The Inflation Crisis, and How to Resolve It

17

Inflation and Interest Rates

One of the persistent causes of inflation is the perennial demand for cheap money. The chronic complaint of businessmen, and still more of politicians, is that interest rates are too high. The popular complaint is directed especially against the rate for home mortgages.

To cite an example at random, President Lyndon B. Johnson, in his State of the Union message in January 1967, “pledged” to the American people to “do everything in the President’s power to lower interest rates and to ease money.” Whether he knew it or not, this was a pledge to resume and increase inflation.

But it is not merely by presidential pledges that governments seek to hold down interest rates arbitrarily. Since the passage of the Federal Reserve Act in 1913, government efforts and power to hold down interest rates have been built into our monetary system.

The Federal Reserve authorities have three specific powers to enable them to do this. The first is the power to set the discount rate—the rate at which the member banks can borrow from the Reserve banks. The second is the power to change the reserve requirements of the member banks. The third is the power to purchase government securities in the open market.

The first of these powers helps set short-term interest rates directly. When member banks can freely borrow money from their Federal Reserve bank at, say, 6 percent, this fixes a ceiling on the rate they have to pay. They can afford to relend at any rate above that. In classical central bank theory, the discount rate was treated as a penalty rate. In the nineteenth century, the Bank of England, for example, set its discount rate slightly above the rate at which the private banks lent to their own customers with highest credit standing. If a private bank then got into difficulties and had to borrow from the Bank of England, putting up some of the loans due to it as security, it lost by the operation. The discount rate was not supposed to enable a private bank to relend its borrowings from the Bank of England at a profit. But in this inflationary age, that rule has long been forgotten. Most countries today fix their central bank discount rate (sometimes called the rediscount rate) at a level below what the private banks charge even their highest-rated customers.

But there are limitations to prevent a low official discount rate from being too greatly abused as an incentive to inflation. Not only are severe “eligibility” restrictions often put on the kind and term of commercial paper that the member banks are allowed to rediscount, but the would-be member bank borrower may be subjected to embarrassing questioning, and the “discount window” may in effect be kept all but closed. In October 1976, for example, when the Federal Reserve banks were holding $100,374 million in U.S. government securities and extending total credits of $107,312 million, only $67 million of this consisted of loans to member banks.

The second power of the Federal Reserve authorities—the power to lower the reserve requirements of the member banks—could be used to allow the member banks to expand their loans, but in practice the reserve requirement is seldom changed. The required reserve against net demand deposits for “central-reserve city” member banks, for example, stood unchanged at 13 percent from 1917 to 1935. From January 1, 1963, it stood for years at about 16.5 percent. The formula is now somewhat complicated, but not essentially different. There are quicker and more flexible ways to obtain a desired expansion of the money supply.

The chief way is by the power of the Federal Reserve authorities to purchase government securities in the open market. This power is employed almost daily. It is easy to see how it expands the supply of money and credit. A Federal Reserve bank buys, say, $1 billion of U.S. government securities in the open market. It buys them, say, from private holders, and pays for them with a cashier’s check. The sellers deposit their checks in some commercial bank, dominantly in a member bank. The member banks present their checks to the Reserve bank for payment. As a result, their “reserve balances” with the Reserve bank increase $1 billion.

Let us say that the member banks are already “lent up,” that is, that they have already expanded their loans as much as they are allowed to do against their legally required minimum reserves. They now have $1 billion of “excess reserves,” and they are entitled to lend out at least three or four times this amount, the exact multiple depending on how much the borrowers draw out in actual cash. So Federal Reserve bank purchases of every $1 billion of government securities can lead to an expansion of the money and credit supply by some $3–4 billion.

The power of the Federal Reserve System to expand the money supply in this fashion is used daily and heavily. In 1975 the Fed banks made gross purchases of $20,892 million in U.S. government securities (mostly—$11,562 million—Treasury bills with maturities of twelve months or less) and gross sales of $5,599 million. In recent years the system’s total holdings of government securities have tended constantly to increase—from $57,500 million in December 1969, for instance, to $105,682 million in December 1977.

