Zaks Investment Advisory Service

Interest Rates and Inflation

Last time, we started to talk about interest rates. We learned that an interest rate is the price a borrower pays to get money on credit. We also learned that there is a market that determines this price, and it is called, obviously, the credit market. The presence of a well-functioning credit market distinguishes developed countries from developing ones.

We stopped at the fact that interest rates are composed of two parts: one component is the inflationary mark-up, i.e. the part that compensates the creditor for losses due to inflation; and the other – the “real” interest rates, which bring the creditor real returns. At the same time, one should remember that what is being compensated is not the present inflation rate, but the expected one, the one that will reduce the dollar’s purchasing power in the future. So for example, if you borrow $1,000 at the bank for one year at eight percent, and the bank assumes that the average inflation rate over the coming 12 months will be three percent, the real interest rate will be five percent (eight nominal percent minus three percent of the expected inflation).

Real interest rates change fairly slowly. For example, real interest rates for so-called long Treasury bonds, i.e. bonds with a long maturity date, have remained at around three percent for the past 50 years. Sometimes, the real interest rates rose, at other times they fell, but usually they fluctuated within a fairly tight range. The inflation rate, on the other hand, can change quite dramatically. For example, in 1981 it approached 14 percent while today, as we know, it is around three percent. As I have mentioned, one of the components of interest rates compensates the creditor for the assumed losses of purchasing power caused by inflation. The market, of course, does not know what the future rate of inflation will be. It usually values the “expected” or “assumed” inflation rate based on what happened over the recent past. For example, in the early 1980s, inflation in the United States was fairly high (at least, by US standards), and, as I said, at one point had climbed over 14 percent. For a certain number of years after this, the inflationary mark-up was fairly high, even though inflation itself had dropped: the market “remembered” inflation, and was not certain that it might not return. By the early 1990s, after several years of low inflation, the inflationary mark-up fell to about two percent.

In general, “expected” inflation is a very dangerous thing. While inflation remains “under control,” or more precisely, when people believe that it is under control, the economy functions normally. But sometimes a high inflation rate and inept central bank policies lead to the expected inflation rate to start revving itself up, which leads to so-called hyperinflation. Not so long ago, in 1984, the inflation rate in Israel reached 445 percent. Probably the most famous case of hyperinflation hit Germany in 1923. The inflation rate soared above 320 percent per month. In November 1923, you could use a 100-billion-mark note to buy two pints of beer at the bar. A loaf of bread cost 80 billion marks. In 1924, Germany’s central bank issued a new mark – it was worth one trillion old ones. But inflation in Hungary after World War II was even worse (if this can be imagined): every day, between August 1945 and July 1946, prices in Hungary went up by an average of 19 percent (this came to about 19,000 percent a month), and for a few days in July 1946, the prices tripled on a daily basis. Nothing of the sort could happen to us because our central bank (the Federal Reserve) and its chief, Ben Bernanke, would never allow it. Plus, our economy simply cannot be compared to that of Europe after World War II. Still, everyone is – and quite justifiably – afraid of inflation, and a recent small splash of it prompted a fairly large market fall. We will discuss how our Federal Reserve fights inflation some other time.

But let us get back to interest rates. We describe them in the plural form. What kinds of interest rates are there? As a borrower, i.e. a credit consumer, you are interested in mortgage rates. These are, of course, the rates charged by banks and other financial intermediaries for home purchase loans. Auto loans are another category, and so are personal loans. As investor (i.e. credit supplier), you are interested in the rates on bank CDs, on federal government bonds (and notes) as well as short-term Treasury bills, on corporate bonds, and bonds issued by the various municipalities. Like all rates, they vary based on the term for which the creditor takes out the loan. Usually, the longer the term, the higher the rate: so the one-year rate is usually lower than the annual rate on a 20-year loan. But there are exceptions, and right now we find ourselves in one of those rare periods. Right now, the rates on short-term Treasury notes with a one-year maturity date are higher than longer-term interest rates, for example the annual rate on a 10-year Treasury note. This means that the market “assumes” (in quotation marks) that interest rates will drop in the future.

How all of these various interest rates relate to each other, how they are affected by inflation, how they in turn affect the economy, and how our central bank, the Federal Reserve, tries to regulate them – we will talk about all these things next time. But for now, we will have to draw our program to a close. This was Sergey Zaks. Thank you for your attention and until next time.