THE BASIS POINT

A Word On Inflation Expectations

Do rates tend to rise on inflation and fears of inflation? Remember that the real interest rate includes both inflation and the nominal rate of interest. In the case of a loan, it is this real interest that the lender receives as income. If the lender is receiving 3.5% percent from a loan and inflation is at 3.5% percent, then the real rate of interest is zero because nominal interest and inflation are equal.

But what is more important: the actual inflation rate, or what people perceive is the actual inflation rate?

The predominant view at the Federal Reserve remains that the underlying rate of inflation is not on the verge of a dangerous acceleration, but mounting public concern about inflation has increased markedly, and yes, this can cause rates to creep higher in a preemptive fashion.

The Fed is more attuned to high unemployment (although it is not the Fed’s responsibility to increase jobs), a depressed housing market, relatively sluggish economic growth and downside risks to the expansion.

Many are quick to point out that conducting monetary policy is difficult when the economy is sluggish. But it’s very difficult when inflation, or fears of inflation, begin to pick up. The futures market believes that the odds of the Fed leaving overnight rates near 0% through August are higher than 90%. One can look for continued Fed pronouncements that the risk of inflation is low… until it is not.