Both long and short-term interest rates tend to increase above their average levels during periods of deflation, as well as during periods of inflation. But both short and long-term rates have trailed the inflation rate significantly, and by larger amounts at higher inflation rates. In the 14 years since 1790 when inflation exceeded nine per cent, the average interest rate on long-term bonds was barely six per cent.

In the 28 years since 1790 when inflation ranged between 0.5 and 1.4 per cent, the “real” interest rate—arrived at by subtracting the inflation rate from the nominal interest rate—averaged 3.27 per cent. But the real rate declined to an average of 2.14 per cent at inflation levels of 1.5 to 2.4 per cent (17 years) and to a negative 6.69 per cent at inflation levels over 7.5 per cent (17 years). The higher the inflation rate, the less likely a positive real rate of interest.

Because lenders are presumed to take account of projected inflation levels in the interest rates they charge borrowers, many academics have argued that “real” interest rates should be positive and relatively stable over time. Although experience over the 1950 to 1969 period substantiates this conclusion, no other example of extended real rate stability can be found in U.S. history. The idea that long-term bonds are priced to return a real rate of two to three per cent plus compensation for inflation simply isn’t so.