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Long-term inflation expectations, the personal saving rate and credit standards.

AROUND 1980-82 a century-old view of the nature of inflation was shattered by a crisis of confidence in the stability of our currency. That long-held view had perceived each inflation surge as simply the effect of a temporary crisis. Experience had taught that inflation would quickly end when each crisis passed. In the new view, inflation was seen as a continuing problem that might get much worse. This shift in long-term inflation expectations was probably a major cause of the decline in the personal saving rate in the early 1980s. It was also an important cause of the collapse in credit standards that helped precipitate the wild financial gyrations of the 1980s decade. Unfortunately, an awareness of this 1980-82 crisis of confidence together with its impact on the economy is almost totally missing from economic literature. It has important implications for the economic forecaster.


What were the events leading up to this crisis of confidence? As Peter S. Spiro (1989) has pointed out, prior to 1965 inflation surges were always considered to be temporary. Furthermore, periods of deflation were expected to follow periods of inflation. Therefore, the long-term inflation rate was expected to be near zero. A continuous, high rate of inflation outside of wartime was unheard of in the United States prior to 1965.

This view changed at the end of the Korean War when the worst of the economic aberrations caused by World War II were behind us. Figure 1 explains what happened to long-term inflation expectations in the postwar period. The bottom line shows the premium of the Treasury bond interest rate over the prevailing inflation rate. It should not be considered a real long-term interest rate as is commonly (and erroneously) done in much business and economic literature. Long-term real interest rates are nominal rates less the expected inflation rate over the life of the instrument, not nominal rates less the prevailing inflation rate.

The horizontal shaded band covers the range within which nominal long-term interest rates were contained through most of the previous century. Because, as Spiro argued, long-term inflation expectations during this period were near zero, real interest rates were about the same as nominal rates, and therefore also stayed within this band.

As Figure 1 shows, this postwar period contained a small inflation surge in 1956-58 and a much larger fifteen-year surge beginning in 1966 and lasting through 1980. The second surge is generally divided into three smaller surges: the first from 1966 to 1970 associated with the build-up of the Vietnam War; the second from 1972 to 1974 associated with the first oil shock; and the third from 1976 to 1980 associated with the second oil shock. These last two inflation surges were exacerbated by the oil shocks, but not caused by them. In each case the inflation surge began a year or two prior to the oil shock. Furthermore, the major inflation surge began in 1966, eight years before the first oil shock.

A careful analysis of Figure 1 reveals a very important fact. In the postwar period up to 1980, investors continued to believe that inflation surges were temporary and that the inflation rate would soon decline.

As the bottom line shows, during the short 1956-58 inflation surge, and throughout almost all of the long 1966-80 surge, investors were willing to buy and hold bonds with an interest yield close to the prevailing inflation rate. Twice, the yield was far below the prevailing inflation rate. Investors clearly expected throughout these periods that the inflation rate would decline and remain below the then-prevailing inflation rate over the life of the bonds they were holding. To believe otherwise requires one to take the untenable position that investors were willing to buy and hold bonds they believed would give them a zero to negative real return over the life of the instrument. It is inconceivable that investors would do so if they believed inflation would remain at the then-prevailing rate or go higher. During most of this period, they could have increased their current yield by shifting to higher-yielding short-term instruments and also get progressively higher yields in case inflation accelerated.

Not only did investors believe that inflation would decline, but they believed that decline would be substantial. For example, in 1979 investors were buying and holding bonds yielding about 4.5 percentage points below the then-prevailing inflation rate. Because the coupon on the bonds was fixed, the inflation rate would have had to decline quickly by 7.5 percentage points and average that rate over the life of the bond to give the investor, say, a 3 percent real return. A 3 percent real return would be near the center of the range that had prevailed over the previous century.

It is true, of course, that in the 1966-80 inflation surge, investors lost faith in the long-held view that inflation would be followed by deflation, and that long-term inflation rates would be zero. Nominal rates rose above the century-old 2 to 4.5 percent range and stayed there. Investors apparently believed that when inflation rates declined, they would not return to the average zero rate that had prevailed for so long. Nevertheless, up to 1980 they clearly believed that inflation rates would decline substantially from the then-prevailing rates.


