Interest Rates and Inflation

Financial markets are out of whack

As I write this, the interest rate on 10-year U.S. Treasury securities is 1.28 percent. A fairly standard forecast for inflation has it never falling below 2.0 percent any time in the next ten years. Whenever the interest rate is less than the rate of expected inflation, we say that the real interest rate is negative. I consider this a peculiar state of affairs. I do not understand why markets permit it to happen.

In the near term, a three-month government security has been yielding less than 0.1 percent, even though inflation recently averaged close to 10 percent at an annual rate (multiply a monthly CPI increase of 0.9 by 12). If you had savings in a bank or in a money market fund the last few months, your savings were eroded by inflation.

When the real interest rate is negative, people with savings should try to find assets that will hold their value. It does not pay to leave your money in the bank. If nothing else, you should fill your refrigerator and your pantry, since the prices of groceries will go up.

If you run a business, you should be borrowing like mad. The interest rate on 90-day commercial paper is less than 0.1 percent. Inventories should appreciate at a faster rate than that. Every firm should be loading up on inventories in this environment. Auto dealers should have their lots filled. Hardware stores should have their shelves stuffed.

Long-term investment, too, should be very high. Bernie Saffran, the undergraduate economics professor who taught me public finance, joked that “At a low enough discount rate, it pays to dam the Crum,” referring to a small creek than ran near the college. He said that the Army Corps of engineers would calculate the benefits and costs of infrastructure projects using a very low interest rate, which could justify many projects. If a project costs $100 and earns $1 of benefits every year, then at an interest rate of 1 percent it breaks even—a 1 percent interest rate says that you are willing to wait 100 years to get your money back.

At a negative interest rate, you don’t even have to get your money back in 100 years. A project that costs $100 and has one penny of benefits every year is still a good project.

Corporate America, unlike the U.S. Treasury, does not enjoy a negative real interest rate. The 10-year rate on high-quality corporate bonds is about 2.5 percent, meaning that it is close to 0.5 percent above the expected rate of inflation. Still at a real interest rate of 0.5 percent, any project that earns fifty cents a year for every $100 in up-front investment is worth doing. Businesses should be investing heavily in labor-saving equipment and software.

Goods vs. Services

So far, I have been describing inflation in physical goods. I claim that households and businesses should invest in goods when the real interest rate is negative or very low. Those purchases, of course, only serve to raise prices further.

For much of the past two decades, inflation has been driven by the price of services, especially in education and health care. It is difficult to stock up on services. In my household, I do not say, “Health care costs are rising. Let’s beat the price increases and get lots of medical treatments right away. I’m going to get three colonoscopies this week.”

Hospitals and universities cannot build up inventories of services. The college cannot say “Let’s accumulate another three semesters of psych 101 this month, because prices are headed up.”

So I can understand a situation in which the real interest rate is negative and inflation is mostly in service prices. If goods prices are falling, then the real interest rate in terms of goods is actually not negative. In fact, for most of the past twenty years, we have seen a decline in the prices of many goods, particularly adjusted for quality, with overall inflation driven more by services.

Perhaps financial markets expect a return to the state of affairs in which prices increase for services but fall for goods. In that case, interest rates can remain below the overall inflation rate.

Faith in the Fed

Another interpretation of negative real interest rates is that the Fed has promised to keep interest rates low for many years. If money managers believe that the Fed will keep its promise, then they might as well purchase bonds at low interest rates. The Fed has their back, as it were.

If you do not believe that the Fed can or will keep its promise to hold interest rates low for many years, and you want to speculate, you should go short in the market for long-term Treasuries. There are exchange-traded funds that do this. Betting against Treasury bonds has not been profitable in recent years, but it could turn out spectacularly if today’s negative real interest rates prove to be unsustainable.

For now, I am refraining from speculating on ETFs that profit from increases in interest rates. In other words, I am not putting my money where my mouth is (except that I have invested a lot in inflation-indexed bonds, or TIPs).

But my mouth will tell you that the Fed may not be able to keep its promise. In order to keep interest rates down when goods price inflation is heating up, the Fed will have to buy more and more bonds. This means pumping out more and more money, which lead to more goods price inflation, which will put upward pressure on interest rates, which will force the Fed to buy more bonds, etc. As the late economist Herbert Stein said, “Something that cannot go on forever, stops.”

The big question going forward is this:

• Will inflation will go back to “normal,” meaning that the prices of services like higher education and health care go up, but goods prices trend downward?

• Or are we in a new environment, with rising prices for goods, in which case sooner or later interest rates have to rise, also?