Speculation, Deregulation, and the Interest Rate
LEONARD A. RAPPING AND LAWRENCE B.
PULLEY
By Alex Macri
• The article is intended to identify the cause of
the abnormally high interest rates which
prevailed throughout the 1980’s.
• In providing the historical context, R&P ascertain
that during this decade the magnitude of the
interest rates was the highest it had ever been
since the beginning of the Industrial Revolution.
• The thesis R&P attempt to refute is that these
high interest rates resulted from the Fed’s
indirect credit rationing via the reserve
requirement channel.
• R&P state that since financial innovations
during this period severed the link between
reserve requirements and credit rationing, their
counter-thesis pins the blame for these high
interests rates on deregulation/financial
innovation.
• R&P construct their thesis thusly:
• B/w 1969 and 1977, the Fed managed investor
expectations by pegging interest rates; Treasury
bonds fluctuated b/w 6 and 7%
• In other words everyone knew the “rules of
the game” and financial speculation was
confined within the boundaries established by
these rules.
• In 1978 the Fed ceased this interest pegging
policy.
• Investors interpreted this abandonment and
the concomitant decontrol of deposit rates as
a signal of a looming recession.
• Consequently many investors became
destabilizing bears.
• In order to bolster their thesis, R&P draw a
demarcation line b/w financial instruments
whose returns were subject to regulation and
those whose were not.
• They argue that in a period of volatility
generated by “unfair” distribution of income,
“irrational” speculation ensues in those
financial instruments whose returns are
unregulated: real estate, equities, collectibles,
gold and foreign exchange
• Controlling the interest rate is an effective
method of controlling this speculation.
• In the context of deregulated interest rates,
returns on interest bearing assets will begin to
increase in some direct proportion with an
expected increase in these assets’ returns.
• This explanation of high interest rates is called
the portfolio or asset preference explanation.
• A different model for explaining interest rate
levels establishes the demand for credit on the
basis of prices and the scale of output while the
supply of credit is determined by the savings
rate and the amount of credit creation by the
banking system.
• Inflation expectations are yet another interest
rate setting model. The prospect of inflation
will increase the demand for money (up to a
certain point) via both the supply and demand
channels.
• Fisher model:
R t = Em(rt |фt-1 ) + Em(πt|фt-1 )
• The first term can be eliminated with the
assumption that in the long run the real rate
will equilibrate around a more or less constant
value denoted by ρ.
• The small deviations from this constant value
are denoted by µt.
• Fisher equation than becomes
R t = ρ + Em(πt|фt-1 ) + µt.
• This equation has not proved to be empirically
robust; the expected real interest rate is not
constant.
• In order to address this inadequacy Carlson (1977)
and Tanzi (1980) examined the impact of changes
in real variables.
• The augmented model than becomes:
1) R t = Em(rt |фt-1 ) + β1Em(πt|фt-1 ) + µt
2) Em(rt |фt-1 ) = ρ - β2 Em(πt|фt-1 ) – β3 LIQt + β4ACTt
+ β5σRt + υt
Em(rt |фt-1 ) = captures incomplete adjustment
to expected inflation level. ρ - β2
LIQ = proxy for shifts in LM curve.
ACT = proxy for shifts in IS curve.
σRt = interest rate volatility
ρ = constant component of expected real interest
rate.
Combining 1) and 2)
• R t = ρ + β0Em(πt|фt-1 ) – β3 LIQt +β4ACTt +
β5σRt + wt
where:
β0 = β1 – β2
wt = µt + υt
• The data plugged into the model:
Expected inflation rates gathered from records
of predictions made by economists.
• Six month T bills rates from 6:1959 to 12:1983
were used as proxies for nominal interest
rates.
• M1 growth is the proxy for liquidity
• σRt = interest rate volatility.
• R&P find that interest rates after 1979
continued to rise despite a decrease in actual
and expected inflation.
• R&P conclude that the high interest rates
characteristic of the period cannot be explained
by the traditional interest rate models or
foreign exchange markets.
• R&P posit that irrational speculation coupled
with interest rate deregulation have far more
explanatory power for these rates.
• The solution is to therefore penalize
speculation. Doing this would indirectly
control interest rates.
• In the absence of such penalization R&P
forecast the persistence of high interest rates.
• Although R&P are encouraged by the Fed’s
determination to step in as required in order to
prevent a repeat of the Great Depression, they
believe the power to selectively penalize
speculators must also be a part of the
regulatory regime.