Sometime around 1980-82 investors changed their long-term inflation expectations dramatically. They lost confidence that Washington (including the Federal Reserve System) would be able to bring inflation under control. They began to fear that inflation would get much worse.

Evidence of this shift is clear. Throughout most of the 1970s investors had bought and held bonds with yields so low that the inflation rate would have had to decline substantially if investors were to earn a real return of, say, 3 or 4 percent over the life of the bond. In contrast, for five years beginning in 1982, investors required a nominal bond yield high enough so that even if inflation rose 4 or 5 percentage points and stayed there for the life of the bond they would still earn a 3 or 4 percent real return on their instruments. If investors had not believed inflation would remain high or perhaps even get worse, those not requiring high liquidity would have moved part of the immense sums they held in low-yielding short and intermediate term instruments into long-term bonds, thereby increasing their current yield and putting themselves in a position to profit from bond appreciation when inflation and long-term interest rates declined.

Anyone who visited much with fixed-income money managers in late 1981 will remember that foreboding sense of crisis as bonds plunged to dismal new bear-market lows and investors gave up on the expectation of a return to price stability. This shift from one extreme to the other was a watershed event. It was the first time in the history of the United States that the likelihood of continued high inflation became accepted. It was, indeed, a crisis of confidence. Surely it must have affected several aspects of economic behavior including the personal saving rate.

Since 1986, as Figure 1 shows, fears of worsening inflation have faded and the inflation risk premium has declined. But investors still demand a nominal interest rate far enough above the prevailing inflation rate to protect against a modest worsening of inflation.


As indicated by Figure 1, the crisis of confidence was followed by a sharp decline in the personal saving rate. The decline was not just to the bottom of the 6 to 8 percent range that had persisted for most of the previous quarter century but fell far below that range. The saving rate decline continued to 1987. Since then it has shown a modest recovery.

Was the crisis in confidence responsible for a significant part of the decline in the saving? A study by Bosworth et al. (1991) demonstrated that any theory of the saving rate decline must be consistent with the fact that the saving rate declined for all age groups, all income groups, and all asset-holding groups. We also argue that in addition to being broad-based and pervasive, causal forces must have come to a distinctive climax at the beginning of the 1980s.

The "crisis of confidence" theory meets these criteria. The acceleration of inflation to its 1979 climax was the dominant economic feature of the 1970s. Surely it affected all demographic and economic groups. The climactic nature of the inflation experience fits the paradigm of modern chaos theory, a gradual build-up of stresses resulting in a final sudden break with the past, often triggered by a minor event (the butterfly effect).

In addition, the "crisis of confidence" theory follows the experience of inflation's well-known impact in many countries. When people lose confidence in price stability, the natural reaction is to go into debt, buy tangible things that will appreciate in value, and reduce saving. That is exactly what happened following the crisis in confidence.

Three of the most popular explanations of the 1980s saving rate decline have been that they were due to demographic changes, to changes in income distribution, and to the wealth effect of asset appreciation. But as Bosworth et al., have pointed out, those theories do not explain why the saving rate declined across all age, income, and asset-holding groups. Furthermore, we argue that they do not explain the suddenness of the decline in the 1982-87 period. (Bosworth et al. do not argue that those three factors have no effect on the saving rate in the long run. Rather they just do not explain the sudden 1980s decline in the saving rate.)

The decline in income growth and a lesser need for retirement and emergency funds due to the expansion of social security and health insurance are also cited as possible causes of the 1980s saving rate decline. These are possible arguments for a long-term decline in the saving rate but they, too, are deficient in explaining the suddenness of the 1980s decline.

So far we have ignored the question of whether or not inflation expectations of investors are reasonably representative of the expectations of the saving community as a whole. Since investors include the well-to-do public that does most of the saving, they do represent a substantial part of the saving community. But another group of middle and lower income consumers also affects the aggregate saving rate by borrowing (dissaving). This borrowing is impacted by another factor, changes in credit standards. Credit standards, in turn, are affected by inflation and by inflation expectations.


