“Nobody can predict interest rates, the future direction of the economy or the stock market.”
Peter Lynch
Interest rates are so much more than we might think and how they’re calculated in relation to inflation is critical.
Essentially, there are two kinds of interest rates:
- Real rate of interest
- Nominal rate of interest
1. Real interest rate = the growth rate of your purchasing power
The Real rate takes into account the impact of inflation. This is important because inflation affects purchasing power, effectively stripping away the amount a dollar can buy in the future as opposed to a dollar today. This is important, because the Real rate illustrates the purchasing power of the interest on a loan you take out, whether that’s a personal, home, credit card or auto loan.
2. Nominal interest rates = the growth rate of your money
The Nominal rate does not take inflation into consideration. This is often the quoted or advertised rate for a loan.
Here’s where the bank comes in as they calculate the Real interest rate. The bank has to account for the amount they’re loaning to you and the rate of inflation. They calculate the return on the amount they loan to you by subtracting the inflation rate from their nominal rate. They easily calculate the Real interest rate like this:
r = R – i
R = Nominal interest rate
r = Real interest rate
i= Inflation rate
For example, if the bank’s list rate is 5%. The inflation rate is 2% (where the Fed tries to keep it). The bank will see a return of 3% by adjusting for inflation. They have lost a hefty chunk of their return because of inflation and the erosion of the purchasing power of the amount of interest paid on the loan.
It’s important to remember that the bank is loaning you money that they borrowed from the fed. The spread between the interest rate at which they loan to you and the rate the Fed loaned to them is the bank’s profit.
One more thing: The Fisher Effect
Founded by economist Edwin Fisher in 1930, the Fisher effect asserts that the Nominal rate changes with the expected inflation rate. This is calculated with the long term in mind, as nominal interest rates don’t immediately jump when inflation changes. As inflation increases, investors will demand higher Nominal rates of return. It takes into account what people believe about inflation. For example, if people believe that things are going to be great and inflation is curbed, they are more likely to invest. The Fisher equation can be calculated as:
R = r + E[i]
R = Nominal interest rate
r = Real interest rate
E[i] = current expectations of inflation
Investors factor in the Fisher Effect to maximize the rate of return on their investments. If they believe inflation will grow at a higher rate, they will seek out investments that exceed the rate of inflation in order to grow their purchasing power and maintain positive ROI. It’s a tricky game to play since no one really knows what the inflation rate will be in the future; investors are working off a hunch or a belief or at best, an expectation.
