CP

30 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment

on other prices and easing fears of serious long-term inflation. Earlier, those fears

had pushed interest rates to record levels. The economy from 1984 to 1987 was

strong, but the declining fears of inflation more than offset the normal tendency

of interest rates to rise during good economic times, and the net result was lower

interest rates.^8

The effect of inflation on long-term interest rates is highlighted in Figure 1-5,

which plots rates of inflation along with long-term interest rates. In the early 1960s,

inflation averaged 1 percent per year, and interest rates on high-quality, long-term

bonds averaged 4 percent. Then the Vietnam War heated up, leading to an increase in

inflation, and interest rates began an upward climb. When the war ended in the early

1970s, inflation dipped a bit, but then the 1973 Arab oil embargo led to rising oil

prices, much higher inflation, and sharply higher interest rates.

Inflation peaked at about 13 percent in 1980, but interest rates continued to in-

crease into 1981 and 1982, and they remained quite high until 1985, because people

were afraid inflation would start to climb again. Thus, the “inflationary psychology”

created during the 1970s persisted to the mid-1980s.

Gradually, though, people began to realize that the Federal Reserve was serious

about keeping inflation down, that global competition was keeping U.S. auto

FIGURE 1-5 Relationship between Annual Inflation Rates and Long-Term Interest Rates,

1962–2001

Notes:

a. Interest rates are those on AAA long-term corporate bonds.

b. Inflation is measured as the annual rate of change in the Consumer Price Index (CPI).

Sources:Interest rates are from the Federal Reserve Bulletin;see http://www.federalreserve.gov/releases.The CPI data are from http://www.

stls.frb.org/fred/data/cpi.htm.

Percent

16

14

12

10

8

6

4

2

0

Long-Term

Interest Rates

Inflation

1963196519671969197119731975197719791981198319851987 1989 1991 1993 1995 19971999 2001

16

14

12

10

8

6

4

2

0

(^8) Short-term rates are responsive to current economic conditions, whereas long-term rates primarily reflect
long-run expectations for inflation. As a result, short-term rates are sometimes above and sometimes below
long-term rates. The relationship between long-term and short-term rates is called the term structure of in-
terest rates,and it is discussed later in the chapter.

28 An Overview of Corporate Finance and the Financial Environment