Mundell-Tobin Effect Epiphany!

Mundell–Tobin effect

The Mundell–Tobin effect suggests that nominal interest rates would rise less than one-for-one with inflation because in response to inflation the public would hold less in money balances and more in other assets, which would drive interest rates down.

I hadn't really given this much thought. I just sort of assumed that the Fed was the only one driving interest rates down if inflation picked up.

Think about it though.

1. You are 50% in stocks and 50% in cash.
2. The CPI starts climbing at 1% per month pace.
3. That cash position stinks.

So there you are. You've got a problem.

What do you do next?

1. You could buy something with that cash.
2. You could buy some bonds that pay at least some interest. Something is better than nothing.

If you choose option #1 then the person you bought from will be faced with the same problem you just had. Eventually someone will choose option #2. When they do they will be driving interest rates down.

So while it is true that bonds yields would rise as inflation rose, there would be some money that was once in cash that would move into bonds. It would therefore seem likely that nominal interest rates would not rise as fast as inflation rises. That's assuming I understand this process correctly.

1970s

UK RPI: ~13.7%
UK Short-Term Rate: Ordinary Funds, Consistent Series: ~9.5%
UK Real Interest Rate: ~-4.2%

US CPI: ~7.8%
US Short-Term Rate: Ordinary Funds, Consistent Series: ~6.8%
US Real Interest Rate: ~-1.0%

Wow. I thought real interest rates were bad in the US during the 1970s. I hadn't looked at the United Kingdom.

That's why I am so willing to lock in any kind of positive real interest rate long-term.

I have anecdotal evidence that supports the Mundell-Tobin Effect. My IRA sat in cash for more than 4 months because I did not think inflation would be much of an issue. Had inflation been running at a higher rate I would have kept that money in TIPS and therefore driven the TIPS real yields down.

Source Data:
Lawrence H. Officer, "What Was the Interest Rate Then?" MeasuringWorth, 2008