Until the 1970s, all recorded history showed that bond yields were tied to the general price level, not the rate of price inflation as commonly believed. However, since then, the statistics say this is no longer the case, and bond yields are increasingly influenced by the rate of price inflation. This article explains why this has happened, and why it is important today.
This paper is a follow-up on my white paper of October 2015.[i] In that paper I explained why, based on over two-hundred years of statistics, long-term interest rates correlated with the general price level, and not with the rate of inflation. I now take the analysis further, explaining why the paradox appears to no longer apply.
The two charts which illustrate the pre-seventies position are Chart 1 and Chart 2 reproduced below.
The charts take the yield on the UK Government’s undated Consolidated Loan Stock (Consols) as proxy for the long-term interest rate, and the price index and its rate of change (the rate of price inflation) as recorded in the UK. The reasons for using UK statistics are that Consols and the loan stocks that were originally consolidated into it are the longest running price series on any form of term debt, and during these years Britain emerged to be the world’s leading commercial nation. Furthermore, for the bulk of the period covered by Gibson’s paradox, London was the world’s financial centre, and sterling the reserve basis for the majority of non-independent foreign currencies.
The evidence from the charts is clear. Gibson’s paradox showed that the general price level correlated with long-term interest rates, which equate to the borrowing costs faced by entrepreneurial businessmen.
