By: Phil Kernen
The rapid increase in inflation seen in 2021 has raised awareness of the price of another financial indicator and how negative they are, real rates. What are real interest rates, and how are they different from the rates we see and reference every day?
The Fisher Effect’s economic theory describes the relationship between nominal interest rates, inflation, and real interest rates. Quoted market levels and lending agreements reference nominal rates. U.S. Treasury bonds, mortgage rates, and auto financing rates are nominal rates that account for inflation. Real rates remove inflation and leave us with a more meaningful comparison point across periods. Lending agreements do not reference real rates, but real rates offer a more accurate measure of purchasing power progress.
For example, say you borrow money to buy a house at 3%, and inflation is 2%. The nominal rate for your loan is 3%, and the real rate is 1% (3% less 2% inflation). Now say your nominal mortgage rate is 3%. The most recent inflation measures for 2021 showed the Consumer Price Index increasing 7%, so the new real borrowing rate is -4%. Assuming the inflation rate stays elevated over the life of your loan, the lender will have less purchasing power after inflation, and the borrower will have paid off their fixed rates loan with inflated money.
Imagine receiving a 5% nominal raise at work for 2022, and inflation is 2%. Your real rate of wage increase is 3%, bringing you more purchasing power. However, considered against 7% CPI, your raise is now a purchasing power loss of -2% due to inflation. Low unemployment has finally raised wages for skilled and unskilled labor. Unfortunately for too many workers, higher inflation turns those overdue wage increases into reduced purchasing power.
The difference between nominal and real applies to economic growth measurements too. Nominal GDP growth accounts for inflation, whereas real GDP adjusts inflation out. According to the Bureau of Economic Analysis (BEA), for 2021, nominal GDP (the BEA calls it current-dollar GDP) was 10%, but real GDP growth was 5.7%. Real growth allows you to compare periods across time to see how productivity grows without being misled by increasing price levels.
Federal Reserve policy impacts nominal rates directly and real interest rates indirectly. The Fed sets the overnight nominal interest rate, currently 0%. It also purchases U.S. Treasury notes to keep rates used for terms longer than overnight lower and purchases Mortgage-Backed Securities to help lower home borrowing rates. These actions offer more liquidity to market participants to increase economic activity.
Federal Reserve policies also impact the stable value of money, and sometimes these policies go too far for too long in one direction, which is where we are now. Higher inflation forces us to return attention to real rates because it drives them down without the Fed intending to do so. At the same time that the Fed will be raising nominal rates, it may find itself in the uncomfortable position of having presided over the highest inflation readings in four decades and pushed real rates to their lowest point ever.
Pay attention to real rates. If the Fed can’t wrangle inflation and raise them along with nominal rates, their monetary policy will stay as easy as ever.