 4 .3 1 97 4 - 1 97 5 -4 3 .6 1 97 6 -6 5 .6 S ou rce: Table, “ Federal Reserve Bulletin. Fiscal O p erations: 2.8 3.5 Sum m ary,” Federal standards the deficits in 1975 and 1976 were indeed large, and it is not surprising that they generated considerable concern. But what happened to credit markets and interest rates during this period? FRAMEWORK FOR ANALYZING CREDIT MARKET CONDITIONS Credit market conditions can be discussed in terms of a simple supply and demand framework which lumps all credit markets together.4 The quantity of credit and the price of credit (the market interest rate) are determined by the supply of and the de mand for credit. The total demand for credit consists of a private demand plus a Government demand. An increase in the Federal deficit which is financed by increased Government borrowing results in an in crease in the Government’s demand for credit and, hence, an increase in the total demand for credit above what it would be in the absence of the in creased Government borrowing. The extent to which the increased Federal deficit increases the total 4The discussion in this paper is only in terms of the nominal supply and demand for credit and nominal rates of interest. Page 9 FED ERAL RESERVE B A NK OF ST. LO UIS demand for credit depends in large part on whether the deficit is predominantly due to “active” or “pas sive” elements in the budget.5 Discretionary changes in Federal expenditures and taxes which result from Congressional or Executive actions are “active” ele ments in the budget. Nondiscretionary, or automatic, changes in Federal expenditures or taxes which result from changes in the level of economic activity are “passive” elements in the budget. A Federal deficit which is primarily the result of active elements in the budget will tend to produce a larger increase in the total demand for credit than if the deficit were pri marily due to passive elements. This tendency re flects the fact that credit finances economic activity. If the budget deficit is the result of passive elements, the decline in economic activity which leads to the increased deficit is also generally accompanied by a decline in the private demand for credit. Given an increase in the total demand for credit from an increased Government deficit, regardless of whether the deficit is active or passive, the market interest rate increases as potential borrowers bid for the available credit. As a result, the quantity of credit supplied increases as suppliers of credit are induced to increase their lending by the rise in interest rates. Since Federal Government borrowing is relatively in sensitive to changes in the cost of borrowing, the main effect of a rise in the market interest rate is on private sector borrowing. If other factors are un changed, private borrowers will want to borrow a smaller quantity of credit at this higher interest rate. Since the total quantity of credit supplied is larger, this implies that the proportion of credit going to the Government is larger. The resulting absolute decrease in the amount of private sector credit is one illustra tion of the argument that Government borrowing “crowds out” private borrowing.6 This simplified analysis describes the underlying rationale for some of the warnings expressed in 1974-75 about higher interest rates and private bor rowing. It was maintained that if the Government increased its debt by $50 to $100 billion in order to 5For a detailed discussion of “ active” and “ passive” budget deficits, see Keith M. Carlson, “ Large Federal Budget Defi cits : Perspectives and Prospects,” this Review ( October 1976), pp. 2-7. 6For a detailed discussion of “ crowding out” , see J. Kurt Dew, “ The Capital Market Crowding Out Problem in Perspective,” Federal Reserve Bank of San Francisco Econom ic Review (D ecem ber 1975), pp. 36-42; Roger W . Spencer and William P. Yohe, “ The ‘Crowding Out’ of Private Expendi tures by Fiscal Policy Actions,” this R eview (O ctober 1970), pp. 12-24; and Keith M. Carlson and Roger W . Spencer, “ Crowding Out and Its Critics,” this R eview (Decem ber 1975), pp. 2-17. Digitized for Page FRASER 10 JANUARY 1977 finance the large projected deficits, with other factors unchanged, market interest rates would rise. Further more, it was claimed that if the Federal Reserve pur chased