If spot rates are rising, why does this imply an inflationary environment?
This is in reference to CFA quote:
‘Because nominal yields incorporate a premium for expected inflation, an upward sloping yield curve is generally interpreted as market expectation of increasing future inflation’
Am looking at this a few ways:
When rates rise then this is to slow down inflation and stop spending and encourage saving. Would this not result in slower growth and potentially a deflationary environment?
Or are we saying that because spot rates have risen each year that has been done to curb inflation and therefore we are still witnessing inflation
Or finally, if rates rise bond prices fall implying a movement from safe haven assets to risk assets such as equity implying growth and therefore inflation.
We must differentiate shocks on economic variables from long-term path (behavior) of economic variables.
Let’s assume for a moment we are in a good economic environment and we are very sure the economy is going to grow for the next 20 years. What will happen to interest rates and inflation? Certainly both will rise. We don’t care how much by now, so just talk about the direction. Developed countries are an example of this. Their long-term positive growth since decades has affected inflation rate. A large pizza in UK is around 50 pounds (62.7 USD). With 62.7 USD in Peru, I can buy 3 pizzas of the same quality. Accumulated inflation in UK is much larger than in Peru. However, inflation year to year appears to be the same in both countries (around 1 - 2%) implying that the future economic growth in Peru will not be the same as depicted by the UK since decades ago. In other words, Peru will never achieve the same life standard that UK possesses now.
An interest rate spot curve [today] plots the rates for different loan maturities, so for higher maturities, rates are higher because they include risk premiums (default, credit, liquidity, inflation, etc). An upward sloping interest rate curve is commonly interpreted as good future economic environment, because as we saw in the example above, inflation and interest rates will rise. Also, the higher maturities rates are expected to become the short-term interest rates when that time arrives, once again, implying that future economic environment will be much better than now. In simple terms, If today the 1-year rate is 4% and the 30-year rate is 7%, in 29 years the 1-year rate will become 7%.
As I commented above, an upward sloping yield curve is a sign of good future economic performance, hence higher inflation.
Be careful with deflation and lower inflation. Inflation is an increase in prices. Lower inflation than before means that prices are still growing but at a lower pace. Deflation, in the other hand, is when prices are lower than before (negative growth rate). Deflation is dangerous because the economy can fall into a deflationary spiral, which means that people expecting future prices are going to fall, they postpone consumption and investment today making prices even lower. The spiral.
Central banks role is to prevent economy to show a random growth. Inflation and interest rates are inversely related; so yeah, central banks want to slow down the economy.
Everything is related.
Bonds are safer than equities. Investors will always prefer both at the same time, but in different weights of course. If rates go higher, bond prices will go down undoubtedly. Equity prices depend on more variables: is the economy expected to grow? how much money is derived from bond market to equity market to make equity prices up?, etc. Commonly the forces are subtle, unless we are in a market crisis.
Harrogath thanks for taking the time to write that detailed explanation. It certainly helped.
A couple questions: Why do interest rates and inflation move up together in the future if the economy grows? You didn’t explain that.
Secondly,you wrote Central banks role is to prevent economy to show a random growth. Inflation and interest rates are inversely related; so yeah, central banks want to slow down the economy.
This is my thinking also. There is an inverse relationship between rates and inflation. Therefore if inflation was to rise surely rates would rise to mitigate this. Is this what you meant earlier when you said that the two move up together?
I assumed in my example no business cycles, only positive growth. A bit unrealistic, but just for educational purposes. I meant that when an economy grows inflation and interest rates go up, it is an empirical result. Nevertheless, it has a theoretical explanation:
Supply and Demand are forces that seek equilibrium. As demand is always more volatile than supply, inflation in prices of _ goods and services _ is inevitable. The higher the demand in the middle to long-term, the higher the inflation. Higher demand occurs when economies are healthy [and expected to grow].
Interest rates movements are driven by demand and supply _ of money _. The supply is given and 100% controlled by the central bank, and the demand for money is represented by individuals and companies in the economy. The higher the demand for money, the higher the interest rate will be. If the economy is expected to grow, the demand for money is also expected to grow, hence interest rates.
The thing here is that inflation must be controlled via interest rate. So, when inflation is starting to peak, interest rates increase and cut that inflation bump. It is a dynamic relationship.
Yup, the relation of both variables is really tight and dynamic.