Getting Real About Interest Rates Video

Thanks for tuning into It’s Your Money – your favorite personal finance show. I’m Mike Kaiman.

On today’s show, I thought we’d open up the phone lines and let you, our loyal viewers and radio listeners ask questions.

Ok, first caller—Memphis Tennessee and Amanda, hello!

Amanda: Hello! I’m Amanda and I earned $1,000 mowing lawns over the summer. My parents want me to open a savings account with that money, but I kind of want to keep it in a shoebox under my bed where I have easy access to it. What would you recommend?

Mike: Well, having a savings account will help you. If you put that money into an account that’s paying a 3 percent interest rate, about this time next year you will have $1,030. That’s assuming you don’t withdraw any of your money.

Amanda: I could totally buy more things with an additional $30!

Mike: But there’s something else you need to know about and that’s the real interest rate.

Amanda: What’s that?

Mike: So, to understand real interest rates, you have to first understand inflation.

Amanda: You mean like when I notice egg prices shooting up at the grocery store?

Mike:  Kind of.  It’s easy to mistake price movements for some goods and services, like eggs, as inflation but that’s just a price fluctuation of one item.  Inflation is an increase in the average price level of many goods and services. When the inflation rate goes up, it indicates that the prices of many goods and services are going up—your dollars will then buy less than they did before. In other words, the purchasing power of your money goes down when the inflation rate goes up. If your income is not rising as quickly as inflation, that could be a real problem. But let’s not get ahead of ourselves.

Amanda: So, what does that have to do with my saving account?

Mike: Just like your purchasing power declines when the inflation rate goes up, Interest rates are also affected by inflation.

Amanda: What does that mean?

Mike: For example, when you have a savings account, interest is at work increasing the amount deposited, while inflation is at work reducing each dollar’s value.

Imagine a bucket. The bucket is holding your purchasing power, so it is actually holding all of the things you could buy. Now imagine there is a faucet above the bucket dripping purchasing power into the bucket. This drip represents interest payments. But the bucket also has a small hole in the bottom, allowing your purchasing power to leak out. This leak represents inflation. If the bucket has purchasing power dripping in and leaking out at the same time, what will happen to the level of your purchasing power in the bucket?

Amanda: Well, it depends on which is faster—the dripping or the leaking.

Mike: Correct! If the drip of interest at the top is faster than the leak of inflation at the bottom, your purchasing power will increase, and you can buy more stuff. But, if the leak is faster than the drip, your purchasing power will decrease, and the amount of stuff you can buy will be reduced.

Amanda: Well, that’s crummy.

Mike: Let’s put some numbers to this.  Say that in that year prices, on average, rise 3 percent—that is, the inflation rate is 3 percent. Then you would need the entire $1,030 to buy what $1,000 purchased one year earlier.

Amanda: Wait, what?!

Mike: After taking inflation into account, your 3 percent interest rate wouldn’t allow you to buy any more goods and services than you could a year earlier. Put differently, the 3 percent you earned in interest would offset the 3 percent reduction in purchasing power caused by inflation.

So, at the end of the year, your purchasing power would be no more; it would be no less; it would be the same. Think back to our bucket example. With a 3 percent interest rate dripping in at the top and a 3 percent inflation rate leaking out the bottom, the level in the bucket would stay the same.

Amanda: So, when making economic decisions I should take inflation into account?

Mike: Correct. Inflation erodes the purchasing power of money. When talking about interest rates, the terms “real” and “nominal” are used to distinguish between rates that do and don’t take inflation into account.

A “nominal interest rate” is the rate that banks and financial institutions quote or state. It does not consider inflation. It is the actual rate paid. For example, the interest rate paid to you on a savings account is a nominal interest rate.

A “real interest rate” is an interest rate that has been adjusted for inflation.

To calculate a real interest rate, you subtract the inflation rate from the nominal interest rate. In mathematical terms we would phrase it this way: The real interest rate equals the nominal interest rate minus the inflation rate.

Now let’s go back to your $1,000 deposit. Using the formula, a 3 percent nominal interest rate minus a 3 percent inflation rate equals a real interest rate of 0 percent. So, in real terms, as a depositor you have not gained any purchasing power, nor have you lost any purchasing power. Stated differently, any extra purchasing power you might have earned in interest was canceled out by inflation.