a large proportion of the increased debt in an attempt to prevent this increase in interest rates, higher expected rates of inflation would result. This, in turn, would lead to higher interest rates. The above analysis also implied that the nominal quantity of credit outstanding would increase. The above outlook for the credit market depended heavily on the assumption that there would not be a substantial decrease in the private demand for credit. Some analysts, however, maintained that the recession would induce much lower private investment because of higher excess capacity, and that the private de mand for credit would therefore decrease substantially during fiscal 1975. Private borrowing would be lower primarily as a result of a decline in the private de mand for credit and not as a result of a rise in market interest rates. This decrease in private demand, ac cording to proponents of this view, was expected to offset, although not totally, the increase in the Govern ment’s demand for funds.7 This point of view generally maintained that the credit market would be basically unaffected, in terms of price and total quantity, by the large increase in Government borrowing. As a result of the changes in private and Government demands, the distribution of total credit would change, but interest rates would not be substantially increased and the quantity of credit outstanding would be increased only slightly. Of course, in the absence of the Government’s in creased borrowing, the expected decrease in private demand would have implied even lower interest rates in 1975-76, according to this view. GOVERNMENT BORROWING, PRIVATE BORROWING, AND THE CREDIT MARKET IN FISCAL 1975 AND 1976 In 1975 and 1976, short-term interest rates did not rise above their mid-1974 peaks, but instead tended to decline. Although short-term rates rose in mid-1975 and again in mid-1976 (see Chart I), these upward movements were not sustained and were not as severe as some analysts had expected. In mid-1975, the up ward movement in short-term rates peaked at rates below 7 percent, and in mid-1976 they peaked at "Pierce estimated that Government borrowing in calendar year 1975 would increase by $80 billion while borrowing by other nonfinancial sectors would decrease by $72 billion. See Pierce, “ Interest Rates,” pp. 106-8. F E D E R A L R E S E R V E B A NK OF ST. LO UIS JANUARY C h a rt I C h o n II Short-Term Interest R ate s Long-Term Interest R ate s R a tio S c a lt R a tio Scalo R a tio S o l a 1977 R a tio Sc ala L I FH A 3 0 -y e a r m o rtgage s. D a s h e d lin e s in d ic a te d a ta not a v a ila b le . P re p a re d b y F e d e ra l R e se rve B a n k of St. Louis rates below 6 percent. In both cases, short-term rates were well below the 1974 peaks of about 12 percent for four- to six-month commercial paper and about 9 percent for three-month Treasury bills. Long-term in terest rates also generally declined from mid-1974 levels, although not as dramatically or consistently as short-term rates (see Chart II). [2 M o n t h ly a v e r a g e s of T h u rsd a y figures. 13 A v e r a g e o f y ie ld s o n c o u p o n iss u e s d u e o r c a lla b le in ten y e a r s o r m ore, e x c lu d in g issu e s with F e deral estate t a x p riv ile g e s . Y ie ld s a re c om puted b y this Bank. L ate st d a t a p lo tte d : F H A - N o v e m b e r ; O t h e r s - D e c e m b e r . . . . . . P re p a re d b y F e d e ra l R eserve B a n k o f St. L ou is This was the largest year-to-year decrease in the amount of funds going to the private nonfinancial sector in the post-World War II period. Table II Funds Raised b y N o n fin a n c ia l Sectors* The funds raised by all nonfinancial sectors in fiscal 1975 were about $8 billion lower than in fiscal 1974 (see Table II). In order for both interest rates and the total amount of new credit to be lower in fiscal 1975 than in mid-1974, the total demand for credit must have decreased in 1975. Since Government demand for credit increased in fiscal 1975, private demand must have decreased substantially.8 A decrease in the demand for credit by the private sector would have to more than offset the increased Government de mand in order for the total demand for credit to decline. While the Federal Government raised $50.7 billion in fiscal 1975, compared with $3.3 billion in fiscal 1974, all other nonfinancial sectors raised $132.6 billion — a decrease of $55.5 billion from the fiscal 1974 level. 