Real interest rate

What Is Real Interest Rate?

The real interest rate represents the true return on an investment or the actual cost of borrowing after accounting for the impact of inflation. It is a fundamental concept within Monetary policy and Investment analysis, providing a more accurate picture of financial outcomes than the stated nominal rate. While a nominal interest rate is the rate advertised by a lender or financial institution, the real interest rate adjusts this figure to reflect changes in purchasing power due to rising prices. Understanding the real interest rate is crucial for investors, savers, and policymakers as it reveals the actual change in wealth over time.

History and Origin

The clear distinction between nominal and real interest rates is largely attributed to the American economist Irving Fisher. In his work, Fisher formalized the relationship between these two rates and inflation, which became known as the Fisher Equation.²⁰ Fisher's insights provided a foundational understanding of how inflation erodes the value of money over time and how this erosion impacts the actual return on financial instruments or the real cost of debt. His theory laid the groundwork for modern economic thought on interest rates and their interaction with the price level.¹⁹

Key Takeaways

• The real interest rate is the nominal interest rate adjusted for inflation, reflecting the true change in purchasing power.
• It provides a more accurate measure of the cost of borrowing for debtors and the yield for creditors or investors.
• Negative real interest rates occur when the rate of inflation exceeds the nominal interest rate, leading to a loss of purchasing power.
• Policymakers, particularly central banks, closely monitor the real interest rate as a key indicator for guiding monetary policy decisions.¹⁸
• The real interest rate influences investment behavior, encouraging different levels of risk-taking depending on its level.

Formula and Calculation

The real interest rate is calculated by adjusting the nominal interest rate for inflation. The most common and simplified formula, often referred to as the Fisher approximation, is:

A more precise formula, known as the Fisher Equation, accounts for compounding effects:

Where:

• (R) = Real Interest Rate (as a decimal)
• (r) = Nominal Interest Rate (as a decimal)
• (i) = Inflation Rate (as a decimal)

This formula provides a more accurate picture of the true time value of money when considering inflationary environments.¹⁷,¹⁶

Interpreting the Real Interest Rate

Interpreting the real interest rate involves understanding what it signifies for economic agents. A positive real interest rate means that the return on a savings account or investment is outpacing inflation, leading to an increase in actual purchasing power. Conversely, a negative real interest rate indicates that inflation is eroding wealth faster than the nominal return is accumulating, resulting in a decrease in purchasing power., For borrowers, a higher real interest rate implies a greater true cost of debt, while a lower or negative real interest rate reduces the actual burden of repayment. This concept is fundamental for assessing the actual profitability of investment opportunities and the true burden of debt.

Hypothetical Example

Consider an individual who deposits $10,000 into a savings account that offers a nominal interest rate of 4% annually. Over the same year, the economy experiences an inflation rate of 3%.

Using the simplified formula:
Real Interest Rate = Nominal Interest Rate - Inflation Rate
Real Interest Rate = 4% - 3% = 1%

This means that while the individual's money grew by 4% in nominal terms, the real purchasing power of that money only increased by 1%. If the inflation rate had been 5%, the real interest rate would be 4% - 5% = -1%, indicating a loss of purchasing power despite earning nominal interest. This example highlights how the real interest rate provides a clearer understanding of the actual growth or erosion of wealth.

Practical Applications

The real interest rate has numerous practical applications across various financial and economic domains:

• Investing: Investors use the real interest rate to assess the true return on their portfolios, especially for fixed-income securities like bonds. For instance, Treasury Inflation-Protected Securities (TIPS) are designed to offer a real rate of return by adjusting their principal value based on changes in the Consumer Price Index.
• Monetary Policy: Central banks, such as the Federal Reserve, closely monitor real interest rates when making decisions about monetary policy.¹⁵ Adjusting the federal funds rate aims to influence real interest rates, thereby impacting borrowing, lending, and overall economic growth.¹⁴
• Lending and Borrowing: Lenders evaluate the real interest rate to ensure their loans provide a positive return after accounting for inflation, while borrowers consider it to understand the actual cost of their debt. Higher real interest rates can discourage consumer spending and business investment.¹³ Reuters regularly reports on how central bank decisions on nominal rates interact with inflation expectations to influence real interest rates and economic activity.¹²,¹¹,¹⁰
• Economic Analysis: Economists and policymakers utilize the real interest rate to gauge the true stance of monetary policy and to forecast future economic conditions. It is a key factor in models that predict consumption, investment, and aggregate demand.