How Rates Are Reduced

So the government can bring about lower interest rates, in the first instance, by two methods. It can do it directly by reducing the discount rate of the central bank and allowing private banks to borrow freely at that rate. Or it can do it indirectly by “increasing the supply of loanable funds”—that is, by inflating. It can inflate in this way through getting the central bank to purchase its bonds, or it can “monetize” its debt directly—that is, it can just print the money to pay for what it buys. The latter process, however, is too naked, too raw, too clearly seen through, and no respectable government today resorts to it. Modern governments prefer the more complicated method I have described above, because the majority of voters (and even some of the politicians) are only dimly aware of precisely what is being done.

In sum, if we directly lower the interest rate, we encourage more borrowing and therefore encourage an increase in the money-and-credit supply. If we begin by increasing the money-and-credit supply, we thereby lower the interest rate. So one begets the other: lower interest rates bring about inflation, and inflation brings about lower interest rates.

But there is a catch that the inflationists and easy money advocates do not foresee. The second effect is at best temporary. Inflation brings about lower interest rates only in the short run. In the longer run inflation brings about higher interest rates than ever, for inflation, by raising prices, lowers the purchasing power of the monetary unit. Lenders begin to catch on to this. They want a real return, say, of 5 percent a year. But in the preceding year prices rose an average of 6 percent. If prices continue to rise at that rate, it will take a nominal return of something like 11 percent to bring a real return of 5 percent. So lenders begin to demand a “price premium” sufficient to insure themselves of something close to their normal return.

The current nominal interest rate demanded and offered is therefore determined by the composite expectations of lenders and borrowers concerning the future rate of inflation. These expectations, in turn, are largely influenced by the past and present rate of inflation. Experience shows that these expectations, in the early stages of inflation, tend to lag greatly behind what the future rate actually turns out to be.

For a long time officialdom, in particular, tries to ignore the situation completely. Thus in the raging German hyperinflation of 1919–23 the Reichsbank kept its official rate unchanged at 5 percent until June 22, 1922, and even then began raising it only one percentage point a month till practically the end of the year. In 1923 it began to pay more attention to reality. It was charging 90 percent in September of that year and 900 percent after that. But it never did catch up with reality. At the beginning of November 1923 the market rate for “call money” rose as high as 30 percent per day, or more than 10,000 percent on an annual basis.

I have earlier pointed out that the classical (or at least the late nineteenth century) British theory and practice of the discount rate placed it above the rate that the private banks were charging their own best customers for loans. The rediscount privilege was ostensibly granted to the private banks only for emergency use. It would be restricted to such use, it was assumed, if the banks paid a penalty rate for what they were forced to borrow. But when our own Federal Reserve banks began to operate in 1914, they soon began to set the discount rate below the market rate under the influence of political pressure and an easy-money ideology. The rate of the New York Federal Reserve Bank was set at 6 percent in 1914, but was down to 4 percent by 1917. In the Depression, from 1933 to 1935, it was held under 2 percent, falling to the incredibly low rate of 1 percent between 1937 and 1946. Even in August 1958, though prices were rising in that year and the purchasing power of the dollar had already fallen to only about forty-eight cents compared with 1939, the discount rate was set at only 1.75 percent.

Other leading central banks throughout the world followed much the same easy-money policies. The discount rate almost everywhere became a national show-window rate; it bore little relation to the high market rates that the majority of businessmen were actually obliged to pay.

But the central banks have lately been forced to pay some attention to these realities. We get an instructive table if we put together two separate tables in the December 1976 issue of International Financial Statistics, published by the International Monetary Fund. Our combined table compares, for thirteen industrial countries, the average annual yields (if held to maturity) of central government bonds of at least twelve years’ life, with the respective discount rates of the central banks of those countries. The figures are mainly those for October 1976.

Thus it will be seen that though the short-term discount rate is below the long-term government bond yield in ten of these countries, there is in general a remarkable correspondence between the two rates in nearly all the countries. The very high nominal discount rates in Italy and the United Kingdom reflect the high nominal long-term rates that then prevailed in those countries. And both were so high because the rates embodied the price premium that lenders demanded because they expected future inflation rates approximately equal to recent past inflation rates.

