Edward Renshaw
Professor of Economics
State University of New York at Albany
Many macroeconomic principles textbooks contain a page or two illustrating the Keynesian notion that "by trying to save more consumers may end up saving less". Validating the "paradox of thrift" in its strongest form, however, was so difficult in the early post World War II period that the basic idea is seldom mentioned in more advanced textbooks concerned with macroeconomics.
Unemployment insurance and other transfer payment programs to aid families with workers that have lost their jobs, however, have made it more feasible for consumers in general to actually increase their savings during an economic recession by purchasing government securities (directly or indirectly) and helping to finance an automatic increase in the government deficit.
While the peak in the Commerce Department's personal saving rate usually comes fairly early in a business expansion, the data in Table 3.1 would suggest that there may be some truth to the idea that the saving behavior of consumers can precipitate a recession. During the last five business expansions for which we have revised data the personal saving rate has consistently increased during the quarter containing a peak in economic activity.
It used to be the case that consumers could be counted on to lower their saving rate during an economic recession and in so doing help to moderate and shorten the recession. During four of the last five recessions, however, the personal saving rate was also higher during the trough quarter for real GDP than before the quarter containing a peak in economic activity.
One of the problems with monetary policy is that consumers, banks and business enterprises cannot be relied upon to behave in a "socially responsible way" in response to changes in short term interest rates. For monetary policy to be highly effective at regulating the economy consumers should increase their saving rate in response to a rise in short term interest rates and decrease their propensity to save whenever interest rates are allowed to decline. This sort of response, however, has only occurred on an annual basis about two thirds of the time (Renshaw 1992, Table 1.89). Some of the theories that have been developed by economists to explain consumption suggest that household behavior should be perverse.
The life cycle hypothesis, which was invented by Modigliani and Brumberg in (1954), for example, implies that persons who want to even out their consumption over an entire life time should save more when real interest rates are low and save less when they are high. For those persons with most of their financial assets in savings accounts, CDs and money market funds, tight money and the prospect of rising interest rates opens up the possibility of a consumption boom.
If enough consumers take advantage of rising interest rates in this way the Fed, in an effort to control inflation, may have raise interest rates to the point of practically destroying the new housing industry and in the process tip the economy into an unwanted recession.
It used to be the case that consumers could be relied upon to reduce their personal saving rate during years containing a recessionary trough in business activity, as defined by the National Bureau of Economic Research, and in so doing help to moderate the recession. Since the recovery of the S&P composite stock price index from the crash of 1929, and the great depression of the 1930s, to a new historic high on September 22, 1954, however, affluent consumers have begun to appreciate that years containing a recessionary trough are usually the most rewarding times to save more and invest one's financial wealth in common stock and long term bonds.
If one could have correctly forecasted all those years containing a trough in business activity since 1929, and had invested in a portfolio similar to the S&P index at the beginning of the year, the average financial return for the year (including dividends) would have been 31.6 percent versus a more risky average return of less than ten percent for the year after a recessionary trough in business activity. See Table 3.2.
Beginning in the fourth quarter of 1954 and during five of the last seven recessions the personal saving rate has increased during trough years. In the other two cases, which are associated with the more prolonged sixteen month recessions of 1973-75 and 1981-82, there was a decline in the personal saving rate of only three-tenths of a percentage point. These declines can be considered very anemic in comparison to the .8 to 5.8 percentage point declines which occurred during the five recessionary trough years from 1929- 54.
For risk averse investors who are trying to even out their consumption over an entire life time, for workers who are fearful of loosing their jobs, and for sophisticated investors who want to make a killing in the stock market, there are rational reasons for trying to save more during economic recessions. They make it easier for one to understand why monetary policy has acquired the reputation of only working after a long and variable lag.
The propensity for commercial banks to thwart the intent of monetary policy is particularly apparent when one examines cyclical changes in their balance sheets. As loan demand begins to dry up during economic recessions commercial banks seldom lower their interest charges in an aggressive manner and beat the bushes for additional lending opportunities. They are more likely to pump a disproportional amount of their increased lending power into US government securities (Table 3.3).
The incentive to behave in such a perverse way could be reduced to a considerable extent if Congress were to abandon the idea that all of the income generated by a member bank's required reserves should be subject to a 100 percent tax. A better approach would be to eliminate reserves that do not pay interest, require all banks and thrift institutions to keep a minimum proportion of their assets invested in US government securities, and then levy a stiff excise tax on all of their holdings of US government securities, or at least those holdings in excess of the percentage that is required to give the Board of Governors some control over the money supply.
