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If high inflation strikes the American economy, high interest rates are likely to follow. Even though rising interest rates can make all types of financing -- from credit cards to home mortgages to...
If the true value of the project is only known to the borrower, the lender must incur a monitoring or auditing cost in order to reveal the true project returns and receive full re-payment. The size of the external finance premium that results from these market frictions may be affected by monetary policy actions.
Fixed-rate mortgages are vulnerable to inflation risk, which means that borrowers with such mortgages are better off under unexpectedly high inflation (as the inflation lowers the real present value of their loan repayments), while they are worse off if there is a drop in inflation that lowers interest rates.
The equation is an approximation; however, the difference with the correct value is small as long as the interest rate and the inflation rate is low. The discrepancy becomes large if either the nominal interest rate or the inflation rate is high. The accurate equation can be expressed using periodic compounding as:
For the average borrower, a rate reduction of just 1% could mean a six-figure reduction in your interest charges and a significant drop in your monthly payment.
Chief among them is that inflation remains sticky: According to the Fed's preferred gauge, annual "core" inflation, which excludes the most volatile categories, was 2.8% in October.
In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation (higher or lower).
Even if you manage to score a 1.5% APY with a no-fee online savings account, your money is still losing purchasing power to the tune of about 7% per year with inflation at current levels.