Nominal and real interest rates are important terms because they play different roles in your financial decisions. If the real interest rate is positive, it means you have more purchasing power. If the real interest rate is negative (nominal interest rate minus the inflation rate), it means you have less purchasing power – at least when it comes to investments and earning interest on your money.
What is the difference between nominal and real interest rates?
Nominal interest rates are those that are not adjusted for inflation. You may see a nominal interest rate advertised for a product such as a mortgage or a high-yield savings account. Real interest, on the other hand, is the rate adjusted for inflation, reflecting the actual cost and purchasing power of borrowed or invested funds.
Nominal interest rates show you the price of money and reflect the current market conditions. They may be influenced by the federal funds rate or another benchmark rate. This nominal rate tells you how much money you will pay (like interest on a loan) or earn (like interest on a savings account). The real interest is what tells you about the amount of purchasing power that investors, savers, or lenders gain from that interest.
Inflation
The nominal interest rate is the rate available to consumers and businesses looking to borrow money or earn interest on an account. It changes constantly as it is influenced by monetary policy, investor sentiment, and other market conditions, including inflation expectations (not actual inflation). For example, if the interest rate on a savings account is 0.4% and based on the federal funds rate, it may rise to 0.5% if the federal funds rate increases first.
Note: The interest rates offered by lenders, banks, credit unions, and other financial institutions can vary widely and may also reflect their business strategies and profit expectations.
Nominal interest rates already take inflation expectations into account. If the Federal Reserve anticipates rising inflation, it may increase the target federal funds rate, affecting many other interest rates, such as those on mortgages, auto loans, savings accounts, and other financial products.
Since nominal interest rates are based on inflation expectations or negative inflation, it’s important to learn more about other products or investments that adjust for actual inflation. These products or investments reflect real interest.
The Federal Reserve publishes interest rates on its website daily. These rates are used as benchmarks for interest rates on savings accounts, mortgages, and more. The rates include the federal funds rate; yields on Treasury bills, notes, and inflation-protected securities (TIPS); and the average U.S. banking interest rate. There are also regular surveys of consumers and economists, along with Federal publications on inflation expectations, which lenders and financial institutions incorporate into their rates.
Cost of Money vs. Purchasing Power
Nominal interest rates represent the actual cost of money to businesses and consumers. They measure how much you pay or receive in interest, but not what you can buy with that money, also known as purchasing power. Here’s how it works.
Suppose you deposit $10,000 in a one-year certificate of deposit (CD). At the end of the year, the bank pays you 1% over the principal, so you receive $10,100.
At the beginning of that year before depositing that money in the CD, you could buy a basket of goods worth $10,000, leaving you with $0. By the end of that year, after 1% inflation, the same basket of goods costs $10,100. When your CD matures, you have the additional 1% you earned in interest, but you have nothing if you use that money to buy the same basket of goods. Inflation has wiped out your earnings.
Nominally
You had an extra $100 earned from interest on a CD. In reality, you have the same purchasing power you had before due to 1% inflation over that year. In this example, the nominal interest rate is 1% and the real interest rate is 0%.
What does this mean for investors?
When nominal interest rates are higher than inflation rates, real interest rates are positive. When nominal interest rates are lower than inflation rates, real interest rates are negative. This is important to understand when looking at interest rates on investments compared to current inflation rates.
For example, between March 2020 and December 2021, real interest rates as measured by the 10-year TIPS yields were negative. This occurs when the yields on the daily Treasury yield curve are lower than the expected inflation rate, causing TIPS yields to fall into negative territory. When this happens and the real interest rate is negative, instead of earning interest on an investment in TIPS, you would be paying to keep that TIPS investment instead.
TIPS stands for Treasury Inflation-Protected Securities. They are investments that pay interest and adjust principal based on the Consumer Price Index (CPI). So, if the CPI increases, the principal is adjusted upward, but if it falls, the principal is adjusted downward.
Note: TIPS are available in five, ten, and thirty-year maturities. TIPS pay interest twice a year on the adjusted principal. The original or higher adjusted principal is paid at maturity.
Why would someone invest their money in TIPS?
In times of high inflation, TIPS may seem like a relatively safe investment option. TIPS investments may not meet investors’ expectations if inflation rates do not rise to the expected levels or if actual TIPS yields are negative. However, despite the negative real yields, some experts consider TIPS to be one of the easiest ways to protect their portfolios from long-term inflation.
Another explanation could be uncertainty and the phenomenon of “flight to safety.” You might be willing to pay a small premium for assets like bonds or TIPS that carry little or no capital risk. You might consider this a safer option than investing in stocks or exchange-traded funds (ETFs) in the stock market during volatile or uncertain economic periods.
Negative real interest rates such as the 10-year TIPS yield are unusual, but they happen. Before 2020, the last time the 10-year TIPS yield went negative was in December 2011. It remained there until May 2013, when investors began selling bonds after Federal Reserve Chairman Ben Bernanke announced that the Fed would start tapering asset purchases. This caused interest rates to rise, a phenomenon known as “taper tantrum.” Since bond prices move inversely to interest rates, this increase caused bond prices to fall.
A similar announcement occurred in July 2021 when the Fed stated that it would slow bond purchases toward the end of the year. However, there was no “taper tantrum” in response, and yields remained about the same.
Note: Negative real interest rates do not occur frequently in the United States. In the past, they were typically the result of extraordinary interventions by the Federal Reserve.
Conclusion
Nominal and real interest rates matter because they play different roles in your financial decisions. If the real interest rate is positive, it means you have more purchasing power. If the real interest rate is negative (nominal interest rate minus inflation rate), it means you have less purchasing power – at least when it comes to investments and earning interest on your money.
When
It is about borrowing money; negative real interest rates may affect borrowers, such as potential buyers who see low-interest rates as an attractive time to buy, driving demand for homes and their prices. At the same time, businesses may be more inclined to borrow funds to finance projects or acquisitions. On the other hand, conservative investors may face tough choices about where to put their money.
Source: https://www.thebalancemoney.com/nominal-vs-real-interest-rates-5214217
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