8Susan R. Roesch and Keitli M. Carlson both noted this. See Roesch, “ The Monetary-Fiscal Mix,” p. 2; and Carlson, “ Large Federal Budget Deficits,” p. 6. The fall in private de mand was also discussed by R. Alton Gilbert, “ Bank Financing of the Recovery,” this Review (July 1976), pp. 2-9. (Billions of Dollars) Fiscal Year Total * * U.S. Government All Other Nonfinancial 1965 $ 71.2 1 96 6 76.0 1.6 74.4 1 96 7 60.8 1.8 59.1 $ 3.8 $ 67.5 1968 97.0 20.7 76.3 1 96 9 9 6.7 -0 . 4 97.1 1 97 0 93.6 3.8 89.8 1971 124.4 19.5 105.0 1 972 161.5 19.4 142.1 1 973 202.1 19.5 182.6 1 974 191.5 3.3 188.1 1 975 183.3 5 0.7 132.6 1 97 6 241.0 82.8 158.2 ♦Based on the sum o f unadjusted quarterly flows fo r each fiscal year, series updated as o f N ovem ber 1976. **Columns m ay n ot sum to total due to rounding. S ource: Table, “ Sum m ary o f Credit Market Funds F low o f Funds Section, Board o f Governors o f Funds Raised in Credit M arkets: Raised by N onfinancial S ectors,” Division o f Research and Statistics, the Federal Reserve System. Page 11 F E D E R A L R E S E R V E B A NK OF ST. LO UIS The decrease in the private demand for credit can be attributed in a general way to the decline in the level of economic activity between late 1973 and early 1975, during which time the United States experi enced its most severe postwar recession. However, the specific factors affecting the demand for credit, as well as the supply of credit, are more complex. The last recession was preceded by a number of shocks to the economy: the oil embargo and subse quent large increase in the price of energy; the end of wage and price controls; crop failures; and the intro duction of new Government regulations regarding pollution and safety. These factors all combined to effect a one-time increase in the price level and a reduction in the country’s productive capacity.9 The increase in the price level was first per ceived as an increase in the rate of inflation, and led to upward revisions in lenders’ and borrowers’ ex pected rates of inflation, at least in the short term. As a result, the supply of credit decreased and the de mand for credit increased, and market interest rates rose rapidly in fiscal 1974. However, without any further shocks to the price level, the rate of change of prices returned to its previous pace. As lenders and borrowers realized this, their inflationary expectations were revised downward. This resulted in a decline in the demand for credit and an increase in the supply, leading to a decline in market rates of interest. Furthermore, the possibility of future oil embargoes, new wage and price controls, and further substantial changes in Government regulations resulted in in creased uncertainty about the future state of the econ omy and lowered business confidence concerning profitable productive opportunities. Consequently, producers became more cautious about committing themselves to new investment projects, and the de mand for credit to finance such investment declined. This general uncertainty also led to a substantial increase in the supply of short-term credit as many economic units sought to build their “liquidity” as protection against future contingencies. Another fac tor which contributed to the decline in private de mand for short-term credit in fiscal 1975 was the sharp decrease in inventory investment during the first half of 1975, which tended to reduce short-term private borrowing.10 In contrast to fiscal 1975, the total funds raised in fiscal 1976 by all nonfinancial sectors increased by JANUARY 1977 about $58 billion. Since the 1976 budget deficit was larger than the 1975 deficit (Table I), the Govern ment demand for credit again increased. The Federal Government raised $82.8 billion in fiscal 1976, an in crease of about $32 billion over the fiscal 1975 level of $50.7 billion (see Table II). The funds raised by all other nonfinancial sectors also increased in fiscal 1976, by $25.6 billion over the fiscal 1975 level. Neverthe less, these private nonfinancial sectors raised almost $30 billion less in fiscal 1976 than in fiscal 1974. Although the total funds raised by the private sec tor increased in fiscal 