What is inflation?
Inflation is defined as an increase in the price of a bunch of Goods and services that project an economy.It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
There are several variations on inflation:
Effect on Interest Rates
Inflation greatly effects time value of money (TVM). It is a major component of interest rates which are at the heart of all TVM clculations. Actual or anticipated changes in the inflation rate cause corresponding changes in interest rates. Lenders know that inflation will erode the value of their money over the term of the loan so they increase the interest rate to compensate for that loss. Chart IIbelow showed that inflation has been nearly continuous in the U.S. since shortly after World War II. As you can see, long-term loans made at the real rate of interest without an inflation premium would have actually produced negative returns due to the declining purchasing power of the dollar.
An estimate of the inflation premium contained in interest rates can be seen by comparing two risk-free securities with the same maturity date, one with a fixed rate and the other with a rate indexed for inflation. The Fed strongly influences short term interest rates with their monetary policy. However, longer term rates are set by the market and reflect an inflation rate which is its current best guess.
Although it may not be a perfect indicator, the yield of a 10 year, fixed-rate U.S.Treasury note when compared with the rate of a Treasury Inflation Protected Security (TIPS) of the same maturity at least shows that some amount of inflation premium certainly does exist. For example, the Fed Funds rate was recently at 1% and the year-to-year percent change in the CPI (current inflation rate) was 2.3%. At the same time, the annual yield of the fixed-rate note was 4.75% while the TIPS note was at 2%. This would indicate that the market currently expects an average annual inflation rate of around 2.75% (4.75% - 2%) over the ten year period and have added that inflation premium to the fixed-rate, non-inflation protected note.