Whether you are borrowing money or lending by investing in bonds, money market funds or another interest-bearing security, the interest rate will reflect prevailing market conditions. Interest rates fluctuate for a number of reasons. A major factor affecting interest rates is the inflation premium. Knowing what an inflation premium is and how it affects interest rates will help you make better investment and buying choices.
Inflation is a persistent and progressive increase in the prices of goods and services. An inflation premium is the part of prevailing interest rates that results from lenders compensating for expected inflation by pushing nominal interest rates to higher levels. Actual interest rates (without factoring in inflation) are viewed by economists and investors as being the nominal (stated) interest rate minus the inflation premium.
The primary market force causing an inflation premium is an expectation of inflation. When inflation is significant (as it has been to varying degrees since World War II), lenders know the money they will be repaid will be lower in value. They raise interest rates to compensate for the expected loss. A contributing factor is that borrowers, believing prices will rise, are more willing to pay higher interest rates to purchase goods and services on credit sooner, rather than later, when they believe prices will be higher.
Interest rates have three components. The first is the risk-free return. This is the amount of interest that lenders charge for the use of their money if there is no risk of not being repaid. The inflation premium is added to the risk-free rate to offset expected losses from the declining value of money due to inflation. The third component is the amount lenders charge to offset credit risks.
It’s impossible to precisely calculate the inflation premium, since it depends on expectations about the future. However, it’s fairly simple to estimate the inflation premium. Typically, this is done by starting with the current interest rate on U.S. Treasury Inflation Protected Securities (TIPS). TIPS carry virtually no risk and are inflation-protected, so their rate closely approximates a real-risk rate. Treasury T-Bills have similarly low risk, but are not inflation-protected. Simply subtract the TIIPS rate from the T-Bill rate to obtain an estimate of the inflation premium. Use securities of the same maturity (10-year securities are most often used).
An investor will derive some advantages from taking the inflation premium into account. When inflation is high, or expected to decline, look for long-term fixed rate securities to “lock in” high market rates. Conversely, If you expect inflation to rise, you will want to focus on variable-rate or short-term securities (if you are borrowing, the reverse is the case). However, predicting inflation rates is difficult, especially for long-term investments. Most financial analysts place more importance on the credit-risk component of interest rates as a primary concern.