Real interest rates have rapidly increased recently as monetary policy has tightened in response to higher inflation. Whether this uptick is temporary or partly reflects structural factors is an important question for policymakers.
Since the mid-1980s, real interest rates at all maturities and across most advanced economies have been steadily declining. Such long-run changes in real rates likely reflect a decline in the natural rate, which is the real interest rate that would keep inflation at target and the economy operating at full employment–neither expansionary nor contractionary.
The recent increase in real interest rates is likely to be temporary, according to a report published on the International Monetary Fund (IMF) blog by Jean-Marc Natal and Philip Barrett. The rise in rates reflects tightened monetary policy in response to higher inflation. Historical analysis shows that global forces have had a modest impact on the natural rate, while factors like productivity growth and demographic changes have driven the decline in natural rates over the past 40 years. Looking ahead, the report suggests that natural rates in advanced economies will remain low, with emerging market economies converging towards those rates. The outlook for real interest rates will depend on factors such as government debt, climate policies, and deglobalization.
Visual Capitalist made a graphic to show the real interest rates (ex ante) of 40 major world economies, using data from Infinity Asset Management.
What are Real Interest Rates?
Real interest rates refer to the interest rates adjusted for inflation. They represent the return on investment or the cost of borrowing after accounting for the impact of inflation. In other words, real interest rates reflect the purchasing power of money.
To calculate real interest rates, the nominal interest rate is adjusted by subtracting the inflation rate. The resulting value indicates the actual increase in purchasing power or the real return on an investment.
Real Interest Rate = Nominal Interest Rate – Inflation Rate
Real interest rates are important for both lenders and borrowers as they provide a more accurate measure of the cost of borrowing or the return on investment. High real interest rates indicate that borrowing costs are relatively high compared to the inflation rate, which can affect consumer spending and investment. Conversely, low or negative real interest rates suggest that borrowing costs are relatively low compared to inflation, which can stimulate borrowing and investment.
Central banks and policymakers closely monitor real interest rates to assess the overall economic conditions and make decisions regarding monetary policy.
Are Real Interest Rates Important?
Yes, real interest rates are highly relevant in the realm of finance, economics, and policymaking.
Here are a few reasons why real interest rates are important:
- Investment decisions: Real interest rates help individuals, businesses, and investors assess the attractiveness of various investment opportunities. By considering the real interest rate, they can determine whether an investment has the potential to generate positive real returns after accounting for inflation.
- Borrowing costs: Real interest rates impact the cost of borrowing for individuals and businesses. When real interest rates are high, borrowing becomes more expensive relative to the inflation rate. This can influence borrowing decisions, affecting consumer spending, business investments, and overall economic activity.
- Monetary policy: Central banks monitor real interest rates to evaluate the stance of monetary policy. By adjusting nominal interest rates based on inflation expectations, central banks can influence real interest rates to stimulate or cool down economic activity. Changes in real interest rates can affect borrowing costs, investment decisions, and inflationary pressures.
- Inflation expectations: Real interest rates can provide insights into market expectations for future inflation. If the nominal interest rate is higher than the expected inflation rate, it implies positive real interest rates, which could indicate expectations of lower future inflation. Conversely, negative real interest rates might suggest expectations of higher inflation in the future.
- Economic stability: Real interest rates are closely related to the overall economic environment. High real interest rates can dampen economic growth, while low or negative real interest rates can encourage borrowing, spending, and investment. Therefore, understanding real interest rates is crucial for policymakers in managing economic stability and promoting sustainable growth.
Research IP highlights that real interest rates play a significant role in investment decisions, borrowing costs, monetary policy, inflation expectations, and overall economic stability. They provide valuable insights into the actual returns on investments and the cost of borrowing after accounting for inflation, making them highly relevant in various financial and economic contexts. Importantly, this flows through to portfolio construction decisions. Quite simply, we need to ensure our clients can still purchase their bread and milk in future years, so portfolios need to adapt.
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Photo credits: Visual Capitalist, Galeanu Mihai (Getty Images)