Thursday, January 20, 2011

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

7 comments:

getyourselfconnected said...

My post is up. I know we disagree on the Au/Ag thing but those graphs jumped out at me. Thanks for the excellent work.

Stagflationary Mark said...

GYSC,

If everyone agreed about everything then we would all own exactly the same amount of everything and we'd bore the @#$% out of each other, lol. :)

Anonymous said...

Whoa. That MT hypothesis is startling.
Jus me

Stagflationary Mark said...

Jus me,

I just hope I understand it correctly. I tried to figure out the intent from that one paragraph.

It took me a few minutes to make sense of it.

dearieme said...

The only car loan I've ever taken out was in the UK in the 70s. We paid negative real interest. And the car lasted 15 years.

Mind you, that was the only new car we've ever bought.

dearieme said...

The only car loan I've ever taken out was in the UK in the 70s. We paid negative real interest. And the car lasted 15 years.

Mind you, that was the only new car we've ever bought.

Stagflationary Mark said...

dearieme,

My 1996 Camry is halfway to becoming a collector vehicle, although I'd have to stop using it for regular transportation. ;)