Examples of how the option value to waiting can lead to significant increases in required rates of return are given in Dixit and Pindyck (1994). BIS Review 68/2002  9  Chart 6 Consumption and deflation in Japan, 1985-2002  Note: Inflation is measured using the consumer price index excluding foodstuffs. The overnight interest rate is the nominal overnight uncollateralised call rate. Source: Thomson Financial Datastream. (iii)  Aversion to long-term contracts and excessive resources devoted to hedging inflation risks. As we have seen, high inflation goes hand in hand with greater uncertainty about future inflation. Inflation is, therefore, associated with a positive risk premium to compensate investors for that uncertainty. The longer the time horizon, the greater the risk premium is likely to be. That discourages long-term contracts and interest rates in such contracts will often depend upon future spot interest rates. Floating-rate mortgages are a good example. With a floating-rate mortgage the borrower is exposed to the risk of sharp fluctuations in the proportion of income that is devoted to debt service, as many households in Britain still remember from the late 1980s when interest rates doubled to 15%. Fixed-rate mortgages eliminate that risk, but at the cost of introducing a new risk: the real value of the outstanding debt may change relative to the value of the house. John Campbell and João Cocco (2002) have suggested that a superior contract would be a fixed-rate mortgage where the principal was index-linked. That would reduce both income and capital risk.
For each (approximate) decade for which the data on 80 sub-components of the retail prices index are available, the chart shows the relationship between the standard deviation of those relative prices and the inflation rate in each month. At low inflation rates, say up to 4% a year, it appears that it is the absolute value of changes in relative prices that is linked to the inflation rate. This would be the case, as in Britain recently, where changes in relative prices, whether up or down, were largely responsible for short-term fluctuations in the inflation rate around a relatively stable long run level. Variability in relative prices might lead inflation to be either above or below the inflation target, but not systematically in one direction or the other. Increases in house prices move the inflation rate up and falls in oil prices move it down. In both cases, an increase in the variability of relative prices leads to movements of inflation away from the target, but not in a systematic direction. But at higher rates of inflation (or deflation) the deviation of inflation from zero is positively correlated with the variability of relative prices. Hence, outside a range close to price stability, the higher the inflation rate, the greater is the variability of relative prices.