Inflation, Interest, and Relative Prices

Irving ([1930] 1965) first elaborated the hypothesis that interest rates contain market forecasts of future inflation rates. If the market is efficient or rational, it makes the best possible forecasts of future inflation rates, given the information available when interest rates are set. However, the hypothesis that interest rates contain the best possible assessments of expected future inflation rates is only clear-cut in a world where the inflation rate is unambiguous, as is true, for example, when relative prices are constant so that all goods experience the same inflation rate. If relative prices change, an overall inflation rate may be difficult to define even for an individual consumer. In fact, relative prices vary substantially during the 1953-77 period that we study. We propose a model to explain the observed behavior of interest rates and money prices of consumption goods which allows for relative price changes but is nevertheless in the spirit of Fisher. The model attributes the Fisher effect relationships between interest rates and inflation rates observed in the data to a component of expected inflation rates which is common to all In setting interest rates on treasury bills, the market appears to respond only to the common part of the expected inflation rates of different goods. However, there are seasonals in expected inflation rates which are different for different goods. We suggest that these differential seasonals reflect real costs of providing different goods to the market at different times of the year and hence are properly ignored by the market in setting interest rates. Finally, there is increasing similarity in the movement of the unexpected inflation rates of different goods for longer measurement intervals. In part, we interpret this as the result of a gradual reallocation of resources in response to. surprise shifts in supply or demand conditions. The tests use data for the U.S. Consumer Price Index and its major subcomponents from 1953 to 1977. * Graduate School of Business, University of Chicago, and Graduate School of Management, University of Rochester. The comments of Nicholas Gonedes, Michael Jensen, Merton Miller, Walter Wasserfallen, and a referee are gratefully acknowledged. This research is supported by the National Science Foundation.