One way inflation can influence the saving rate is by corrupting credit standards, especially when inflation is expected to be prolonged at unpredictable rates. No market-managed economic system can function well without a reasonably stable currency. A stable currency is the only way by which we can relate present value to future value. Inflation introduces a high degree of uncertainty as to future value, and encourages speculative judgments about the likely appreciation of the value of assets used as loan collateral and about increases of income of borrowers that will enable them to repay loans.

For example, how much should a lender advance to someone for the financing of a home? When prices are stable, credit standards such as loan-to-value ratios, carrying-charge-to-income ratios, maturities, etc., can be developed from experience. But when an unknown degree of inflation must be factored into the decision, great opportunity for excessive speculation and unsound lending practices prevail.

Part of the wildness in corporate finance, home financing, and other real estate lending in the 1980s was undoubtedly due to the fact that established credit standards were abandoned as unwise guesses were made about the future of inflation. We were at sea without a compass.

Nowhere in the United States was the collapse of credit standards so spectacular as in corporate finance. The ratio of debt to total capitalization for the Standard & Poor's 400 industrials held steady at about 30 percent throughout the 1970s and into the 1980s. Then it rose sharply to about 45 percent. High leverage and junk bonds came to be marks of creative financing rather than foolhardy speculation. To a lesser extent, this collapse of credit standards was also evident in most aspects of personal finance and likely affected the personal saving rate.

During the 1965-80 period of erratically accelerating inflation, credit standards on consumer loans eased moderately. But a further major easing occurred following the 1980-82 shift in inflation expectations, as evidenced by the sharp increase in the ratio of consumer installment credit outstanding to personal income. Maturities on average loans on new cars rose from about forty-five months to an unprecedented fifty-five months, with a large proportion at sixty months. For much of the life of a sixty-month loan, the collateral value of a car is below the outstanding debt. The use of credit cards rose dramatically. Home equity loans became popular. Customers with dubious credit histories found it easier to get loans. The inadequacy of those liberal credit standards has been demonstrated by the skyrocketing of personal bankruptcies. Surely the deterioration of credit standards had something to do with the decline in the aggregate personal saving rate by allowing part of the population to spend beyond its income.

Conventional wisdom often suggests that deregulation of financial institutions was an important cause of the collapse in credit standards. This was undoubtedly true in the case of saving and loan associations after the passage of the Garn-St. Germain Act of 1982. But no other major acts of financial deregulation occurred except those that allowed interest rate ceilings to rise to adjust to the realities of existing high inflation rates.


We have examined the relationship between inflation expectations and the saving rate in five other major countries--the United Kingdom, France, Germany, Italy, and Japan--and in four of them have found "crises of confidence" similar to that experienced in the United States, although somewhat less pronounced. Only Germany had a different performance, and Germany had a far milder bout with inflation than did the other countries.

Each of the four countries experienced accelerating inflation initially thought to be temporary as evidenced by very low premiums of long-term interest rates over the prevailing inflation rate. In each case inflation continued to a crisis point when investors finally came to believe that a high rate of inflation would be prolonged or even worsen. The crisis point was followed by a decline in the personal saving rate.

This evidence from other major countries adds some credibility to our hypothesis that a crisis of confidence in long-term price stability had a significant impact on the saving rate.

Comparisons between the United States and other countries in this regard cannot properly be summed up by a coefficient of correlation or other short statistical presentation. An appraisal of the validity of our conclusions can best be made by an inspection of the year-by-year data for each variable for each country presented in chart form, available from the authors.(1)


This paper has had limited objectives: to document the 1980-82 crisis of confidence in the stability of our currency and to suggest that this crisis was probably a significant factor behind the 1980s decline in the personal saving rate and the collapse of credit standards.

As for the future, the major implication is that the inflation scenario of the past quarter century described in this paper probably will not be repeated; inflation surges will be short lived. This forecast is important because it implies significant control over government by financial markets.

