Inflation Doesn’t Have to Mean High Interest Rates

Issues like the semiconductor shortage are pushing up prices. Investing in production can be a better way to deal with inflation than interest-rate rises.

By Jon Sindreu of The WSJ. 

From 2012-2020, the highest annual inflation rate was 2.3% and in six of those years it was under 2%. But from April 2020-April 2021, the consumer price index was up 4.2%.

First, why might we expect that inflation might lead to higher interest rates?

One reason is that the expected rate of inflation will affect the nominal interest rate.

Nominal interest rate = real interest rate + expected rate of inflation + (real interest rate)*(expected rate of inflation)

The real interest rate is the rate you would charge on a loan in a world with no inflation. You add the rate of inflation since you don't want to lose out due to inflation when you get paid back.

The last term, (real interest rate)*(expected rate of inflation), is also necessary to make sure the lender does not lose to inflation.

So if you lend $100, to be paid back one year from now and you want to charge a10% real interest rate, in a world with an annual inflation rate of 10%, you actually need to charge 21%, not just 20%.

You might think that you would get the 10% real rate and the extra 10% compensates you for inflation. But not quite.

You need to get paid back $110 just to keep up with inflation. Then you had wanted to make a 10% real return on top of that. What is 10% higher than 110? 121. And 121 is 21% higher than 100, the amount you loaned.

So here is the calculation

.21 = .10 + .10 +(.10)*(.10) = .10 + .10 +  .01 = .21

The article hints that our somewhat high inflation rates won't last long. If that is the case, then lenders will not be adding much to the real interest rate to get the nominal interest rate.

The other reason why we might think interest rates will rise due to inflation is that the Fed might raise them to reduce aggregate demand (AD). Too much aggregate demand will give us high inflation rates. Again, if it is true that we are only going to have a temporary increase in the inflation rate, the Fed won't need to do this.

The graph below shows how too much AD brings big price increases.

If we are at AD2 (so we have the full-employment GDP) and AD increases (like to AD3), then we start getting larger increases in prices (higher inflation). A higher interest rate will reduce or keep AD constant to prevent this inflation. But again, if the current high inflation is temporary, then the Fed will not need to raise interest rates.

Excerpt from the article:

"Inflation is back. The U.S. consumer-price index surged to a 13-year high of 4.2% in April, official data showed Wednesday. The eurozone’s figure is a weaker 1.6%, but still a two-year high. The global bond market isn’t panicking yet. The pandemic led many distressed companies to slash prices in 2020. Investors always knew that, as the economy reopened, some year-over-year increases would be huge.

The prices of most products haven’t changed much. CPI gyrations are mostly down to a few items particularly affected by lockdowns and travel restrictions, such as airfares and restaurant prices, as well as commodities. Excluding food and energy, U.S. inflation in April was just 3%.

One inflation driver stood out in Wednesday’s data: The global shortage of semiconductors. Partly because it is impairing production of new cars, the prices of used autos jumped 10% in April from the previous month—accounting for over a third of the all-items increase."