Real interest rates: Meaning, Criticisms & Real-World Uses

What Are Real Interest Rates?

Real interest rates represent the true return on an investment or the true cost of borrowing, adjusted for the impact of inflation. This crucial concept within macroeconomics provides a more accurate picture of economic purchasing power changes over time, distinguishing it from the stated nominal interest rate. Understanding real interest rates is fundamental for investors, lenders, borrowers, and policymakers alike, as it reflects the actual increase or decrease in financial wealth after accounting for changes in the price level. When the real interest rate is positive, an investment or loan is genuinely growing in value beyond the rate of rising prices. Conversely, a negative real interest rate indicates that the return or cost is being eroded by inflation.

History and Origin

The concept of distinguishing between real and nominal interest rates is largely attributed to the American economist Irving Fisher. In his seminal work, "Appreciation and Interest" (1896) and later "The Theory of Interest" (1930), Fisher laid the groundwork for understanding how changes in the price level affect interest rates.⁵, He formalized the relationship between nominal interest rates, real interest rates, and inflation expectations, which became known as the Fisher Equation.⁴ Fisher's insights were pivotal in developing modern macroeconomic theory, providing a framework to analyze how inflation influences economic decisions and the true cost of money.³,² Before Fisher, while some economists had touched upon the idea, he was instrumental in developing it into a comprehensive theory that has since become a cornerstone of financial and economic analysis.¹

Key Takeaways

Real interest rates reflect the actual return on an investment or the true cost of borrowing after accounting for inflation.
They provide a more accurate measure of the change in purchasing power compared to nominal interest rates.
A positive real interest rate indicates that an investment is outpacing inflation, while a negative rate means inflation is eroding value.
The concept is fundamental for sound investment decisions, lending policies, and monetary policy setting.
The Fisher Equation is the primary formula used to calculate real interest rates.

Formula and Calculation

The relationship between real interest rates, nominal interest rates, and inflation is expressed by the Fisher Equation. While an exact formula exists, a widely used approximation is sufficient for most practical applications.

The approximate Fisher Equation is:

[
r \approx i - \pi
]

Where:

( r ) = Real interest rate
( i ) = Nominal interest rate
( \pi ) = Inflation rate (or expected inflation rate)

For more precise calculations, especially during periods of high inflation, the exact Fisher Equation is used:

[
1 + r = \frac{1 + i}{1 + \pi}
]

This can be rearranged to solve for the real interest rate:

[
r = \frac{1 + i}{1 + \pi} - 1
]

Both formulas highlight how inflation directly impacts the real return on an asset or the real cost of debt. When determining the risk-free rate, for example, economists often look at real interest rates.

Interpreting Real Interest Rates

Interpreting real interest rates involves assessing the true economic impact of an interest rate. A positive real interest rate signals that capital is appreciating in value, providing an incentive for saving and investment. For lenders, it means they are earning a return that genuinely increases their purchasing power. For borrowers, it represents the actual cost of their loan after inflation.

Conversely, a negative real interest rate indicates that the nominal return on an asset or the nominal cost of borrowing is less than the rate of inflation. In such an environment, the purchasing power of money held or invested is eroding over time. While this can be detrimental for savers, it can incentivize borrowing and spending, potentially stimulating economic growth in the short term. Policymakers, particularly central banks, closely monitor real interest rates to gauge the restrictiveness or looseness of their monetary policy.

Hypothetical Example

Consider an individual, Sarah, who deposits \$1,000 into a savings account that offers a nominal interest rate of 5% per year. At the same time, the annual inflation rate is expected to be 3%.

To calculate the real interest rate Sarah is earning, we can use the approximate Fisher Equation:

( r \approx i - \pi )

( r \approx 0.05 - 0.03 )

( r \approx 0.02 ) or 2%

This means that while Sarah's money account balance will grow by 5% nominally, her actual purchasing power only increases by 2% due to the 3% inflation. If, however, the inflation rate were 6%, the real interest rate would be:

( r \approx 0.05 - 0.06 )

( r \approx -0.01 ) or -1%

In this scenario, even though her money earns 5% interest, her purchasing power actually declines by 1% because inflation is outstripping her nominal return. This highlights the importance of considering the time value of money in real terms.

