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Inflation premiums in the interest rate

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rjljr2 Posted: Wed, Sep 26 2007 12:18 AM

An expectation of long term inflation would seem to be factored into (loan) interest rates. Rothbard makes this point in "Making Economic Sense", ch. 8:

http://www.mises.org/econsense/ch8.asp,  in particular:

 As prices rise, and as people begin to anticipate further price increases, an inflation premium is placed on interest rates. Creditors tack an inflation premium onto rates because they don't propose to continue being wiped out by a fall in the value of the dollar; and debtors will be willing to pay the premium because they too realize that they have been enjoying a windfall .

However, Rothbard in CH 11 of Man, Economy and State (MES) argues also that any expected future change in the purchasing power of money should already be factored into current prices, by people bidding up  / down the prices now, so although there is a purchasing power component of the natural rate of interest, it is due to actual and not anticipated changes.  This seems to make since to me.. but I don't know how to apply it in the case of chronic inflation caused by constant credit expansion, and from that understand what Rothbard said (above) in "Making Economic Sense".

Maybe the answer has to do with understanding how loan interest rates relate to the natural rate.  In times of chronic inflation, the (observed) natural rate of interest will have a purchasing power component that reflects the actual past inflation. This seems clear.  But won't loan interest rates have to deal with anticipated future inflation rather then past? A lender is not going to assume zero inflation going forward, is he? But if the inflation is very certain (as it seems to be), why aren't prices already bid up now, leading to an expectation of zero future inflation???? <* Eyes crossed now :) *>

 I am clearly a little confused on this point, but I think it is important given the recent actions of the Fed. As the Fed continues to pump money into the economy in an attempt to keep the federal funds rate low, it seems (if there is an inflation premium), the fed will reach a limit as inflation begins to dominate the interest rate, leading finally to the long postponed recession or worse:

And this is why, when the public comes to expect further inflation, Fed increases in reserves will raise, rather than lower, the rate of interest. And when the acceleration of inflationary credit finally stops, the higher interest rate puts a sharp end to the boom in the capital markets (stocks and bonds), and an inevitable recession liquidates the unsound investments of the inflationary boom.

(Also from "Making economic sense")

Any help with this point is sincerly appreciated. I hope I am not missing too simple a point. Maybe it is covered later in MES :) 

 

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rjljr2 replied on Mon, Oct 1 2007 11:54 AM

 Upon further reflection, I have not been able to completely reconcile these two concepts. 

1) "Inflation premiums" due to chronic inflation (from Rothbard's Making economic sense)

2) Anticipation of inflation eliminating these same preimums. (from Man economy and state)

I think the answer may be that these are two very different situations Rothbard is talking about. In case 1), we are talking about the hampered market environment, with chronic inlfation caused by centrally controlled interest rates. I can't see how it is possbile in such a case to bid up prices to eliminate an anticpated constant RATE of inflation, so inflation premiums on loans could occur.  In 2), we are talking about the unhampered market economy of MES, where chronic constant inflation of this kind perhaps cannot occur. 

Anyone help making this crystal clear would be appreciated.

 

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