In So what’s the best way to hedge against inflation? I
talked about how nominal interest rates (the full interest rate quoted by
banks) are made up of two components (check out paragraph three for a recap).
The “expected inflation” component is simple enough to undertand, but
businesses generally don’t care about this. Once you borrow money, inflation in
a funny way is your friend (making Ben Bernanke your hero). Just as the
dollars that Rob Mariano won in 2010 weren’t worth as much as the dollars his
wife won six years earlier on Survivor, the dollars that businesses use to pay
back their loans years later are not worth as much. To understand this abstract
use of the term value think which dollars you rather have, the ones that Rob
was given, or the ones that Amber was given six years earlier, that could buy
more goods. Businesses that borrowed in 2004 got Amber’s dollars, and the banks
that lent the money were getting Rob’s dollars back in 2011. So if the nominal
interest rate rises (and hence your nominal borrowing costs rise) but expected inflation
rises as well, they tend to cancel each other out, and the real cost of
borrowing hasn’t changed. What’s left is the real interest rate that businesses
need to be concerned about. This relationship holds virtually one to one. If
the expected inflation rate falls by one percent, the nominal interest rate tends
to falls by one percent, but businesses have no incentive to invest further,
even though the nominal interest rate has fallen. In the long run lenders face
the same trade off. If their inflation expectations rise they will be happy as
long as nominal interest rates rise to compensate them (one percent higher inflation,
one percent higher nominal interest rates). you can see that even though the nominal
interest rate has changed, no one has borrowed more or saved more. The nominal
interest rate is (approiximately) equal to the real interest rate plus
inflation expectations.
Its only when that residual, the real interest rate, changes
that there is an incentive to move money. This residual is simply determined by
borrowers and sellers getting together and deciding on an interest rate in the
market: it is determined by the demand for and supply of savings. It should be
becoming clear now that it is not controlled by the central bank, at least in
the long run. So what’s the best way to hedge against inflation explains how investors
vote with their feet and determine interest rates. In the short run the RBA can
print money and lower nominal rates as in The Wonderful Central Bank of Oz (which,
holding all else equal lowers real rates) but rates will eventually rise back
to their original level to maintain the real interest rate, and then a little
bit more to compensate savers for the extra inflation from the additional money
printing. The primary point to take away is that the real interest rate hasn’t changed.
This illustrates, and this is common, accepted, mainstream
economics, that the reserve bank can only affect the real interest rate and
borrowing in the short term. Any investment made at the lower interest rate thanks
to the Central Bank will be unprofitable when things normalise.