Interest rates ; Monetary policy - United States ; Economic conditions - United States

Joseph Bisignano

English

Research Papers in Economics

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January 8, 1982
Real Interest Rates
Noonecan be certain howlongthe recession
will last, because there are both new and old
sources ofuncertainty intheoutlook. The old
elements are summarized by the fact that
economists are usually pretty miserable
forecasters ofeconomic turning points. The
newelementsofuncertaintyare contained in
the factthatthetea leavesatthe bottomofthe
monetary-aggregate teacups are becoming
increasinglydifficultto 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 (check-
like) balances have added to the problem.
Real interest rates-rates adjusted for infla-
tion-provide an additional elementof
uncertainty in the outlook. The behaviorof
real interest rates, indeed, could act as a
potentially stabilizing element in the reces-
sion and recovery. In years past, economists
thought of"automatic stabilizers" almost
exclusively as fiscal tools, operatingthrough
such elements as unemployment insurance
and a progressive income-tax structure. But
with the Federal Reserve's move in October
1979to de-emphasize control ofshort-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
forexcessive concern with short-term interest
rates. In theirview,theFed'sreluctanceto let
interest rates move quickly upordownex-
acerbated fluctuations in the real economy.
For example, the Fed's reluctance to let rates
fall quicklyenough in a recession led to a
money-supply contraction, which in turn led
toadeeper-than-necessarydecline inthe reaI
economy. The result, theargumentgoes, was
"pro-cyclical" monetary growth, with mon-
ey expanding too rapidly in a recovery and
too slowly during a recession.
Consider, for example, the behavior ofM-1
duringtne 1973-75 period. That aggregate-
currency plus bankdemand deposits-
expanded by 7.3 percent in 1973 but only
by4.9 and 4.6 percent in 1974 and 1975,
respectively. The critics thus charge that, in
an environmentofoil-price shock and high
inflation, the Fed's interest-rate policy pro-
vided 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 October1979, inter-
est rates soared, to the great surprise ofmost
economists. Noone had guessed the heights
that interest rates would rise to, or the ex-
treme volatility ofrates.
Even moresurprisingwas the behaviorofreal
interest rates. The notion ofreal interest rates
goes back at least to the time ofIrving 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 antici-
pated inflation is notdirectly observable,
economists often use a proxy in the form of
the past inflation rate or, alternatively, the
actual inflation rate overthe asset's life.
The real interest rate was very low, on aver-
age, throughout mostofthe 1975-79 period
(see chart). The rate was calculated by
subtracting the deflatorfor personal con-
sumption expenditures from the three-month
commercial-paper rate. In fact, the real
commercial-paper rate averaged -.05 per-
cent, or effectively zero, between January
1975 and September 1979. The economy
grew at a rapid rate afterthe 1975 recession,
with annual real growth rates ranging be-
tween 3.2 and 5.5 percent, but the real in-
terest rate showed noapparent cyclical
movementduring that period.Ir~(~;~l~lY@J IR2. (~;$)~lf\o/ ~
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Opinions expressed in this ne\.\.!sletter do not
necessZlrilv reflE.:ct the view~; of the rnanagernent
of th0 Ff,deral Reserve Bank of San Frand~,co,
or of the Board of Covernors of the Federal
Reserve System.
Real interest rates theoretically should playa
stabilizing role in the economy. As theecon-
omy softens, real interest rates should fall in
an environment ofsluggish real aggregate
demand, butthese low rates shouId then
stimulatedemand and promote arecovery. 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.
The inflation rate was the same-9percent-
at the end as at the beginning ofthe 1975-80
business-cycle expansion, and this perhaps
could be attributed tothe factthatreal interest
rates failed to respond to real growth overthat
period. But in actuality, the inflation rate
moved cyclically in that span, falling almost
to 5 percent in 1976 but heading steadily
upwards after that. It is this rapid upsurge in
inflation, ofcourse, which monetary and fis-
cal policymakers have tried to reverse in the
past two years.
What do we know?
In a recent article in Challenge magazine,
Professor Alan Blinder, ofPrinceton Univer-
sity, argues thatthe Federal Reserve oughtnot
to ignore the very high real interest rates
which have developed since the Fed moved
to its newoperating procedures. His argu-
ment infers that the Fed should target real
interest rates rather than monetary aggre-
gates, given the problems in interpretingthe
