Thread by @JWMason1

You often hear that higher inflation is associated with higher real interest rates - that's supposed to be one of its major costs. I don't know where this bit of folk wisdom came from, but the reality is exactly the opposite. Higher inflation almost always means lower real rates.

The US has experience many episodes of inflation (and some of deflation) over the past century, and the early 1980s is the *only* case in which higher inflation has been associated with higher real interest rates.

To the extent that interest rates are linked to inflation, this is entirely mediated by the central bank. Higher inflation may cause the central bank to tighten, and bond yields do (slowly and incompletely) move with the policy rate.

In a world without a central bank, there is just no relationship between inflation and interest rates at all. During the Civil War, when the US saw the highest inflation rates of the whole 19th century, nominal bond yields actually fell.

I'm a big fan of @M_C_Klein's Overshoot, and there's a lot to like in his latest one. But as is the way of the internet I'm going to pull out the one paragraph I don't agree with, where he gets tripped up on exactly this issue. theovershoot.co/p/the-case-for…

Note that he claims that "markets" will generate higher real interest rates if inflation rises -- i.e. that nominal rates will rise by more than inflation. I don't think there's a single historical case of this happening independent of central bank tightening.

Second, he says that businesses don't want to invest in an environment of high inflation because they won't to "tie up their cash in long-term projects." This is exactly backward.

"Tie up" is a metaphor here. What happens when a business invests is that it *spends* cash to acquire machinists structures, and other means of production. In an environment where cash is losing value, that becomes more attractive, not less.

If you're paying money at today's prices in order to sell something for whatever the market price turns out to be in a year or two or three, is that likely to work out better when prices are rising, or falling? Inflation makes long-term investment more attractive, not less.

And indeed, the high point for fixed investment as a share of GDP came exactly when you'd expect if inflation favors investment-- at the peak of the late-1970s inflation. (It's weird to me that so few people know this.)

Matt gets this right a bit later, when he turns to households. Inflation, he rightly says, should make consumers *more* inclined to buy durables - the equivalent of fixed investment by business. But in fact, there are signs that households are seeking to reduce durable purchases.

And of course, if people see now as a bad time to buy vehicles and other durables, that's not only a sign that they see today's high prices as a transitory aberration. It's also a reason to think that they will in fact be transitory, as demand shifts back to more elastic sectors.

Going back to interest rates - the idea that changes in inflation are fully (or more than fully) passed thru to nominal interest rates is often called the "Fisher effect" but Irving Fisher himself was quite aware that this is not in fact the case. voxeu.org/article/misnom…

As Fisher himself said: "When prices are rising, the rate of interest tends to be high but not so high as it should be to compensate for the rise; and when prices are falling, the rate of interest tends to be low, but not so low as it should be to compensate for the fall”

Even 100 years ago, there was plenty of data to show that inflation bounces around a lot while nominal interest rates are quite stable. The "real" interest rate is just an ex post residual - it is not real in an ontological sense.