Limitations and Criticisms

While the real interest rate offers a crucial perspective, its calculation and interpretation are not without limitations. One primary challenge lies in accurately measuring or forecasting the rate of inflation. The real interest rate often relies on expected inflation, which can differ significantly from actual (realized) inflation, making the ex-ante (expected) real interest rate different from the ex-post (realized) real interest rate. Various approaches exist for measuring inflation expectations, including model-based and survey-based measures, but these can be challenging to obtain and may not always align with true market expectations or consumer sentiment.⁹,⁸,⁷

Furthermore, the simplified Fisher approximation can become less accurate during periods of high inflation. The more precise formula addresses this, but data availability and the complexities of forecasting future inflation remain inherent difficulties. Additionally, the real interest rate, particularly the observed risk-free rate, may not fully capture the specific risks or returns associated with individual investments or loans, as it often refers to a broad economic measure rather than a tailored return.

Real Interest Rate vs. Nominal Interest Rate

The core difference between the real interest rate and the nominal interest rate lies in the adjustment for inflation. The nominal interest rate is the stated or advertised interest rate on a loan or investment, without any consideration for the changing value of money due to inflation. It represents the percentage increase in the amount of money owed or earned.⁶,⁵

In contrast, the real interest rate accounts for inflation, reflecting the actual change in purchasing power. It tells you how much more or less goods and services you can buy with your money after accounting for price changes. For instance, if you earn a 5% nominal interest rate on a bond, but inflation is 3%, your money's purchasing power only effectively increases by 2% (the real interest rate)., Confusion often arises because the nominal rate is what is explicitly quoted and seen in financial transactions, while the real rate provides the underlying economic reality. The real interest rate is derived by subtracting the inflation rate from the nominal rate, providing a measure of the true cost of funds to a borrower and the true yield to a lender or investor.⁴

FAQs

Q: Can the real interest rate be negative?
A: Yes, the real interest rate can be negative. This occurs when the inflation rate is higher than the nominal interest rate. In such a scenario, the purchasing power of your money decreases over time, even if you are earning interest in nominal terms.

Q: Why is the real interest rate important for investors?
A: For investors, the real interest rate is crucial because it indicates the true return on their investments after accounting for the erosion of value caused by inflation. It helps them understand whether their investments are genuinely growing in terms of purchasing power or simply keeping pace with rising prices.³

Q: How does the central bank influence the real interest rate?
A: A central bank influences the real interest rate primarily through its monetary policy, specifically by setting its target for the federal funds rate. While the central bank directly controls nominal rates, these actions, combined with inflation expectations, indirectly affect the real interest rate in the economy, influencing borrowing costs and investment incentives.²

Q: What is the difference between ex-ante and ex-post real interest rates?
A: The ex-ante real interest rate is the expected real interest rate, calculated using the nominal interest rate and expected future inflation. The ex-post real interest rate, on the other hand, is the actual real interest rate, calculated using the nominal interest rate and the actual (realized) inflation rate over a specific period. The difference arises because future inflation is uncertain.

Q: Does the real interest rate affect my mortgage?
A: For a fixed-rate mortgage, your nominal interest rate remains constant. However, the real cost of your mortgage changes with inflation. If inflation rises, the real interest rate you are paying effectively decreases, making your future repayments less burdensome in terms of purchasing power. For an adjustable-rate mortgage, changes in the nominal rate, often tied to a benchmark like the risk-free rate, and inflation will directly impact your real interest rate.¹