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).
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
-
The top stocks in the FTSE 100After a year of strong returns for the UK’s flagship index, which FTSE 100 stocks have posted the best performance in 2024?
-
A junior ISA could turn your child’s pocket money into thousands of poundsPersuading your child to put their pocket money in a junior ISA might be difficult, but the pennies could quickly grow into pounds – and teach them a valuable lesson about money
-
What is tracking difference?Tracking difference is a useful figure to help you understand how a fund or portfolio is performing.
-
Trading terms: The Santa RallyGlossary Will the Santa Rally result in its traditional December effect on global markets?
-
What is Bitcoin?Bitcoin can take a little effort to get to grips with. Dominic Frisby explains just what it is, and why you should take notice of it.
-
Barbell strategyGlossary A “barbell… investment strategy means weighting a portfolio towards the two extreme ends of an asset class with nothing in the middle.
-
Real exchange rate
Glossary The real exchange rate between two currencies combines the nominal exchange rate with the ratio of the price of goods or services in two different countries.