Where there has recently been hyperinflation, discount rates have been forced to reflect this, at least in part. In October 1976 the discount rate in Brazil was 28 percent and in Colombia 20 percent. In Chile the discount rate rose from 15 percent in 1971 to 20 percent in 1972 and 50 percent in 1973. In the first quarter of 1974 it was raised to 75 percent, after which it ceased to be reported.

A review of past inflation records reveals that though interest rates eventually rise to reflect expectations of future price rises, they tend for an astonishingly long time to lag behind the rate that would have been sufficient to protect the lender and give him a customary real yield. This lag persists because it seems to take a long period for lenders to abandon their habit of thinking only of the nominal yield from their investments. To protect themselves they must consider, instead, the real yield to them after allowing for inflation. They must adequately estimate the extent of future inflation during the life of their loan. As a result of failure to do this, they frequently find that they have accepted a negative real interest rate.

Consequences of Manipulation

This was illustrated in an instructive article by Ernest J. Oppenheimer in Barron’s (August 30, 1976). “Ever since the New Deal,” he charged, “the Federal government has pursued a deliberate policy of manipulating interest rates in favor of borrowers, notably itself.”

He presented a table covering the thirty-six years from 1940 to 1975 inclusive. This listed in four separate columns (1) the actual yields in each year of three-month U.S. Treasury bills and of long-term government bonds, (2) the “annual inflation rate” (i.e., the price rise each year), (3) the “assumed normal yield” (i.e., the yield that would have been sufficient to compensate the holder if it were to offset the “inflation” rate and in addition give the holder a real yield of 2 percent from his Treasury bills and 3 percent from his bonds), and (4) a calculation of the “real” gain or loss to the investor in that year.

The table revealed that on this calculation the investor in U.S. Treasury bills lost money in all but six years, and the investor in long-term bonds lost money in all but three years of the thirty-six year period. The interest payments these investors received during the whole period were not even sufficient to offset what they lost through inflation.

Summarizing what happened in 1975 alone, Oppenheimer wrote, “Altogether, in 1975 the Federal government paid $31 billion interest on its $577 billion total indebtedness. Just to cover the inflation rate of 9.14 per cent [that year] would have required $52.7 billion. Thus investors in government securities lost over $21 billion on inflation in one year, not to mention any return on capital.”

It is important to keep in mind, however, that these investor losses were not directly the result of government manipulation of interest rates. This manipulation caused the losses only insofar as it helped to cause the inflation. The buyers of all fixed-return securities, private as well as government, suffered similar real losses during the same thirty-six years. What the buyers paid for these securities was the market rate at the time, but the market rate (except in rare cases) proved insufficient to compensate them. The cure is not, as Oppenheimer seems at one point to suggest, that the government (or any other borrower) should offer to compensate the lender for any inflation-loss actually suffered. That would be ruinous to most borrowers. The cure—for this as well as a score of other evils—is simply to halt inflation.

After an inflation finally comes to an end, in fact, the high nominal interest rates eventually brought about by the inflation tend to continue; and then they give the lender far more than the customary real yield. This was illustrated in Germany during and after the hyperinflation of 1919–23. While interest rates never caught up with the rate of price increase until the very end, in April and May 1924—five to six months after the inflation was over—monthly loans in Berlin were receiving interest equivalent to 72 percent a year.

The pure rate of interest is not a merely monetary phenomenon. It reflects what is called time-preference. It means the discount of future goods as against present goods. It helps to determine the proportions in which money is spent and saved, the times and proportions in which consumption goods are made and capital goods are made. It acts as a guide to which projects are likely to be profitable and which not. It helps to determine the entire allocation and pattern of output.

Because inflation leads inevitably to distortions in the interest rate, because during it nobody knows what future prices, costs, or price-cost relations are likely to be, it inevitably distorts and unbalances the structure of production. It gives rise to multitudinous illusions. Because the nominal interest rate, though it rises, does not rise enough, funds are more heavily borrowed than before; uneconomic ventures are encouraged; corporations making high nominal profits invest abnormal sums in expansion of plant. Many regard this, when it is happening, as a happy byproduct of inflation. But when the inflation is over much of this investment is found to have been misdirected—to have been malinvestment, sheer waste. And when the inflation is over, also, there is found to be, because of this previous misdirection of investment, a real and sometimes intense capital shortage.