**A non-political starting point**

Let’s begin by looking at the effect that changes in the rate of inflation can make on the real return from buying a 10-year bond. Don’t worry about whether the example is particularly realistic. I mostly want to illustrate what happens when inflation changes.

Assume we’re the lender and we’ve just bought the bond with a coupon of 4% at par for $1000. The transaction happens in the belief that inflation will be 1% per year, meaning an anticipated real return of 3% per year on the money we have lent. This implies the present value of the repayment of principal is expected to be $905 and the present value of the coupon payments (ignoring any real gains or losses on their reinvestment) is, say, $360. The total is $1265.

Suppose, right after we’ve bought the bond, inflation suddenly drops to zero and stays there. Then the return of principal has a present value of $1000 and the coupon payments are worth $400. The total is now $1400, which has just raised the cost to the borrower by about 11%, and boosted our return by the same amount. We stand to make a windfall!

On the other hand, suppose inflation shoots straight up to 4% annually, completely wiping out the real return from the coupon payments. The return of principal now has a present value of $675, and the coupons are worth about $335. In other words, the borrower gets the use of the $1000 for ten years basically for free. We have no more money at the end of the ten years than we had at the beginning.

Even worse, let’s say inflation gets dialed up higher, to 6% per year. The principal repayment is now worth $558 in today’s dollars and the coupons are worth about $300. So we’re suddenly taking a bath!?! We’re in the position that we stand to lose about 15% of our money . The borrower will have the use of the funds for ten years but will pay back far *less* than he borrowed in the first place.

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