The Financial Express

Inflation, expected inflation, and interest rate spread

Abdullah A. Dewan   | Published: February 10, 2020 21:49:02

Inflation, expected inflation,  and interest rate spread

The new interest rate caps (6.0 per cent on deposit and 9.0 per cent on lending) will have its debut on April 1, 2020. In a February 06 piece entitled "Should all loans come under 6-9pc ceiling?" (Drs) Aminul Karim and Ariful Islam argued that these interest rate caps - especially the lending rate cap at 9 per cent for all kinds of loans is not pragmatic, rather "a one size fit all" gambit, if you will. I fully subscribe to their arguments against such an indefensible strategy lacking all economics rationales.

Obviously, all borrowers are not created equal - some may have pristine credit history, while others carry less credit worthy baggage. Some investment projects are more promising, while others could be subprime and risky. Additionally, services and cost structures of operations can vary from banks and to bans. However, their article failed to address an inescapable determinant of interest rate - the role of expected rate of inflation in future real rate of return.   

Understanding the economic processes that generate inflation has been an important, yet elusive, objective for macroeconomists and monetary policy authorities. One piece of the puzzle is the role of inflation expectations (in short, infexps) in the inflation generating process. Infexps affect interest rates (nominal interest rate (NIR) = real interest rate (RIR) + expected inflation  (EIR)) and, consequently, investment expenditure, aggregate demand, and actual inflation. They affect labour negotiations and consequently, wages, production costs, and actual inflation. Economic policies work not only through their direct effects, but also through their effects on expectations, including expectations of inflation.

Inflation expectation data can be made available from consumer survey responses or from forecasts using econometric models. In the U.S many private institutions generate such forecasts.

It is now well known that when the total money supply exceeds the value of goods and services available for sale the economy will experience inflationary pressures as prices rise. In theory though, rising prices should self-depress inflationary pressure by subduing demand -- forcing prices down. Unfortunately, it doesn't always work that way; instead, inflation has inertia of its own, often reinforces itself, especially if wages and prices increase in tandem. However, independent central bank (CB) such as the Federal Reserve, Bank of England, and Bank of Japan are exclusively empowered to administer the nation's money supply. Therefore, one way to control inflation and infexps is to raise interest rates by pursuing a contractionary monetary policy.

If inflation persists, people learn to anticipate ongoing price increases and plan accordingly. If they expect the purchasing power of money would decline, they tend to speed up spending for two reasons: today's money will be worth less tomorrow and prices are lower today than they will be tomorrow.

To understand the inflation and inflation expectations-generating processes one must make a crucial distinction between inflation and relative price increase. Consumers often observe price increases in some daily essentials and become concerned that inflation has been set in motion -- a mistaken idea for sure. What they really experience is changes in relative prices -- price increases of some goods in relation to other goods.

Inflation is a condition that afflicts all prices, not just the prices of specific basket of goods or services. Changes in relative prices reflect changes in the supply and demand conditions of specific markets (for example, markets for beef and chicken). The two aren't always so easily separable. Sometimes, we experience such a large and persistent relative price change that it temporarily ripples through the inflation data. The obvious example is oil prices.

Energy prices increase the costs of everything so adversely that it's baffling virtually every business and household directly or indirectly. Purchasing the same amount of energy-intensive goods and services requires people either to earn more, save less, or purchase fewer non-energy-based items. The government or the central bank (CB) obviously cannot offset these costs because they don't produce oil or increase the production of other essentials directly.

Back in 1968, Nobel Laureate economist Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the expense of "just a little more" inflation. He predicted that people would come to anticipate that extra inflation and then would change their behaviour in various ways. If policymakers still expected people to behave as they had in the past, they would attempt to do things that were no longer possible. In effect, Friedman was warning policy makers not to treat inflation expectations as a static concept, but to appreciate the interdependence of inflation and inflation expectations.

Why should inflation expectations matter so much? It so happens that when infexps are managed well -- specifically, when they are anchored, the CB (with independent policy making authority) can best promote a sustainable economic growth path while managing money supply and interest rates. Additional benefit of such an anchored inflationary expectation environment and stable inflation would allow stability of the exchange rate. It is nearly impossible to maintain the stability of the exchange rate in a high-inflation environment.

Infexps matter because all forms of savings, borrowing for consumer durables, house mortgage loans, business investment, and so on are forward looking - whether you receive interest income or paying off loans.  Your money is worth more today and is subject to loss in value (purchasing power) due to future inflation. For example, if inflation is expected to be higher in the future, borrower would gain and would be inclined to borrow now because he/she will be paying off loans which will have less purchasing power and the lender would be less inclined to lend unless the higher expected inflation is built into the loan contract.  Consider the interest rate equation again,



Obviously, the difference between nominal interest rate and the real interest rate is the expected rate of inflation. If lending rate (NIR = 9%) does not adjust upward with higher expected inflation rate, lending institutions' real return will take a hit and may even have a negative real rate of return, which is unsustainable. Can Bangladesh Bank anchor the expected rate of inflation and hence actual inflation to maintain the sustainability of interest rate cap at 9.0 per cent? Does BB or Bangladesh Bureau of Statistics (BBS) have the state-of-the-art econometric models to forecast inflation expectations or collect survey responses of consumers about expected inflation? The bottom line is that lending rate should be set based on credit worthiness of borrowers with reasonable provisions for inflation adjustments.

Dr Abdullah A Dewan, formerly a physicist and a nuclear engineer at Bangladesh Atomic Energy Commission (BAEC), is Professor of Economics at Eastern Michigan University, USA.



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