What’s the Relationship Between Inflation and Interest Rates?

money; via Flickr

Question: I am confused about the cause/effect relationship between inflation and interest rates.

Many economic talking heads claim that interest rates will rise if present monetary policy produces inflation. But the principle of supply and demand suggests that if money is plentiful, its cost — i.e. interest rates — should decrease. Thus any rise in interest rates would be the result of fiscal policy to fight inflation and not just because of inflation, right? Hope you can straighten me out without using “stagflation.”

Paul Solman: Great. A question that baffles millions. Thanks, Denny, for providing a golden opportunity (if you’ll pardon the adjective) for trying to clarify.

First, interest rates DO rise as a result of inflation. What I wrote here recently probably bears repeating:

Think of a market interest rate as the sum of three separate factors: waiting, repayment risk, and inflation.

First, waiting — also known as the time value of money. Imagine an inflation-free environment, such as today’s. Which would you take: a thousand dollars today or a thousand dollars, guaranteed, a year from now? Unless you’re a very unusual person, it’s the thousand right now, so you can do something with the money. If you forgo the money, you generally need to be paid something for doing so, for waiting — in recent history, around 2 percent a year.

Second is the risk of not being paid back. This is why folks with low FICO scores have to pay such high rates of interest. This obviously varies enormously. But the U.S. government has generally been thought to pay the “risk-free” rate: 0 percent for risk. The rest of the interest rate is inflation. If money is losing value and you lend it, you’re going to expect to be reimbursed for the loss.

Say you and I both expect an inflation rate of 10 percent next year, Denny. I ask to borrow a thousand dollars from you. What rate will you charge me? LESS THAN 10 percent? Great. Let’s make that a loan for a billion dollars, shall we?

Look, here’s the flaw in your logic: If you’re paying for your dollars IN dollars, then the less the dollars are worth, the more dollars you’ll have to promise in the future to pay back what you borrowed. That IS a higher interest rate.