1976, the private demand for credit did not show a substantial increase. In fact, private short-term credit declined during most of fiscal 1976. The sluggish private demand for credit during fiscal 1976 showed up in the decline of busi ness loan demand at commercial banks and the vol ume of commercial paper outstanding, both of which are primary sources of short-term credit by corpora tions.11 The volume of commercial paper declined between March 1975 and May 1976, while business loans at commercial banks declined throughout fiscal 1976. With an increase in the Government’s demand for credit and little change in private demand, the total demand for credit increased. However, interest rates did not increase, as would be expected if the total demand for credit increased while the supply was constant. Instead, in fiscal 1976 interest rates were generally lower than in fiscal 1975. This combination of lower interest rates and higher credit indicates that the supply of credit increased both absolutely and relative to the total demand for credit. The decrease in the rate of inflation since mid-1974 and the moderate rates of growth of the monetary base and the money stock during fiscal 1976 resulted in downward revisions of investors’ expected rates of inflation. This tended to increase the supply of credit since lenders did not have to require as high an inter est rate to maintain their purchasing power. In addi tion, the amount of funds available for lending increased during fiscal 1976, as indicated by an al most 19 percent increase in gross private saving over this period.12 The distribution of credit between the Government and private sectors has changed considerably in the last two fiscal years. In fiscal 1975, 27.7 percent of all n Ibid., p. 4. !lSee Denis S. Kamosky, “ The Link Between Money and Prices — 1971-76,” this Review (June 1976), pp. 17-23. lftSee Gilbert, “ Bank Financing,” pp. 5-6. Page 12 1-Gross private saving includes personal saving and undis tributed corporate profits ( with inventory valuation and capital consumption adjustments). FEDERAL RESERVE BANK OF ST. L O UIS Table III JANUARY Table IV Proportion o f Total Funds Raised by N o n fin a n c ia l Sectors G o in g to the U.S. Governm ent* Federal Reserve H o ld in g s o f Federal Debt (Percent) Fiscal Year U.S. Government 196 5 5 .3 % Period Ending June: Change s in Federal Debt (Billions of Dollars) C hanges in Federal Debt Proportion of Held by Change in the Federal Federal Debt Reserve Banks Held by the (Billions of Federal Reserve Dollars) Banks (Percent) 1966 2.1 1967 2.9 197 0 $ 6.8 $3.6 196 8 1971 19.5 7.8 40.0 1969 21.3 ** 1972 20.6 5.9 28.6 1 97 0 4.1 1973 18.9 3.6 19.1 1971 15.6 197 4 2.2 5.5 250.0 1972 12.0 1975 51.0 4.2 8.2 197 3 9.7 197 6 82.9 9.7 1 1.7 1 97 4 1.7 1975 27.7 197 6 34.4 ♦Based on the sum o f unadjusted quarterly flows fo r each fiscal year, series updated as o f N ovem ber 1976. ♦♦Represents a net outflow fo r this sector (negative flow ). Source: Table, “ Summary o f Funds Raised in Credit M arkets: Credit Market Funds Raised by N onfinancial S ectors,” Flow o f Funds Section, Division o f Research and Statistics, Board o f Governors o f the Federal Reserve System. funds raised in the credit markets by nonfinancial sectors went to the U.S. Government, up from 1.7 percent in fiscal 1974 (see Table III). The Govern ment’s share of funds increased further in fiscal 1976, to 34.4 percent. THE FEDERAL DEBT AND THE FEDERAL RESERVE As shown in Panel 3 of Chart III, the proportion of the total outstanding Federal debt (total gross public debt less debt held by U.S. Government agencies and trust funds) held by the Federal Reserve had been rising fairly steadily through 1974 — from about 12 percent in 1962 to almost 24 percent in fiscal 1974. In the ten fiscal years prior to fiscal 1975, the largest increase in the Federal debt was recorded in fiscal 1968, $20.7 billion, of which 26.6 percent was mone tized.13 From fiscal 1970 through fiscal 1974, the Federal Reserve generally monetized over 20 percent of the increases in the Federal debt (see Table IV ). Many analysts expected this pattern to continue through fiscal 1975 and 1976, but instead the Federal Reserve monetized much lower proportions of the increases in the debt. 13The Federal Reserve does not purchase Government securi ties directly from the Treasury when engaging in open market operations. Rather, it purchases securities which the Treasury has already sold to the private sector. 