“The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of “inflation.” When prices are rising, the real interest rate is less than the nominal rate since the borrower repays with dollars that are worth less. But when prices are falling, the real interest rate exceeds the nominal rate. This is exacerbated by the fact that borrowers can deduct only nominal interest payments when calculating their taxable income.”
“By late 1919, the inflated structure of wartime prices began to sag. In early 1920, a worldwide depression got under way. In the United States, the governor of the Federal Reserve Bank of New York, Benjamin Strong, confided that “[w]e must deflate.” Up went interest rates and down plunged commodity prices. From May to December 1920, the Federal Reserve’s index of 12 commodity prices fell by 40%. Between July and December 1921, a price index of 10 crops plunged by 57%. Wages and consumer prices registered substantial, though less dramatic, declines. By mid-1921, America’s depression had bottomed and recovery begun. Prices stabilized, and deflation ended.”
Read pages 10-12 (pages 8-10 of pdf page count) to see what happened to real interest rates during the Great Depression (before the central bank manipulated them down again). Research suggests that real interest rates climbed to over 10% (bottom of page 11).
So, let’s try this one more time… Interest rates go UP in anticipation of deflation because default risks are rising (increasing the risk premiums), the value of the currency is rising (and so will the cost = interest rate), and creditors will demand a higher price for money because money will be in scarcer supply. Nominal rates can go up, and often go up drastically in anticipation of deflation (see the effects of the credit bubble popping for examples…this is deflationary); real rates rise even higher than nominal rates.
