Currently, the federal reserve interest rate is 0-0.25%, and the inflation is 2-3%. Does this contradict the no-arbitrage principle? (The arbitrage being: borrow money at 0.25% and invest it in the "basket of goods" or other non-inflating assets). Essentially, the borrower gets paid to hold assets. Why?
closed as off topic by Quant Guy, chrisaycock Jul 21 '12 at 1:35
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This is not an arbitrage because the transaction costs of the basket of goods is too high. Ever try to sell an item on eBay? I doubt you'll get 2-3% more for it next year, even new in box. Some of the items in the basket are current consumption goods. Good luck selling those fresh fruits and vegetables next year for 2-3% more than you paid. Others are mere estimates of costs people incur, not actual goods. How on earth are you going to resell a year's rent? Also, the 0.25% interest rate only applies for overnight loans if you are a prime bank. For individuals borrowing "unsecured" (as I doubt your basket of goods counts as proper collateral), the rate is much higher.
Separately, this is also not an arbitrage because it is doing exactly what the Fed is trying to encourage, namely more borrowing and more current consumption. This is known as having a policy of negative real interest rates, and it has happened many times in many places in the past.
As for why the Fed is trying to encourage this behavior, that is a very complicated question on the goals of monetary policy, and is out of the scope of this site.