Chapter 6 Interest Rates 167These tendencies do not hold exactly, as demonstrated by the period after 1984.
Oil prices fell dramatically in 1985 and 1986, reducing in" ationary pressures on
other prices and easing fears of serious long-term in" ation. Earlier these fears had
pushed interest rates to record levels. The economy from 1984 to 1987 was strong,
but the declining fears of in" ation more than offset the normal tendency for interest
rates to rise during good economic times; the net result was lower interest rates.^2
The relationship between in" ation and long-term interest rates is highlighted
in Figure 6-3, which plots in" ation over time along with long-term interest rates. In
the early 1960s, in" ation averaged 1% per year and interest rates on high-quality
long-term bonds averaged 4%. Then the Vietnam War heated up, leading to an in-
crease in in" ation; and interest rates began an upward climb. When the war ended
in the early 1970s, in" ation dipped a bit; but then the 1973 Arab oil embargo led to
rising oil prices, much higher in" ation rates, and sharply higher interest rates.
In" ation peaked at about 13% in 1980. But interest rates continued to increase
into 1981 and 1982, and they remained quite high until 1985 because people feared
another increase in in" ation. Thus, the “in" ationary psychology” created during
the 1970s persisted until the mid-1980s. People gradually realized that the Federal
Reserve was serious about keeping in" ation down, that global competition was
keeping U.S. auto producers and other corporations from raising prices as they
had in the past, and that constraints on corporate price increases were diminishing
Long-Term
Interest Rates1614121086420
1972 1977 1982 1987 1992 1997 2007
Years2002In"ationInterest
Rate (%)Relationship between Annual Inf lation Rates and Long-Term
F I G U R E 6! 3 Interest Rates, 1972–2007Notes:
a. Interest rates are rates on AAA long-term corporate bonds.
b. In" ation is measured as the annual rate of change in the consumer price index (CPI).
Source: St. Louis Federal Reserve web site, FRED database, http://research.stlouisfed.org/fred2.
(^2) Short-term rates are responsive to current economic conditions, whereas long-term rates primarily re! ect
long-run expectations for in! ation. 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 interest
rates, and it is discussed later in this chapter.