Amanda: Well, if I’m not earning any real interest why shouldn’t I just keep my money in a shoebox under my bed?

Mike: Well, let’s figure out what the real interest rate is on a deposit in a shoebox. You don’t receive interest at the Bank of You, so the nominal interest rate on that money is 0 percent. But let’s say the inflation rate is still 3 percent. The real interest rate you would earn at the Bank of You is negative 3 percent. So, you would actually lose purchasing power.

Other reasons to keep your money in the bank are that banks are safe, and deposits kept at a bank are insured by the FDIC, whereas deposits at the Bank of You are not. You are likely better off depositing your money in a bank, even if the real interest rate is 0 percent.

Amanda: Thanks for the info. I’m definitely going to keep my money in a bank account. I’m also going to keep an eye on inflation to check the purchasing power of my money.

Mike: Take care. Remember to “keep it real.”

So far, we’ve discussed interest rates from the perspective of a depositor, but they’re also important to borrowers. Let’s see if we have any borrowers calling in.  Duluth, Minnesota…hello!

Jasmine: Hey, I’m Jasmine and I have a loan with a 5 percent nominal interest rate. Currently the inflation rate is 3 percent, so according to your equation, (says under her breath, “lets’ see – nominal interest rate of 5 percent minus inflation rate of 3 percent”) I’d be paying a real interest rate of 2 percent, correct?

Mike: Correct.

Jasmine: But if inflation increases to 5 percent, I’m paying a real interest rate of 0 percent?

Mike: Yes, well done! You’ll notice two things here:

First, the nominal interest rate did not change at all, but the higher inflation rate reduced the real interest rate from 2 percent to 0 percent.

Second, at the higher inflation rate, the borrower benefits from a lower real interest rate—essentially, the money would be borrowed interest-free, once we adjust for inflation.

However, the bank that made the loan would receive no real return on the loan.

Jasmine: Thanks for clearing that up for me.

Mike: No problem.  We’ve got time for one more caller—Buellton, California and —hello!

Carlos: Hi Mike, thanks for having me on the show. It seems like some people gain from inflation, while others are worse off. So, does inflation create winners and losers?

Mike: You are correct! Especially when inflation is unexpected.

Carlos: What’s the “unexpected” part?

Mike: Well, if banks knew that inflation was going to happen, they’d adjust the interest rate for the inflation rate to make sure they are a “real” return on the loan. But, when it’s unexpected, they don’t have the chance to make an adjustment.

Carlos: OK, that makes sense. So, who wins and who loses when inflation is unexpected?

Mike: Unexpected inflation creates winners and losers, and borrowers definitely benefit when unexpected inflation results in them paying lower real interest rates. Lenders, on the other hand, are the losers in this case and are not satisfied with the lower real rate. This assumes that the interest rate is fixed; otherwise, banks would increase the interest rate along with the inflation rate.

Carlos: OK, that makes sense. Can you give me an example?

Mike: Sure. Take, for example, a 15-year mortgage with a 6 percent nominal interest rate. With a 3 percent inflation rate, the real interest rate will be 3 percent. But if the inflation rate were to unexpectedly rise to 7 percent, the real interest rate would become negative 1 percent. In this instance, the borrower would benefit, but the bank would earn a negative real interest rate on the loan.

On the other hand, if the inflation rate dropped to 1 percent, the real interest rate would increase from 3 percent to 5 percent, making the borrower worse off and the lender better off.

You can see that a stable, predictable inflation rate can take much of the guesswork out of the decision to save, borrow, or lend.

In the United States, the Federal Reserve System has been charged by Congress to maintain price stability and maximum employment. Price stability means a low and stable inflation rate, and the Fed uses monetary policy to achieve this goal.

Carlos: How low is “low and stable"?

Mike: I’m glad you asked. The Fed’s goal is to maintain a 2 percent inflation rate over the longer run.

Savers, borrowers, and lenders all benefit when inflation remains low and stable—they can conduct their transactions without having to consider whether a high or rapidly changing inflation rate might impact their finances in real terms.

Well, it looks like we’re out of time, Thanks for listening, and remember to “keep it real.”