Inflation Risk Premium Inflation Risk Premium
Imagine the lenders of the 1970s and early 1980s. Some of them had lent their money for 25 years at 4% and 5%. When inflation was increasing at 12%, this meant that they were receiving a return of -7% and -8%. Another way to look at this is to think of the effect on a lender's capital. Let's say that you wanted a new car which costs $10,000, but you decide to wait for a year. You put your $10,000 in the bank or a bond at 6%. You wait the year. Your $10,000 has grown to $10,600. You withdraw your money and wander over to the car dealership. The dealer informs you that the price of the car you want is $11,000. You question the price and the answer is: "We have raised the price of our car in line with inflation, which was 10%. You now understand why people in Brazil, which has more than 10% inflation per month, spend their pay on something as soon as they get it!
Not only do lenders want to be compensated for the inflation they expect, they also want to be compensated for the risk that inflation could increase during the term of their loan. Obviously, if they are lending very short term, say one month, they have a pretty good idea what inflation will be during that period. If they are lending longer term, say 30 years, they will demand a steep premium as they have very little idea what inflation will be 10, 20 or 30 years later. Generally, the longer the term, the higher the interest rate. That is why 5 year mortgages usually have much higher rates than floating rate or very short-term mortgages and why 5 year GICs have higher rates than 30 day GICs. When short-term rates are lower than long-term rates, the yield curve is said to be "normal". The extra "risk premium" is for inflation changes. In the mid 1980s, even though inflation was low, interest rates were still very high, reflecting fears of the higher inflation of the 1970s and early 1980s.
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