1977 5 3 .0 % S ou rce: Table, “ Ow nership o f Public Debt.” selected issues o f the Federal Reserve Bulletin. To finance the 1975 deficit, Federal debt increased $51 billion.14 During fiscal 1975, the Federal Reserve increased its holdings of the outstanding debt by $4.2 billion, so that 8.2 percent of the increase in the debt was monetized (see Table IV ). In fiscal 1976, 11.7 percent of the $82.9 billion increase in the debt was monetized. Consequently, there was not a large in crease in the growth of the monetary base, and the expected surge in the money stock did not materialize (see panels 4 and 5 of Chart III). While the propor tion of the total outstanding Federal debt held by the Federal Reserve decreased, a larger proportion was being taken by commercial banks, corporations, and “other investors”15 (see Tables V and V I). SUMMARY AND OUTLOOK Of the total funds raised in the credit markets in fiscal 1975 and 1976, a larger proportion went to the Government than in the previous ten years (Table III). In fiscal 1975, the private demand for funds decreased; the private sector wanted to borrow less at any level of interest rates. Thus, their share of the total funds raised would have declined even if the Government’s demand for funds had remained con stant. On the other hand, had the Government de mand for funds not increased, the decreased demand by private borrowers would have resulted in even lower interest rates. 14Federal debt is not equal to the budget deficit mainly because of: 1) changes in the deficits of off-budget agencies, and 2 ) changes in cash and monetary assets of the Treasury. 15“ Other investors” include savings and loan associations, nonprofit institutions, corporate pension trust funds, dealers and brokers, and certain Government deposit accounts and Government-sponsored agencies. Page 13 JANUARY F E D E R A L R E S E R V E BA NK OF ST. LO U IS 1977 <_nar? in Influence of Federal G o v e r n m e n t Debt on M o n e t a r y E x p a n s i o n 1952 1953 1954 1955 1956 1957 1958 1959 I960 1961 1962 1963 1964 1965 1964 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 R ATIO S C A L E I B ILL IO N S O F D O L L A R S Federal G overn m ent Debt* ----- ‘ F e de ra l G ove rn m e nt D e b t is total g ro s s p ub lic d e b t less d e b t held b y -----__U.S. G o ve rn m e n t a g e n cie s a n d trust funds. The o riqin a l d a ta m a y b e f o u n d in the ta ble entitled "O w n e rsh ip o f Public D e b t” in the F e d e ra l R eserve Bulletin S e a s o n a lly A d j u s t e d ^ +4.8% 4th 1st q tr. 5 2 R A T IO SC A LE ] — I B ILL IO N S O F D O L L A R S I I I ^Federal G overn m ent D ebt n ,r Held b y the Federal Reserve System I p §p S e a s o n a lly A d ju ste d ---- 1st a t d q t r .'6 1 P ERCENT Percent of Federal G overn m e nt Debt Held b y the Federal Reserve System ______________S e a s o n a lly A d ju ste d J| | ______________________________ \ R ATIO SCALE| B ILL IO N S O F D O L L A R S M o n e ta ry Base ___ Se a s o n a lly A d ju ste d ____ Is f qtr. 5 2 ^ inII______ I R A T IO SC A LE | | B IL L IO N S O F D O L L A R S M o n e y Stock Se a s o n a lly Ad ju ste d 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 The first four sh a d e d a r e a s re p re se n t p e rio d s o f b u sin e ss rece ssion s a s d efine d b y the N a t io n a l B u re au of Econom ic R esearch. The fifth s h a d e d a re a is tentative, a n d h a s bee n d e fin e d b y the Fe d e ra l R eserve B a n k of St. Louis. Latest d a ta plotted: M B a n d M S - 4 t h q u a rt e r; O t h e r s - 4 t h q u a rt e r e stim a te d Page 14 F E D E R A L R E S E R V E B A N K OF ST. L O UIS JANUARY 1977 Table V O w n e rsh ip o f Federal Debt (Billions of Dollars) Federal Debt Held By: C orporations State and Local Governm ents Foreign and International O ther Investors $5.6 $15 .3 $24.1 $1 5 .7 $16.8 5.0 14.2 24.5 15.4 16.9 9.0 4.2 11.0 23.6 14.7 19.3 74.2 8.5 4.0 12.0 25.1 12.9 22.7 55.3 77.3 8.1 3.5 11.1 26.4 11.1 22.0 52.6 81.8 7.2 3.2 8.5 29.0 14.8 21.0 65.5 61.0 75.4 7.0 3.3 7.4 25.9 32.7 17.2 315.8 71.4 60.9 73.2 6.7 3.5 9.3 26.9 50.0 14.0 1 97 3 33 4 .7 75.0 58.8 75.9 6.3 3.3 9.8 28.8 60.2 16.6 197 4 336 .9 80.5 53.2 80.7 5.9 2.6 10.8 28.3 57 .7 17.3 Period Ending June: Federal Debt Federal Reserve Banks Insurance Com panies M utual Savings Banks Commercial Banks Individuals 1965 $ 2 5 3 .9 $39.1 $ 5 8 .2 1 96 6 253.2 42.2 54.8 $ 7 0 .7 $ 1 0 .7 72.8 10.0 1 96 7 250 .9 4 6.7 5 5.5 70.4 1968 271.6 52.2 59 .7 1 96 9 1 97 0 268 .9 54.1 27 5 .7 5 7 .7 1971 295 .2 1972 197 5 38 7 .9 84.7 69.0 87.1 7.1 3.5 13.2 29.6 66.0 27.6 1976 470 .8 94.4 91.8 96.4 10.5 5.1 25.0 39.5 69.8 38.2 S ou rce: Table OFS-2, "E stim ated Ow nership o f Public Debt Securities by P rivate Investors,” Treasury Bulletin (Septem ber 1976), p. 65. The Federal Reserve did not purchase a large pro portion of the debt in fiscal 1975 and 1976, compared to the previous five fiscal years. In fact, the Federal Reserve’s share of the total outstanding debt declined in the last two fiscal years. The Government deficit was mainly financed by the private sector, with larger proportions of the debt held by commercial banks, corporations, and some nonbank financial institutions. In fiscal 1976, the supply of credit increased rela tive to demand, so that the increased budget deficit again did not have the adverse effects on interest rates and private borrowing which had been expected by some analysts. As a result of the large decline in the private demand for credit in fiscal 1975 and the in creased supply of credit in fiscal 1976, upward pres sure on interest rates did not materialize. T a b le VI Percentage O w n e rsh ip o f Federal Debt Proportion of Federal Debt Held By: Period Ending June: Federal Reserve Banks 1965 1 5 .4 % 1 96 6 16.6 Commercial Banks Individuals Insurance Companies 2 2 .9 % 2 7 .8 % 4 .2 % 21.6 28.8 3.9 Mutual Savin gs Banks Foreign and interna tional Corporations State and Local Governments 2 .2 % 6 .0 % 9 .5 % 6 .2 % 6 .6 % 2.0 5.6 9.7 6.1 6.7 O ther Investors 1 96 7 18.6 22.1 28.1 3.6 1.7 4.4 9.4 5.9 7.7 1968 19.2 22.0 27.3 3.1 1.5 4.4 9.2 4.7 8.4 1969 20.1 20.6 28.7 3.0 1.3 4.1 9.8 4.1 8.2 1 97 0 20.9 19.1 29.7 2.6 1.2 3.1 10.5 5.4 7.6 1971 22.2 20.7 25.5 2.4 1.1 2.5 8.8 11.1 5.8 1972 22.6 19.3 23.2 2.1 1.1 2.9 8.5 15.8 4.4 1973 22.4 17.6 22.7 1.9 1.0 2.9 8.6 18.0 5.0 197 4 23.9 15.8 24.0 1.8 0.8 3.2 8.4 17.1 5.1 1975 21.8 17.8 22.5 1.8 0.9 3.4 7.6 17.0 7.1 1 97 6 20.0 19.5 20.5 2.2 1.1 5.3 8.4 14.8 8.1 S ou rce: Table OFS-2, "E stim ated Ownership o f Public Debt Securities by Private Investors,” Treasury Bulletin (Septem ber 1976), p. 65. Page 15 The negligible impact of the 1975-76 Federal defi cits on credit markets suggests that these deficits were primarily due to passive rather than active ele ments in the budget. Thus, increased Government borrowing due to the decline in economic activity tended to be offset by a concomitant reduction in private borrowing. For example, it has been esti mated that two-thirds of the budget deficit during this period was due to passive elements.16 Large budget deficits such as those experienced in 1975 and 1976 will continue to be a matter of concern for the next few years. The projected deficit for fiscal 1977 is $57.2 billion, somewhat lower than the fiscal 1976 deficit, and this is before any new tax cuts or spending programs which the new Administration may propose to include in this year’s budget. With a 16Carlson, “ Large Federal Budget Deficits,” p. 6. 16 Digitized for Page FRASER $12-16 billion program like that recently proposed by the new Administration for fiscal 1977, the current budget deficit will probably be larger than the $65.6 billion fiscal 1976 deficit. If the private demand for credit remains sluggish in 1977, as was the case during most of 1976, then there will be little upward pressure on interest rates as a result of the large amount of Government borrow ing required to finance the 1977 deficit. On the other hand, if private borrowing increases rapidly in 1977, the large amount of Government borrowing will con tribute to strong upward pressure on interest rates. Without a matching increase in the supply of credit, such an increased demand will increase interest rates. Under these circumstances, the large Government deficit could lead to the crowding-out effects which some feared would occur in 1975-76.
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