If the tax on bank holdings of US government securities was high enough to make the short term debt of states and some local governments, which is not subject to federal taxation, attractive from an after tax point of view, banks would have an economic incentive to work more closely with these governmental units to develop a backlog of public infrastructure projects which could be accelerated or implemented more quickly during periods of weak demand for bank loans. Bankers would also have a greater incentive to lower the prime rate and encourage business enterprises that are sound credit risks to invest more heavily in new plant and equipment during economic recessions.
Six increases in the federal funds rate from February to November of 1994 failed to slow the economic growth rate to the more sustainable pace that the Board of Governors of the Federal Reserve believed was needed to prevent an acceleration of the inflation rate. This caused some economists and former members of the Board of Governors to suggest that the "Fed's Rate Rises Are Taking Longer to Have an Effect on the Economy" (Bradsher, 1994).
The truth of the matter, however, is that gradual increases in the interest rate paid by banks (when they borrow from each other) have always taken a year or more to slow the economic growth rate (Renshaw 1995). Since the economic recession of 1953-54 there have been eight occasions when the Fed reversed a policy of monetary ease and gradually increased the funds rate for a year or more. Only three of the 32 quarterly growth rates associated with these first year tightening measures were able to sink the economic growth rate for real GDP expressed in 1987 dollars below the 2.9 percent long term average rate for the US economy from 1929-94.
One of the problems with gradualism is that it can provide a powerful incentive for both consumers and business enterprises to behave in a socially perverse sort of way. A slow increase in interest rates in response to inflation fears will encourage some thoughtful consumers to rush into the housing market and purchase a new home before the longer run increase in financing costs makes a better home unaffordable. New home sales, moreover, are now aided by a shift to variable rate mortgages which often postpone increases in long term mortgage rates for a year or more. In such an environment there is a danger that an impatient Board of Governors of the Fed will over react and continue to raise interest rates until the economy is tipped into an unwanted recession.
During the last five sustained efforts to gradually slow the economy before 1994, the Fed eventually became frustrated enough to raise the federal funds rate by more than one full percentage point during at least one quarter. All of these larger increases were immediately followed by a slowing of the growth rate for real GDP expressed in 1987 dollars to a value equal to or less than the longer run average of 2.9 percent (Renshaw 1995).
There have been eight quarters since 1951, when the Fed was freed from the responsibility of stabilizing government borrowing rates, when the Board of Governors became so obsessed with the problem of accelerating inflation that they allowed the funds rate to increase by more than two percentage points over a quarterly period. If the US economy was not already in an economic recession it quickly became mired down in one within one to seven months after the administration of such shock therapy. See Table 3.4.
The belated response of the US economy to the Fed's gradual increase in short term interest rates in 1994 is somewhat surprising since the response of long term rates was to accelerate at an unprecedented pace in relation to short term rates. Between January and June the average yield on FHA mortgages in the secondary market increased 1.98 percentage points compared to an increase of only 1.20 percentage points for the federal funds rate. This type of steepening of the yield curve in response to a gradual tightening of monetary policy had never occurred before and may have been a response to wide-spread hedging in the mortgage market (Fernald 1994).
One of the most encouraging aspects to the rapid response of long term interest rates to the Fed's preemptive strike during 1994, however, is that long term interest rates quickly peaked out and declined in response to the slowing of the US economy during the first and second quarters of 1995.
An inverted yield curve for government securities implies a prediction on the part of participants in the fixed income securities market that long term interest rates are likely to decline. This in turn is only likely to happen if the economic growth rate is slowing down and the economy is in danger of slipping into another recession. There is now an extensive literature on the use of interest rate spreads to forecast economic activity and identify business peaks before they occur. See Lahiri and Wang (1994) and Estrella and Mishkin (1996) for a review of this literature.
Since 1955 the US economy has never experienced an economic recession until at least seven months after the yield on one year Treasury notes first exceeded the monthly yield on ten year Treasury bonds. See Table 3.5. Except for the Vietnam War build up credit crunch inversion of 1965-66 all of the lead times for this recession indicator are in the seven to 17 month range. And except for the two years (1965 and 1967) surrounding the Vietnam War build-up, all December yields for one year Treasury notes in excess of the yield on ten year Treasury bonds have been followed by below average growth rates for real GDP expressed in 1987 dollars.
Modern portfolio theory assumes that risk will be reward in the market place. Since the prices of long term bonds fluctuate more widely than the prices of notes, bills and marketable commercial paper, there is a presumption that the slope of the yield to maturity curve should normally slope upward. If risk is not being reward in the bond market one should probably be cautious about investing in long term bonds and the stock market.
