discount rate / inflation rate relationship

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tarik64's picture

I just read at the end of the pension account reading that there is usually a direct relationship between discount rate and inflation rate… maybe it’s because my mind is shot right now but for some reason I can’t comprehend it in my head… can someone help me out to understand it intuitively? thanks.

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CMLSML's picture

From basic interest rate Fisher relation; r = IP + R. Required rate of return (approx) = Inflation premium + Real rate of return.

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aaronhotchner's picture

What CMLSML said, but it’s not an approximation. It’s a definition. If expected inflation increases, the appropriate discount rate will also increase by the same amount, all else equal.

CMLSML's picture

It is an approximation. Exact is: Nominal = (1+IP)(1+real)-1

There is no substitute for hard work

aaronhotchner's picture

They’re equivalent. You’re just changing the definition of the inflation premium. There is no such real thing as an inflation premium, so you can only refer to it implicitly. Thus, nominal = inflation premium + real is exact. It’s an identity; it can never fail.

Capt. Save_A_Ho's picture

The discount rates in pension accounting are based on rates of return on high quality corporate bonds with similar durations as those of the benefits.  The positive relationship between bond yields and inflation explains the positive correlation between discount rates and inflation.

CMLSML's picture

aaronhotchner wrote:

They’re equivalent. You’re just changing the definition of the inflation premium. There is no such real thing as an inflation premium, so you can only refer to it implicitly. Thus, nominal = inflation premium + real is exact. It’s an identity; it can never fail.

My friend, please see: http://en.wikipedia.org/wiki/Fisher_equation

There is no substitute for hard work

aaronhotchner's picture

It’s a huge misnomer calling the formula “exact,” because it is a theoretical estimation of the interest rate. Like I said, either equation is an identity, and each defines the inflation premium as something different when taken as an identity. There is no rule that says the variables take on exact values as described by the equation; it simply tells you in which “bucket” you should be placing your values.

We can agree to disagree on this, but economics is not a hard science. There are exact solutions to how much energy is in a moving car, or what temperature water boils, but there is no exact solution to how much of some quoted interest rate is due to real interest or an inflation premium. There are no universal laws governing such things.

Granted, philosophical insight is not required to pass a multiple choice exam, but there’s a certain helpfulness in understanding the true nature of the field. I’m a bit too much of an academic for most people, I’m afraid.

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