Practical Applications

Real interest rates are critically important across various financial domains:

Investing: Investors use real interest rates to evaluate the true profitability of their investments. For instance, bond investors look at real yields to understand the return they'll receive after inflation. U.S. Treasury Inflation-Protected Securities (TIPS)) are specifically designed to provide a real return by adjusting their principal based on changes in the Consumer Price Index., These securities offer a direct way for investors to protect their purchasing power. (TreasuryDirect)
Lending and Borrowing: Banks and other financial institutions consider real interest rates when setting loan rates to ensure they earn a genuine return on their capital. For consumers and businesses, understanding the real interest rate on a loan reveals the actual cost of borrowing.
Monetary Policy: Central banks closely monitor and often target real interest rates when conducting monetary policy. By influencing the nominal interest rate, they aim to achieve a desired real interest rate to stimulate or cool down the economy. For example, lowering real interest rates can encourage borrowing and investment, while raising them can curb inflation. The Federal Reserve, for instance, considers inflation expectations when assessing its policy stance. (Federal Reserve Bank of Cleveland)
Government Policy: Fiscal policy decisions, such as government borrowing for public projects, are also influenced by real interest rates, as they determine the true long-term cost of national debt.

Limitations and Criticisms

While indispensable, the concept of real interest rates has certain limitations and criticisms:

Expected vs. Actual Inflation: The calculation of the real interest rate relies on the expected inflation rate, which is inherently uncertain. If actual inflation deviates significantly from expectations, the ex-post real interest rate (the real rate after the fact) can differ substantially from the ex-ante real interest rate (the real rate expected at the time of the transaction). This uncertainty adds a layer of risk for both lenders and borrowers.
Measurement Challenges: Accurately measuring the true inflation rate can be complex. Different inflation indices (e.g., Consumer Price Index vs. Producer Price Index) can yield varying results, leading to different real interest rate calculations. Furthermore, inflation affects different individuals and sectors differently, meaning a single real interest rate may not perfectly reflect everyone's experience.
Market Imperfections: The Fisher Equation assumes perfect capital markets and rational expectations. In reality, market imperfections, such as liquidity constraints or information asymmetries, can distort the relationship between nominal and real rates.
Zero Lower Bound: In periods of very low nominal interest rates, central banks can face a "zero lower bound" problem, where they cannot lower nominal rates below zero. This can constrain their ability to achieve negative real interest rates to stimulate the economy during periods of deflation or very low inflation.
Long-Term Trends: Research on long-term real interest rates suggests that they are influenced by global factors like productivity growth, demographics, and risk premia, making their future trajectory difficult to predict with certainty. (IMF)

Real Interest Rates vs. Nominal Interest Rates

The distinction between real interest rates and nominal interest rates is critical for understanding the true financial impact of an investment or loan. The nominal interest rate is the stated interest rate on a loan or investment, without any adjustment for inflation. It is the rate that is publicly quoted by banks and financial institutions. For example, if a savings account advertises a 3% interest rate, that is the nominal rate.

In contrast, the real interest rate adjusts the nominal rate to account for the erosion of purchasing power due to inflation. It represents the actual economic gain or cost. The primary point of confusion arises because while the nominal rate dictates the numerical change in money, the real rate determines the actual change in what that money can buy. A high nominal interest rate might seem attractive, but if inflation is even higher, the real return could be negative, meaning your money is losing purchasing power. Investors and economists primarily focus on the real interest rate for a clear understanding of economic changes and financial well-being.

FAQs

Why is the real interest rate important?

The real interest rate is important because it tells you the true return on your money after accounting for the loss of purchasing power due to inflation. It helps investors understand if their investments are genuinely growing, and it helps borrowers understand the actual cost of their loans.

Can the real interest rate be negative?

Yes, the real interest rate can be negative. This occurs when the nominal interest rate is lower than the inflation rate. In such a scenario, the purchasing power of your money decreases over time, even if the nominal amount is growing.

How do central banks influence real interest rates?

Central banks primarily influence real interest rates by adjusting the nominal interest rates they control, such as the federal funds rate in the U.S. While they can't directly set the real rate, their actions impact market expectations for inflation and nominal rates, thereby influencing the prevailing real interest rates in the economy and guiding monetary policy.

What is the Fisher Effect?

The Fisher Effect is an economic theory that describes the relationship between nominal interest rates, real interest rates, and inflation. It posits that the nominal interest rate will adjust to reflect changes in the expected inflation rate, aiming to keep the real interest rate constant in the long run.

Do real interest rates affect borrowing or saving decisions?

Yes, real interest rates significantly affect both borrowing and saving decisions. Higher real interest rates incentivize saving because the return on deposits is greater after inflation, while they discourage borrowing because the true cost of debt is higher. Conversely, lower or negative real interest rates tend to encourage borrowing and spending while disincentivizing saving.