Other Factors That Influence Interest Rate Levels
In addition to inflationary expectations, other factors also influence both the general
level of interest rates and the shape of the yield curve. The four most important
factors are (1) Federal Reserve policy; (2) the federal budget deficit or surplus; (3) in-
ternational factors, including the foreign trade balance and interest rates in other
countries; and (4) the level of business activity.
Federal Reserve Policy
As you probably learned in your economics courses, (1) the money supply has a major
effect on both the level of economic activity and the inflation rate, and (2) in the
United States, the Federal Reserve Board controls the money supply. If the Fed wants
to stimulate the economy, it increases growth in the money supply. The initial effect
would be to cause interest rates to decline. However, a larger money supply may also
lead to an increase in expected inflation, which would push interest rates up. The re-
verse holds if the Fed tightens the money supply.
Toillustrate,in1981inflationwasquitehigh,sotheFedtightenedupthemoney
supply.TheFeddealsprimarilyintheshortendofthemarket,sothistighteninghad
the direct effect of pushing short-term rates up sharply. At the same time, the very
fact that the Fed was taking strong action to reduce inflation led to a decline in ex-
pectations for long-run inflation, which led to a decline in long-term bond yields.
In 2000 and 2001, the situation was reversed. To stimulate the economy, the Fed
took steps to reduce interest rates. Short-term rates fell, and long-term rates also
dropped, but not as sharply. These lower rates benefitted heavily indebted businesses
and individual borrowers, and home mortgage refinancings put additional billions of
dollars into consumers’ pockets. Savers, of course, lost out, but lower interest rates en-
couraged businesses to borrow for investment, stimulated the housing market, and
brought down the value of the dollar relative to other currencies, which helped U.S.
exporters and thus lowered the trade deficit.
During periods when the Fed is actively intervening in the markets, the yield curve
may be temporarily distorted. Short-term rates will be temporarily “too low” if the
Fed is easing credit, and “too high” if it is tightening credit. Long-term rates are not
affected as much by Fed intervention. For example, the fear of a recession led the Fed-
eral Reserve to cut short-term interest rates eight times between May 2000 and Octo-
ber 2001. While short-term rates fell by 3.5 percentage point, long-term rates went
down only 0.7 percentage points.
Budget Deficits or Surpluses
If the federal government spends more than it takes in from tax revenues, it runs a
deficit, and that deficit must be covered either by borrowing or by printing money (in-
creasing the money supply). If the government borrows, this added demand for funds
pushes up interest rates. If it prints money, this increases expectations for future infla-
tion, which also drives up interest rates. Thus, the larger the federal deficit, other
things held constant, the higher the level of interest rates. Whether long- or short-
term rates are more affected depends on how the deficit is financed, so we cannot
state, in general, how deficits will affect the slope of the yield curve.
Over the past several decades, the federal government routinely ran large budget
deficits. However, in 1999, for the first time in recent memory, the government had a
44 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
The home page for the
Board of Governors of the
Federal Reserve System
can be found at http://
http://www.federalreserve.gov.
You can access general in-
formation about the Federal
Reserve, including press
releases, speeches, and
monetary policy.
42 An Overview of Corporate Finance and the Financial Environment