aggregates. Apparently, the Fed inadvertently
did justthat between 1975 and 1979, by
effectively removing any cyclical movement
in real interest rates.
Targeting real rates may not be a good idea,
however. First, economists do not have a
good understanding ofreal interest rates-
howtheyare eitherdetermined orcontrolled.
In theory,'a nominal variable like the Fed's
control ofreserves cannot control a real var-
iable like interest rates. Nonetheless, real
2
interest rates give us a better understanding
ofthe behaviorofthe economy than do
nominal interest rates, providing a better
information variablethan control variablefor
the Fed.
In a recent article in the Journal ofMonetary
Economics, Professor Frederic Mishkin, of
the UniversityofChicago, finds that the real
rate is negatively correlated with inflation-
as the last half-decade has shown. In addi-
tion, he finds that real rates are a better
indicatorof"tightness" than nominal rates-
as wasdemonstrated bytheexperienceofthe
Great Depression. Duringthat period, mone-
tary policy appeared "easy" because ofthe
very low level ofnominal interest rates. Yet
real interest rates ranged between 6 and 10
percent between the fourth quarter of 1931
and the first quarter of 1933, reflecting the
severe deflation ofthat period.
The post-1979 record represents a reversal of
the experience ofthe previous half-decade,
with real interest rates fluctuating sharply
in an environment ofdecelerating inflation.
This could mean the advent-eventually, at
least-ofa new type ofbusiness 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
fourto five years ofuninterrupted real growth
followed by double-digit inflation. Instead,
we mayexperience a much bumpierperiod,
which will make obsolete the definition ofa
recession as two successive quarters ofnega-
tive real growth. The "cycle" may become a
lengthy period offluctuatingeconomicactiv-
ity, butone in which growth becomes more
sustainable without accelerating inflation.
Whether this happens will again depend on
the behavior ofreal interest rates. Real rates
have behaved in quiteunexpected fashion
after 1979. The real commercial-paper rate,
for example, hit an estimated 10 percent in
early 1980, became negative on the heels
ofthatspring's "voluntary" credit-restraint
program, and then climbed rapidly after the8
Real Commercial Paper Rate'...
(three-month)
Joseph Bisignano
numbers in each ofthe fiscal years 1982-84.
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 notdisplay the
pattern ofuninterrupted growth seen in the
1976-79period. Real interestrates nowmake
a difference.
6
4
program was suspended in July 1980. Since
that time, high real rates have curtailed
aggregate demands considerably. Conse-
quently,the inflation rate has also fallen, with
the producer-price index decelerating from
a 14-percentrate in March 1980to 6 percent
in November1981 . Ifthe economycontinues
to display negative real growth in coming
months, real rates could fall rapidly, laying
the foundation for a recovery in mid-1982.
Percent
10
The big uncertainty lies in the prospectof
continued Federal deficits in triple-digit
_41-_--L__........__'--_-L.__...I-_.....J1..-_..J
*Nominal rate on agiven month minus the inflation rate over the life of the note.
1981 1979 1977 1975
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
LargeCommercial Banks
Amount
Outstanding
12/23/81
Change
from
12/16/81
Change from
year ago
Dollar Percent
Loans (gross, adjusted) and investments'" 156,228 457 8,930 6.1
Loans (gross, adjusted) - total# 135,106 - 537 10,138 8.1
Commercial and industrial 41,273 - 679 4,082 11.0
Real estate 55,649 9 5,350 10.6
Loans to individuals 23,630 162 - 693 - 2.8
Securities loans 2,258 - 3 762 50.9
U.s. Treasury securities* 5,874 37 - 839 - 12.5
Othersecurities* 15,248 43 365 - 2.3
Demand deposits - total# 42,506 - 4 - 4,089 - 8.8
Demand deposits - adjusted 28,911 382 - 3,597 - 11.1
Savings deposits - total 29,946 - 76 2,159 7.8
Time deposits - total# 89,506 696 15,521 21.0
Individuals, part. & corp. 80,479 431 16,379 25.6
(Large negotiable CD's) 36,094 556 6,635 22.5
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+)/Defidency (-)
Borrowings 'f
Net free reserves (+)/Net borrowed(-)
Weekended
12/23/81
85
1
84
Weekended
12/16/81
44
9
53
Comparable
year~ago period
114
125
11
'" Excludes tradmg accountsecurltles.
# Includes items not shown separately.
Editorial comments may be addressed to theeditor (William Burke) or to the author.... Free copiesof this
andother Federal Reservepublicationscan beobtained bycallingor writingthePublic InformationSection,
Federal Reserve Bank of San Frandsco, P.O. Box 7702, San Francisco 94120. Phone (415) 544~2184.

Real interest rates

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Real interest rates

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Research Papers in Economics