The data in Table 3.4, in any event, support the hypothesis that it has been rather risky to have owned stock after a yield curve inversion. The February 1989 inversion is the only case where one couldn't have sold an index fund tracking the S&P 500 at the end of the month after the first inversion and then been able to repurchase the index at a lower value during the stock market crashes which have followed recessionary peaks in business activity.
If the Board of Governors of the Fed is mindful of the predictive power of an inverted yield to maturity curve and endeavors to keep the curve sloping upward during its efforts to mute or prevent an acceleration in the inflation rate, that might help to inspire enough confidence in the monetary policy of the Fed to prevent the economy from slipping into a recession. It makes sense, in any event, for investors and people who are concerned about the future of economic activity to keep a close eye on the shape of the yield to maturity curve which has now become a component of the Conference Board's revised index of leading economic indicators.
Bradsher, Thomas (1994). "Fed's Rate Rises Are Taking Longer to Have an Effect on the Economy,"The New York Times, December 5, A1 and D5.
Estrella, Arturo and Frederic Mishkin (1996). "The Yield Curve as a Predictor of U.S. Recessions," FRBNY Current Issues, June.
Fernald, Julia, Frank Keane and Patricia Mosser (1994). "Mortgage Security Hedging and the Yield Curve"(Research Paper no. 9411, Federal Reserve Bank of New York), August.
Lahiri, Kajal and Jiazhuo Wang (1994). "Interest Rate Spreads as Predictors of Business Cycles," An unpublished research paper that can be obtained from Professor Lahiri at the Department of economics, SUNYA.
Modigliani, Franco and R. E. Brumberg (1954). "Utility Analysis and the Consumption Function," in K. K. Kurihara. ed. Post-Keynesian Economics(New Brunswick, N.J.: Rutgers University Press).
Renshaw, Edward (1992). The Practical Forecasters' Almanac(Burr Ridge, Illinois: Irwin Professional Publishing).
-----, (1995). "Gradualism in Monetary Policy: Does It Work?" Challenge, May-June, 53-56.
Date of Personal Saving Rate at
------------------------ ------------------------------------
Saving Real Real Saving Quarter Real Real
Rate GDP GDP Rate Before GDP GDP
Peak Peak Trough Peak GDP Peak Peak Trough
(1) (2) (3)n (4)
58-4 60-1 60-4 7.8 6.8 6.9(+) 6.2
67-4 69-3 70-1 8.8 6.4 7.8(+) 7.4*
73-4 73-4 75-1 10.9 9.0 10.9(+) 8.1
75-2 80-1 80-3 10.8 7.2 7.8(+) 8.1*
81-4 81-3 82-3 9.8 8.2 9.3(+) 8.9*
84-3 90-2 91-1 9.2 4.9 5.2(+) 5.4*
92-4p 6.1
(3)n. The (+) symbols identify cases of acceleration in the personal saving rate during quarters containing a recessionary peak in real GDP.
p indicates a preliminary estimate.
*identifies cases where the personal saving rate was also higher during the trough quarter than before the quarter containing a peak in real GDP.
Source of basic data: The Survey of Current Business, January/February 1996, Tables 2 and 4, pp. 110-18.
Date of Business Financial Returns for the S&P Index % Point Change
---------------- ----------------------------------- Personal Saving
Peak Trough Trough Year Following Year Rate Trough Yr.
(1) (2) (3)
Aug. 1929 Mar. 1933 53.0 - 1.5 - .8
May 1937 June 1938 30.0 - .8 -4.3
Feb. 1945 Oct. 1945 35.7 - 7.8 -5.8
Nov. 1948 Oct. 1949 17.8 30.5 -2.1
July 1953 May 1954 51.2 31.0 - .8
Aug. 1957 Apr. 1958 42.4 11.8 .2*
Apr. 1960 Feb. 1961 26.6 - 8.8 1.1*
Dec. 1969 Nov. 1970 3.5 14.1 1.4*
Nov. 1973 Mar. 1975 36.9 23.6 - .3
Jan. 1980 July 1980 31.5 - 4.8 .8*
July 1981 Nov. 1982 20.5 22.3 - .3
July 1990 Mar. 1991 30.0 7.4 .7*
The financial return is equal to price appreciation plus dividends received during the year expressed as a percent of price at the end of the preceding year.
*Identifies cases where the personal saving rate increased instead of declined during years containing an NBER trough in economic activity.
Source of basic data: National Bureau of Economic Research, National Income and Product Account Table 2.1 and Standard and Poor's Security Price Index Record.
