Hi,
I have tried to find an answer to the question of whether inflation influences interest rates (long-term/short-term) or vice versa. I’m not clear on this point. I would appreciate some help on this matter.
Thanks,
davidmich
Reported for forum change.
Both, in some ways. Here is the simple view:
Inflation will determine nominal interest rates as the anticipated rate of inflation must be factored into the nominal rate in order to reach the desired realized rate of return. If my required rate of return is 5% in real dollars (2012 dollars) and I want to make a loan that is profitable for me, I need to factor in inflation. If my assumption is that inflation will be 2%, then I need to set my interest rate on the loan to 7%, in order to have a real rate of 5%.
Traditional economic theory holds that low interest rates will lead to higher inflation. This is because low interest rates encourage borrowing, spending, and capital investment. These in turn stimulate the economy, and a growing economy causes inflation.
So, yes they are certainly connected. The reality gets a lot more complicated, but that’s the basic and standard view.
It’s a duplicate post as well.
Going to slide this over to GQ for you.
I’m really interested in how interest rates and inflation influence each other on global as well as domestic levels. What’s complicated is untangling which is influencing which. Oil consumption will raise the price of manufacturing and goods worldwide, which will in turn have a knock-on effect on inflation, which in turn will determine individual countries’ fiscal policies. Is there any website you know of showing this complex relationship in graph form? It would be very helpful. Thanks.
davidmich
What Darth Panda said is a good start. Interest rates and inflation are closely linked but there can be a lot of other factors. Famine, disasters, disease, distribution disruptions, war and other things can fuel inflation. Interest rates will closely follow because again, the one’s making the loans want a return on their investment. They will also factor in loans that default. It’s Whack-A-Mole.
I sometimes wonder if we make a mistake in artificially trying to keep rates low to avoid inflation and stimulate growth when some inflation might actually be good. This is where I think that Greenspan blew it. Interest rates that were too low led to the crisis. For many of his years the economy was solid enough to absorb some inflation which would have put some of the entitlements, pensions and other long term commitments in a better financial position. Instead, interest rates being too low fomented a crisis.
When the cart is leading the horse you might just be headed off a cliff.
If you’re looking to make a connection between oil consumption and inflation, you’re being too simplistic. That’s only one aspect of a tremendously complex picture.
The U.S. consumer price index alone is far more complicated.
You can argue that oil prices affect all these categories, but they have their own effects. No graph can chart all these.
In addition, inflation does not come about merely from pricing. Population growth, economic growth, resource allocation, and governmental spending all play major roles. The crisis that Europe is facing has little to do with oil, but will greatly affect interest rates. The stagnant economy in Japan for the past twenty years has little to do with oil, but deflation is more of an issue there than inflation.
Inflation is not just pricing and interest rates are not just inflation. It’s vastly more complicated than that.
Thank you for this. Your comments really puts the issue into perspective for me. The inflation/interest rate relationship is complicated. I’m trying clarify it for myself. This has helped.
This is how Investopedia defines inflation:
The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.
“Inflation has been defined as a process of continuously rising prices or equivalently, of a continuously falling value of money.”
http://www.bls.gov/cpi/cpifaq.htm
Perhaps you can suggest a more comprehensive definition.
Thanks
If you really want to be able to dig in, you can’t just look at inflation and interest - you need to see the whole picture. You need to understand have the Fed works, how they utilize open market transactions to drive rates, understand reserve ratios, speed of cash, different types of monies M1 M2, you need to understand supply and demand really well, understand oligopolies and monopolies, basic competitive theory, dead-weight loss, bond and equity markets, various types of elasticity, Pareto distribution, tax impacts on productivity, microeconomics for business: average versus marginal costs, theory of variable cost allocation, production curves, understand price control impacts and tax allocation, cyclical of business, systematic versus idiosyncratic risk and how this drives beta - the utility of money across time, and basic understanding of finance: corporate valuation, required rates of return, tax shields on debt, free cash flow measures, sharpe ratios, and all of that other fun stuff.
You don’t need to go to deep into finance and accounting, but you need at least some of it to make economics meaningful. I can recommend Corporate Finance and Investments. I’ve read both and they’re very good.
The copies here are very expensive, but you can find much cheaper versions if you look around for older editions, used, international, whatever - maybe 50 or 60 bucks each. They’re each about 1,000 pages, you’ll need to read Corporate Finance first, or Investments might be tough to understand at some points. You’ll also need Excel or a good financial calculator to be able to work through the problems.
For economics itself, I actually think that the best, most concise text ever written on basic econ is the Level 1 CFA Curriculum Economics book. And you can get it really, really cheap. It’s only 500 pages, and once you’re through that you’ll be able to see for yourself where you want to go from there.
Keep in mind that you’ll need good (not great) math skills to keep up with some of the work.
What is confusing to most people is that one of the prime ways the Fed influences inflation is through the setting of interest rates on loans to banks. When they want more inflation they lower the rate. This means that people associate lower interest rates with high inflation but as has already been said high inflation leads to high interest rates and low inflation leads to low interest rates. Heres how Milton Friedman put it in an article about the BOJ :
“Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”
Thank you Darth Panda. Your comment gives me very helpful overview of economics. I have read Paul Samuelson’s “Economics”, so I am familiar with some of what you’ve mentioned above, such as supply and demand and elasticity. But I see that I still have more to read to grasp the intricacies of the inflation issue. Thanks again.
Thank you for this. Very helpful.
I found this nice summary of the various schools of thought on what exactly inflation is.