For the past four decades, inflation has been subdued and there hasn’t been much of a reason to learn the difference between nominal and real interest rates. That’s because both numbers were close to the same.
Now, thanks to rapid and rising inflation, that’s all changed. But first let’s define the two. The nominal interest rate is just that. It is the interest rate before taking inflation into account. The interest rate you are quoted when you apply for a loan is the nominal interest rate.
The real interest rate, on the other hand, is the rate after you've accounted for inflation. Let’s see why it matters to know the difference between the two.
Let’s say you as a saver want to earn some interest on your savings. After looking at various bonds and their yields, you settle for a solid looking one-year bond that pays 2% nominal interest.
Now that you know the nominal yield, it is easy to calculate how much money you will earn in interest. At 2% you will earn $2 in taxable profit for every $100 that you lend to the borrower.
But hold on. You earned $2 in taxable profit—what about inflation? Failure to account for inflation can make all the difference in the world to your financial well-being. Going back to our current example where you lent $100, there is no doubt that they will pay you the dollar amount that they owe you, plus interest. You know this because you already did your due diligence and know the company is liquid enough to service its debts.
But, and this is not a trivial but… inflation ran hot at +7% for the past year. That means the $102 you will receive will only buy ~$95 worth of goods and services one year from now. See where they get you? You suddenly went from a $2 profit to a $5 loss in real terms.
Now put yourself in the government’s shoes. You have a mountain of debt to pay, so do you pay the debt with honest dollars, or do you shave a little purchasing power off of them through inflation first?
Unfortunately, we don’t have to guess what the Federal Government and the Federal Reserve will do. We can already see that they flooded the economy with cheap credit, kindled strong inflation, and now they will pay back debt with cheaper dollars.
You can use knowing the difference between real and nominal inflation to your advantage, whether you are a borrower or a lender. For example, at a positive interest rate, you are being paid to lend your money to the borrower. But at a negative rate, you are paying the borrower to take your money!
Calculating the real interest rate is easy. It is simply the nominal yield minus the inflation rate. In our example, the nominal yield was 2% and the inflation rate was 7%. Pretty simple math really. 2-7=-5% real yield.
Now that we understand the difference between the real yield and the nominal yield, let's take a closer look at the chart above which shows the general trend of inflation and interest rates for the past 50 years. As you can see, our real interest rate is down near its lowest level in the past 50 years. But America's history goes back much further than that. Let's stretch a bit further and see if there are periods where interest rates dipped even lower.
When we zoom out, we can see that although negative interest rates are new to most people under 50 years old, they aren't new to the USA. There were prior periods where the real interest rate briefly dipped into negative double-digit territory. Based on previous time frames, it isn't out of the realm of possibility that rates will become even more negative over the next couple of years.
What does this mean to you? We thought you would never ask. It means saving money for retirement is no longer enough. When the cost of living is rising because of inflation, and interest rates are not high enough to compensate for rising prices, it forces the saver to either accept an inflation adjusted loss or become a speculator in hopes of earning more than the bank or the bond will offer.
For those that want to participate in the equity market, we say more power to you. But investing in stocks isn't appropriate for everyone. Positive returns are far from guaranteed and investing successfully either depends on incredible luck, or some degree of knowledge. Knowledge that isn't taught in school we might add.
Now that we see the difference between the nominal and the real interest rate, we can at least understand whether we are making money or losing money in real terms. Unfortunately, sitting in bonds that pay current rates means a guaranteed loss when adjusted for inflation. Negative rates won't always be with us, but for now, you need to increase your return beyond what bonds will pay if you want to maintain your purchasing power. You'll need to accept risks and work hard just to tread water.
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