Relationship Between Inflation, Interest Rates, and U.S. Treasury Bonds

Inflation has resurfaced over the past few months as an economic outcome we should all be acutely aware of.  Besides fiscal policy, a huge determinant of inflation is monetary policy established by the Federal Reserve.

In an effort to spur the economy, the Fed is essentially manufacturing money to the tune of $600 billion to buy U.S. Treasury bonds.  If the demand for Treasury bonds rises, pari passu (all things being equal), the price will rise as well.  An increase in bond prices also translates to a decline in interest rates.  Here is a simplified illustration:

Current Bond Price	Interest Rate	End Payment
$80.00	25%	$100
$90.91	10%	$100
$95.24	5%	$100

In this example, the current bond price is what you’re willing to invest today to receive $100 in one year.  The interest rate identifies the rate of return that will entice you to buy the bond (lending money with the promise of being paid back at a later date).  A company or government borrowing money through bonds will pay a lower interest rate if it is viewed a safe investment.

The Fed’s policy of buying Treasury bonds has the effect of keeping interest rates exceptionally low since, pari passu, more demand à higher bond prices à lower interest rates.

In effect, the Fed is trying to keep interest rates lower than what the Treasury market would ordinarily dictate.  Part of the reason is because interest rates on other debts (particularly residential mortgages) are tied to Treasury yields.  This explains why mortgage rates have been at historically low levels over the past 6-12 months.

Debtors are benefiting from these low rates, but there are major costs to this approach.  Savers are earning next to nothing on bank deposits, which depresses their interest income.  Insurance companies and pension funds are also generating less investment income, which is added concern for state pension funds that may be insolvent within a decade.

Furthermore, the Fed’s policy actions are devaluing the U.S. dollar (namely because it is manufacturing $600 billion not previously part of the money supply).  If one U.S. dollar today is believed to be worth less than it was three months ago, pari passu, suppliers of goods and services would raise their prices to compensate.  People’s incomes are relatively static over the course of a year, but anyone who has shopped for groceries or filled a car with gasoline knows that these expenses rose substantially just in the past few months.

These price increases are especially problematic because spending on necessities is increasing while incomes remain constant, effectively making people poorer.  With a constant income, consumers paying more for food and energy takes away from their discretionary income, thus reducing their ability to make discretionary purchases and pay down debt.

An even more troubling scenario is if investors in U.S. government debt become concerned about 1) the country’s ability to pay its debts and 2) the value of future dollars used to make principal and interest payments.  By monetizing the debt, the Fed’s actions are helping stoke these fears, and it is absolutely imperative that foreign and domestic investors do not lose confidence in the U.S. government.  Sustained concern about our debts will drive up interest rates considerably, making it more expensive to service our debts.  Higher borrowing costs will depress the economy, making it even more difficult to repay investors, which in turn produces a death spiral as evidenced by Greece, Ireland, Portugal, and Spain.

Like with so many other fiscal issues, it is tempting to enjoy artificially low interest rates now and deal with the consequences later, but a little sacrifice now could help prevent an economic cataclysm.