Don’t Forget Inflation!
The nominal interest rate (or money interest rate) is the percentage increase in money you pay the lender for the use of the money you borrowed. For instance, imagine that you borrowed $100 from your bank one year ago at 8% interest on your loan. When you repay the loan, you must repay the $100 you borrowed plus $8 in interest—a total of $108.
But the nominal interest rate doesn’t take inflation into account. In other words, it is unadjusted for inflation. To continue our scenario, suppose on your way to the bank a newspaper headline caught your eye stating: “Inflation at 5% This Year!” Inflation is a rise in the general price level. A 5% inflation rate means that an average basket of goods you purchased this year is 5% more expensive when compared to last year. This leads to the concept of the real, or inflation-adjusted, interest rate. The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest.. In our earlier example, the lender earned 8% or $8 on the $100 loan. However, because inflation was 5% over the same time period, the lender actually earned only 3% in real purchasing power or $3 on the $100 loan.
The diagram below illustrates the relationship between nominal interest rates, real interest rates, and the inflation rate. As shown, the nominal interest rate is equal to the real interest rate plus the rate of inflation1.
Fortunately, the market for U.S. Treasury securities provides a way to estimate both nominal and real interest rates. You can start comparing current real and nominal interest rates by looking at rates on comparable maturity Treasury securities—pick one that is not adjusted for inflation and one that is adjusted for inflation (more about these below). Chart 1 illustrates that there is certainly a difference between the real and nominal interest rates. This difference gives us an idea of the current inflation premium.
Interest Rates in the Real World
Advertised interest rates that you may see at banks or other financial service providers are typically nominal interest rates. This means its up to you to estimate how much of the interest rate a bank may pay you on a savings deposit is really an increase in your purchasing power and how much is simply making up for yearly inflation.
Now, let’s look at some of the inflation-adjusted securities that provide a real interest rate. The blue line in Chart 1 plotted the inflation-adjusted interest rates paid on these securities over the past several years, In 1997, the U.S. government began offering bonds called Treasury Inflation-Protected Securities (TIPS). Unlike other investments that pay a nominal interest rate, TIPS earn a real interest rate. The TIPS securities earn a fixed rate of interest just like many other types of government bonds. But, in addition to the fixed rate, the principal value of your TIPS bond is adjusted for inflation. So, at maturity, TIPS investors receive an inflation-adjusted principal amount. Also, for the unlikely event of deflation, there is a safeguard built into the TIPS system: the final payment of principal cannot be less than the original par value.
I-bonds, issued by the U.S. Treasury, are another type of investment that earns a real rate of return. Unlike TIPS investors, who receive an adjusted principal value at the end of the investment time period, I-Bond investors receive interest payments that are adjusted for inflation twice each year.
Know Your Rate
As with any investment or loan, it’s simply important to understand the interest rate that you are paying or receiving. With this knowledge, you will be able to compare it with other investments or loans and make sure you are getting a deal that is right for you and your financial situation.