Real Interest Rate
The real interest rate is the nominal interest rate adjusted for inflation, measuring the real return to lending or the real cost of borrowing in terms of purchasing power. It is the rate that matters for saving and investment decisions, because it reflects the change in real wealth rather than in nominal amounts. The real interest rate is central to the analysis of monetary policy, capital allocation, and intertemporal choice.
Calculation
The real interest rate is approximately equal to the nominal interest rate minus the expected rate of inflation, a relationship known as the Fisher equation. More precisely, the real rate equals one plus the nominal rate divided by one plus the inflation rate, minus one. The exact and approximate formulas differ when inflation is high, but the approximation is close when inflation is low.
The distinction between ex ante and ex post real rates matters. The ex ante real rate is based on expected inflation and guides decisions at the time they are made. The ex post real rate is based on actual inflation and measures realised returns. When inflation surprises occur, the ex post real rate may differ substantially from the ex ante rate, redistributing wealth between borrowers and lenders.
Determinants
The real interest rate is determined by the balance of saving and investment and by monetary policy. In the long run, it reflects the productivity of capital and the preferences of households for present versus future consumption, a concept captured by the natural, or neutral, real rate. As the supply of saving increases or the demand for investment falls, the natural rate declines.
Monetary policy influences the real interest rate in the short run by setting the nominal rate while inflation is sticky. By lowering the nominal rate faster than inflation falls, a central bank can reduce the real rate and stimulate spending. In the long run, the real rate is determined by fundamentals, and monetary policy affects only inflation, a result known as the long-run neutrality of money.
Significance
The real interest rate is critical for several reasons. It determines the incentive to save and invest, and thus the allocation of resources over time. A high real rate discourages investment and encourages saving, while a low real rate does the opposite. It affects the valuation of assets, since future cash flows are discounted at real rates in real terms or nominal rates in nominal terms. It influences wealth distribution between debtors and creditors.
The real rate also matters for fiscal sustainability, since the difference between the interest rate on government debt and the growth rate of the economy determines the trajectory of the debt ratio. A persistently low real rate makes high debt more sustainable, while a rise in the real rate can rapidly worsen fiscal dynamics.
Recent trends
Real interest rates have declined substantially over recent decades in advanced economies, a trend attributed to demographic change, slower productivity growth, increased demand for safe assets, and a global savings glut. Very low or negative real rates have become common, posing challenges for monetary policy, which faces the zero lower bound on nominal rates and limited room to cut. Negative real rates penalise savers and can encourage risk-taking, raising financial stability concerns.
The causes and consequences of low real rates are a major theme in contemporary macroeconomics. The debate has implications for the conduct of monetary policy, the design of fiscal policy, and the assessment of financial stability, and it has prompted discussions about the appropriate inflation target and the role of fiscal policy in stabilisation.
The natural rate and r minus g
The natural, or neutral, real rate is the rate consistent with output at potential and stable inflation. It is not directly observable and must be estimated, with estimates subject to considerable uncertainty. The natural rate is influenced by the balance of saving and investment, by demographics, by productivity growth, and by the demand for safe assets. Its decline in advanced economies has been a major theme in macroeconomics.
The relationship between the interest rate and the growth rate, captured by the interest-growth differential, or r minus g, is central to debt dynamics. When the real interest rate is below the growth rate, governments can sustain higher debt ratios, because the economy grows faster than the debt accumulates interest. When the differential reverses, fiscal positions can deteriorate rapidly, and adjustment becomes necessary. Understanding r minus g is essential for assessing fiscal sustainability.
The zero lower bound and negative rates
The zero lower bound on nominal interest rates implies that the real interest rate cannot fall below minus the inflation rate. When inflation is low, this constrains the ability of monetary policy to reduce real rates during downturns, motivating unconventional policies. Some central banks introduced negative policy rates to push real rates lower and to discourage hoarding of reserves, though the effects and limits of negative rates remain debated.
Negative real rates, which occur when inflation exceeds the nominal rate, redistribute wealth from creditors to debtors and encourage borrowing and spending. They can support recovery but also encourage risk-taking and asset price inflation. The prevalence of low and negative real rates has prompted reconsideration of the inflation target and of the role of fiscal policy in providing stimulus when monetary policy is constrained.
Measurement and expectations
Measuring the real interest rate requires measuring inflation expectations, which are not directly observable. Survey-based measures, market-based measures from inflation-linked securities and swaps, and model-based estimates each have limitations. The choice of measure can materially affect the estimated real rate and the assessment of the policy stance. Uncertainty about expectations translates into uncertainty about the real rate.
The distinction between ex ante and ex post real rates is also important. Decisions are based on expected inflation, but realised outcomes may differ, redistributing wealth between borrowers and lenders. Unexpected inflation benefits borrowers at the expense of lenders, while unexpected disinflation does the opposite. These redistribution effects are a reason why inflation stability matters for financial contracts and for the distribution of income and wealth.