What is Real Interest Rate

Real interest rate is a very important concept in economics and finance. Unfortunately, many retail investors do not make investment decisions based on real interest rates and as result, they make sub-optimal investment decisions. Knowledge of economics and finance is required to understand real interest rates, because real interest rates are not quoted by banks or other institutions. Bank term deposit (FD) or post office small saving scheme interest rates are always quoted in nominal terms. In this blog post, we will learn the difference between real interest rate and nominal interest rate; we will also learn how to make investment decisions based on real interest rates.

What is Nominal interest rate

Let us first understand nominal interest rate because it is the interest rate quoted by banks and other institutions. Interest rates are quoted on an annual basis and are compounded at certain intervals. In India, banks use quarterly compounding. For example if you deposit Rs 1 lakh in your bank as Fixed Deposit on the 1^st April and if the interest rate is 8%, then after three months you will earn an interest of Rs 1 lakh X (8%/4)= Rs 2,000. The value of your investment after 3 months will be Rs 102,000. The interest earned on Rs 102,000 in the next 3 months will be Rs 102,000 X (8%/12) = Rs 2,040. The value of your investment after 6 months therefore will be Rs 104,040 (Rs 102,000 + 2,040). The interest earned on Rs 104,040 in the next 3 months will be Rs 104,040 X (8%/12) = Rs 2080.8. The value of your investment after 9 months therefore will be Rs 104,040 (Rs 104,040 + 2080.8) = Rs 106,121. The interest earned on Rs 106,121 in the next three months will be Rs 106,121 X (8%/12) = Rs 2122.4. So the value of your investment after 12 months will be Rs 108,243 (Rs 106,121 + 2122). The total interest earned by you in one year will be Rs 8,243.

Many investors may think, nominal interest rate is all they want to know to make investment decisions because based on nominal interest rate and compounding period (quarterly in India), you will know exactly how much money you will get at the end of the investment period. But is it really enough information to make investment decisions?

What us Real interest rate

What is money? Money in its most basic form is a nothing but a piece of paper, but money can fulfil our needs and desires, because money represents purchasing power. The purchasing power of money is eroded over time by a nine letter word called inflation. It is very important that you keep the relationship between money and inflation always in mind, when making investment decision otherwise you will always fall short of your actual goal.

Let us go back to the example, where you invested Rs 100,000 will get Rs 108,243 lakh after one year. But will the purchasing power of Rs 108,243 lakhs one year from now be the same as Rs 1 lakh today. Suppose price of an item is Rs 100. With Rs 100,000 you can buy 1,000 units of the item. Let us suppose inflation rate is 5%; after one year the price of the item will be Rs 105. With Rs 108,243 you can buy 1,031 (Rs 108,243 divided by 105) items. So the interest earned helps you only 31 additional units or in other words your purchasing power increased by only 3% (31 divided by 1000). This is the real rate of return on your investment.

Real interest rate is the rate of interest allowing for inflation. The mathematical formula for Real Interest Rate, also known as the Fisher Equation is (please note that we have given a simplified version of Fisher Equation here for the benefit of all readers):-

What is Inflation

You should know that the inflation figure used in the Fisher Equation is not the inflation over the last one year, but rather the expected inflation over the next one year. It is not possible to know inflation in advance, but one can form expectation based on various data. Some people may form inflation expectation based on average historical inflation rates but this method may be prone to errors. Investors can form inflation expectations based on past data but also consider other factors, like weather conditions (for food prices), global energy prices (for petrol and diesel prices), upcoming festive occasions (for prices of consumer durables etc.) etc. Retail investors can simply follow the Consumer Price Inflation (CPI) data released by the Government every month (available on the RBI website) to get a sense of how inflation is trending.

Different stakeholders in the economy want different inflation outcomes. Borrowers want inflation to be higher in the future, because the money they will be repaying will be cheaper than the money they borrowed. Investors and lenders want inflation to be lower, because they do not want the money they will receive in the future to have less purchasing power than the money they invested or lent. Farmers want prices of food grains to go up, whereas consumers want prices to come down.

Real Interest Rates in investment decisions

Institutional investors make their investment decisions on real interest rates. Short term real interest rates are largely driven by the monetary policy of the central banks (e.g. Reserve Bank of India). However, long term real interest rates are driven more by capital markets. In fact over the past 15 years or so, with increased globalization, long term real interest rates in India are increasingly getting more influenced by external factors like interest rates in other countries, e.g. if interest rates go up in the US it is likely that long term real interest rates will go up in India as well. Hence, short term interest rates (and short term debt fund returns) are likely to be much less volatile than long term interest rates (and long term debt fund returns).

Real Interest Rates have a huge influence on investment decisions and capital flows. High real interest rates will cause people to save more and invest in risk free assets; assuming income remains the same, when people save more, they spend less. It is very important to reiterate here that, we are talking about real interest rates and not nominal interest rate. If real interest rate is low, but the nominal interest rate is high because of inflation, there is no incentive in postponing consumption for savings because the value of money (in form of interest) will be lower in the future due to inflation.

When real interest is high, as discussed earlier, people spend less, demand for goods and services go down; this affects sales turnover, earnings and share prices of companies. Equity as an asset class becomes less attractive; fixed income, on the other hand, becomes attractive due to high interest rates. This situation causes, what is known in economics and finance, as flight to safety. Flight to safety is not just a domestic phenomenon. It also affects flow of capital across markets. The safest asset class in the world is US Treasury Bonds. When real interest rates rise in the US, capital flows from emerging markets (like India) to the US and other developed markets.

If real interest rate is low, then there is no incentive for postponing consumption for saving. As people consume more factory output rises, revenues, earnings and share prices of companies go up. Low real interest rates therefore are positive for equity markets. Also when real interest rates are low, demand for loans to buy machinery and capital goods increase because entrepreneurs believe that the marginal operating profits due to higher production will offset the financing cost (interest expense). Higher capital expenditure will result in higher output and growth; a positive for share prices and equity markets.

How is the Real Interest Rate in India

Nominal interest rates in India have come down quite a bit over the last 2 years or so. However, over this period inflation has also come down. Real interest rate in India is still quite high relative to some other emerging economies. As per some reports, real interest rate in India is around 5%, while that in China is around 2%; real interest rate in the US is also around 2.1 to 2.2%. According to some economists, there is a lot of room for real interest rate to come down in India.

The RBI in its last policy meeting maintained status quo and reiterated its policy neutral stance. Obviously, the RBI is concerned about the upside risks to inflation and therefore would be reluctant to take any action which may cause inflation to flare up. Reducing interest rates can also have an effect on the exchange rate. Monetary policy has complicated implications and the RBI has to maintain a balance in order to ensure macro-economic stability in the country, at a time when our economy has to go through the near term effects of structural reforms of the Government like demonetization, GST etc. The real rate story is likely to play out in the longer term, once the near term disruptive effects of the Government reforms get stabilized and we are back on the roadmap of fiscal consolidation. If it does, it will be very beneficial for long term equity investors.

Conclusion

In this blog post, we discussed the importance of real and nominal interest rates. Investors should take real interest rate into account when taking investment decisions. We also discussed the effect of real interest rate on different asset classes like equity and fixed income. We also discussed about real interest rates in India and why it can be very beneficial for long term equity investors.