Remarkably, inflation surges caused by inflationary fiscal policy may actually be prevented. Apparently many people in government have become aware of the power of financial markets. They now know that even the mere proposal of inflationary fiscal policies can cause sharp declines in bond and stock prices with unpleasant effects. Hence, such inflationary fiscal proposals are less likely to be enacted. No longer will naive investors allow governments (including the Federal Reserve) fifteen years of inflationary policies, as in the 1966 to 1980 period, without demanding the retribution of very high and very destructive interest rates far above the prevailing inflation rate. The century-old view that inflation is just a temporary result of crises died in the 1966-80 inflation. The painful experience of that period left too many scars.

The importance of this development can be made more vivid by a bit of historical conjecture. How might history have played out following the 1966 inflation surge had investors believed it was going to be prolonged rather than temporary? Investors probably would have demanded an inflation risk premium of 8 to 9 percentage points above the then-prevailing inflation rate, as they did in 1982-85 when they finally came to believe that inflation would be a continuing problem. The nominal interest rate on long-term Treasuries would have jumped from about 4 percent in 1965 to about 12 percent in 1966 or 1967. Bond prices would have plummeted, leading to a stock market crash of monumental proportions. Beyond that, results are difficult to estimate. High interest rates may have led to recession and changed government policy toward Vietnam. The inflation rate would surely have declined. Accelerating wage rates would not have become the norm. The subsequent oil shocks would have been easier to contain, and we would have been able to avoid much of the inflationary distortions of the following period, especially the serious recession of 1982 that was necessary to break the back of rising prices. No one can know for sure exactly what would have happened, but economic and political activity would have been much different-and much better.

Financial markets are alert to inflationary fiscal proposals and respond quickly to them. Markets are not, however, as responsive to other inflationary programs. Inflation is caused, or at least exacerbated, by a whole host of government actions. These include many kinds of cost-increasing government taxes and regulations, protectionist measures that reduce competition and increase prices, and encouragement or merely tolerance of monopoly in labor and business.

Financial market response to these inflationary programs is not likely to be prompt enough to prevent their adoption. Rather response is more likely to come only as a delayed response to the inflation that they cause. Nevertheless, inflation, whatever its cause, will not be allowed to accelerate for long.

As for the saving rate, we have no historical experience available by which to judge its response to the current moderating inflation outlook. The saving rate did bottom out and begin a gentle rise in 1987 just after the fear of worsening inflation crumbled, as evidenced by the sharp decline in the premium of nominal bond yields over the prevailing inflation rate.

But much of the present generation has grown up with the fear of continued and perhaps worsening inflation. That fear will not be easily forgotten. And spendthrift habits are difficult to break. Nevertheless, credit standards have been tightened in this moderating inflation environment. Car dealers and real estate salesmen continue to complain about the difficulty of qualifying buyers for credit. We have had the first recession in a decade. Under the pressure of growing competition, a majority of large business firms have been restructured, a restructuring that has reached into the ranks of white-collar workers more than at any time in this generation, raising fears of permanent job losses among many workers who had felt their jobs were secure.

All in all, waning expectations of possible gains from inflation-induced asset appreciation and debt depreciation, together with greater fears of job loss, may continue to move the saving rate back toward its precrisis range of 6 to 8 percent.


1 Anyone desiring to pursue the subject further can obtain the charts together with a far more detailed discussion on the arguments advanced herein by sending a stamped (3 oz.), self-addressed (9 x 12) envelope to Crossroads Research Institute, 50 So. Main Street, Suite 1090, Salt Lake City, Utah, 84144.


Bosworth, Barry; Gary Burtless; and John Sabelhaus. "The Decline in Saving: Evidence from Household Surveys." Brookings Papers on Economic Activity, 1991:1, pp. 183-241.

Sprio, Peter S. Real Interest Rates and Investment and Borrowing Strategy. New York: Quorum Books, 1989.
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Title Annotation:Applied Economics
Author:Thompson, Douglas N.; Ottosen, Garry K.
Publication:Business Economics
Article Type:Industry Overview
Date:Oct 1, 1993
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