Year Dec. to Dec. Growth Rates % of Total Loans & Securities
--------------------------------- -------------------------------
Total Bank US Bank Bank US
Loans & Government Loans & Loans & Government
Securities Securities Leases Leases Securities
1973 13.2 - .9 18.0 71.0 13.6
1974 10.2 - 2.2 13.0 72.8 12.1
1975T 4.4 35.2T - .5 69.4T 15.7
1976 8.0 16.8 7.3 69.0 16.9
1977 10.8 .2 14.0 70.9 15.3
1978 13.7 .7 18.2 73.7 13.6
1979 12.0 4.9 13.7 74.8 12.7
1980T 9.1 18.2T 7.5 73.8T 13.8
1981 5.5 5.1 5.9 74.0 13.7
1982T 7.1 12.5T 6.9 73.8T 14.4
1983 19.8 28.5 8.7 72.4 16.7
1984 11.0 .2 17.5 76.7 15.1
1985 10.9 4.2 10.5 76.5 14.2
1986 9.6 14.5 8.8 75.9 14.8
1987 7.0 8.3 7.5 76.3 15.0
1988 8.1 9.2 9.6 76.9 15.1
1989 6.9 9.1 8.0 77.6 15.3
1990 5.5 13.9 4.6 77.0 16.6
1991T 3.8 24.1T - .3 73.9T 19.8
1992 3.5 18.0 .1 71.5 22.5
1993 5.3 10.1 3.9 70.5 23.6
1994 8.0 - .3 8.2 70.6 21.8
1995 6.9 - 2.4 9.7 72.4 19.9
1996 4.4 - .9 6.4 73.6 18.7
T: identifies years containing a recessionary trough in economic activity.
Source of basic data: Economic Report of the President.
% Point Annualized 12 Month Civilian Months from
Quarter Change in Growth of Inflation Unemployment Business
Funds Rate Real GDP Rate CPI Rate Peak
(1) (2) (3)n (4) (5)
1969-1 .77 6.2 5.25
2---- 2.11*---- 1.0---------5.48-----------3.5--------- - 6
3 .25 2.3 5.70
1972-4 .46 7.0 3.41
1973-1 1.76 11.0 4.59
2 1.40 2.8 6.00
3---- 2.29*---- -1.1---------7.36-----------4.8--------- - 2
4 - .83 4.5 8.71
1974-1 - .60 -3.3 10.39
2---- 2.58*---- 1.8--------10.86-----------5.4--------- + 7
3 - .59 -4.2 11.95
1979-2 .20 .9 10.89
3 1.14 2.6 12.18
4---- 2.35*---- 1.1--------13.29-----------6.0--------- - 1
1980-1---- 3.41*---- 2.0--------14.76-----------6.3--------- + 2
2 -7.72 -9.2 14.38
3 1.40 - .3 12.60
4---- 8.03*---- 8.3--------12.52-----------7.3--------- - 7
1981-1 -4.20 8.0 10.49
2---- 4.40*---- -3.3---------9.55-----------7.4--------- - 1
3 -3.28 4.9 10.95
4 -3.50 -4.9 8.92
1982-1---- 2.31*---- -6.6---------6.78-----------9.0--------- + 8
2 -2.35 1.6 7.06
(3)n. The 12 month inflation rate for the all urban consumer price index, 1982-84 = 100.
*Identifies quarterly increases in the Federal funds rate amounting to two percentage points or more. If the economy was not already experiencing an economic recession it ended up in one within seven months.
Source of basic data: Economic Report of the President and The Survey of Current Business, January/February 1996.
--------Date of--------- Lead -----Values for the S&P 500----- Yield NBER Time After After Recessionary Curve Business in Yield NBER Closing Low Inversion Peak Months Inversion Peak S&P 500 (1)n (2) (3) (4) (5) (6) Dec. 1956 Aug. 1957 - 8 46.67 45.22 38.98 Sep. 1959 Apr. 1960 - 7 56.88 54.37 52.30 Dec. 1965 Dec. 1969 -48 92.43 92.06 69.29 Mar. 1973 Nov. 1973 - 8 111.52 95.96 62.28 Sep. 1978 Jan. 1980 -16 102.54 114.16 98.22 Sep. 1980 July 1981 -10 125.46 130.92 102.42 Feb. 1989 July 1990 -17 288.86 365.15 295.46
(1)n. The first month in a business expansion when the yield on one year Treasury notes rises above the yield on ten year Treasury bonds.
Source of basic Data: The Federal Reserve Bulletin.
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