Real Interest Rates, Inflation, and Default
Nominal bonds issued by governments carry two major risks: inflation and default. The main contribution of this paper is to show how the process for inflation affects the pricing of these two risks. When inflation is procyclical, nominal bonds pay out more in bad times, making them a good hedge against aggregate risk. This implies that, in the absence of default risk, procyclical inflation lowers real rates on nominal bonds. However, procyclical inflation implies that the government needs to make larger (real) payments in bad times, which can increase default risk and thus push up real interest rates. Data from a panel of advanced economies support these predicted patterns of real rates, inflation cyclicality, and default risk. Finally, we turn to a calibrated model to quantify the welfare consequences of inflation cyclicality and to investigate how real rates respond to increases in inflation risk and default risk. While a surge in inflation risk can reduce spreads in the procyclical economy because of improved hedging properties; the opposite is true in the countercyclical economy. However, when default risk is material, higher inflation risk—especially in procyclical economies—can cause larger spikes in borrowing costs in response to increased default probabilities.
