A “real” interest rate is simply an interest rate that has been adjusted to take inflation into account. (A “nominal” interest rate is one that has not been adjusted for inflation.) Real rates matter because inflation reduces the value of any future stream of income.
Take a bank account into which you plan to place £1,000. If inflation is running at 1% then a 2% nominal interest rate looks respectable – your savings will have more purchasing power a year from now. However, if inflation is running at 3%, your savings will have less purchasing power when you withdraw them in a year’s time, even though the £1,000 will have grown (in nominal terms) to £1,020. Of course, the advertised rate on a savings account will be the nominal one, not the real one.
The formal definition of the real interest rate is given by the Fisher equation (named after economist Irving Fisher) and is calculated as(1+i)=(1+r)×(1+ π) where i is the nominal rate, r is the real rate and π is the inflation rate. However, for most purposes, it’s much easier to estimate the real rate by subtracting the inflation rate (either the current rate or the expected rate, depending on whether you are calculating what you have earned in real terms or what you expect to earn) from the nominal interest rate. So in the first example above, the real interest rate is 1% (you are earning a real return of 1% a year). In the second example it’s minus 1% (you are losing money in real terms).
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One way to get an idea of expectations for inflation is to compare yields on index-linked government bonds (whose payments increase in line with inflation) with normal government bonds. The difference between the yield on UK gilts and index-linked gilts of similar maturities (or between US Treasuries and Treasury inflation-protected securities (Tips) gives the “break-even” rate – the level of inflation that means an ordinary bond will return the same as an index-linked one.
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Real exchange rate
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