Real Interest Rates | Personal Finance 101 — Transcript

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1. 0:00Thanks for tuning in to It's Your Money, your favorite
2. 0:03personal finance show.
3. 0:04I'm Mike Kaiman.
4. 0:06On today's show, I thought we'd open up the phone
5. 0:08lines and let you, our loyal viewers and radio listeners,
6. 0:11ask questions.
7. 0:13Okay, first caller, Memphis,
8. 0:15Tennessee, and Amanda.
9. 0:16Hello.
10. 0:17Hello, I'm Amanda and I earned $1000 mowing lawns over
11. 0:21the summer.
12. 0:22My parents want me to open a savings account with that money,
13. 0:25but I kind of want to keep it in a shoebox under my bed
14. 0:27where I have easy access to it.
15. 0:27where I have easy access to it.
16. 0:29What would you recommend?
17. 0:31Well, having a savings account will help you.
18. 0:34If you put that money into an account that's paying a 3% interest rate,
19. 0:34If you put that money into an account that's paying a 3% interest rate,
20. 0:38about this time next year you will have $1,030.
21. 0:42Now that's assuming you don't withdraw any of your money.
22. 0:45I could totally buy more things with an additional $30.
23. 0:49But there's something else you need to know about, and
24. 0:52that's the real interest rate.
25. 0:54What's that?
26. 0:55So to understand real interest rates, you have to first
27. 0:59understand inflation.
28. 1:01You mean like when I notice egg prices shooting up at the grocery store?
29. 1:05Kind of.
30. 1:06It's easy to mistake price movements for some goods and services,
31. 1:10like eggs, as inflation, but that's
32. 1:12just a price fluctuation of one item.
33. 1:16Inflation is an increase in the average price level of many goods and services.
34. 1:21When the inflation rate goes up, it indicates that the
35. 1:24prices of many goods and services are going up.
36. 1:26Your dollars will then buy less than what they did before.
37. 1:31In other words, the purchasing power of your money goes
38. 1:34down when the inflation rate goes up.
39. 1:37If your income is not rising as quickly as inflation,
40. 1:41that could be a real problem.
41. 1:43But let's not get ahead of ourselves.
42. 1:45So, what does that have to do with my savings
43. 1:47account?
44. 1:47Just like your purchasing power declines when the inflation rate goes up,
45. 1:51interest rates are also affected by inflation.
46. 1:55What does that mean?
47. 1:56For example, when you have a savings account,
48. 2:00interest is at work increasing the amount deposited, while inflation
49. 2:03is at work reducing each dollar's value.
50. 2:06Imagine a bucket.
51. 2:08The bucket is holding your purchasing power, so it is
52. 2:11actually holding all of the things you could buy.
53. 2:14Now imagine there is a faucet above the bucket dripping purchasing power into the
54. 2:19bucket.
55. 2:19This drip represents interest payments.
56. 2:23But the bucket also has a small hole in the bottom,
57. 2:27allowing your purchasing power to leak out.
58. 2:29This leak represents inflation.
59. 2:32If the bucket has purchasing power dripping in and leaking out at the same
60. 2:35time, what will happen to the level of your purchasing
61. 2:38power in the bucket?
62. 2:40Well, it depends on which is faster,
63. 2:42the dripping or the leaking.
64. 2:44Correct!
65. 2:45If the drip of interest at the top is faster than the leak of
66. 2:49inflation at the bottom, your purchasing power will increase and
67. 2:53you can buy more stuff.
68. 2:54But if the leak is faster than the drip, your
69. 2:58purchasing power will decrease and the amount of stuff you can buy will be
70. 3:02reduced.
71. 3:03Well, that's crummy.
72. 3:05Let's put some numbers to this.
73. 3:07Say that in the year prices on average rise 3%.
74. 3:11That is, the inflation rate is 3%.
75. 3:15Then you would need the entire $1,030 to buy what $
76. 3:191,000 purchased one year earlier.
77. 3:22Wait, what?
78. 3:24After taking inflation into account, your 3% interest rate wouldn't
79. 3:27allow you to buy any more goods and services than you could have a
80. 3:31year earlier.
81. 3:32Put differently, the 3% you earned in interest would offset
82. 3:36the 3% reduction in purchasing power caused by inflation.
83. 3:40So at the end of the year, your purchasing power
84. 3:43would be no more, it would be no less,
85. 3:46it would be the same.
86. 3:48Think back to our bucket example.
87. 3:50With a 3% interest rate dripping in at the top and a 3% inflation
88. 3:55rate leaking out at the bottom, the level in the
89. 3:58bucket would stay the same.
90. 3:59So, when making economic decisions, I
91. 4:01should take inflation into account?
92. 4:03Correct.
93. 4:05Inflation erodes the purchasing power of money.
94. 4:08When talking about interest rates, the terms real and nominal
95. 4:11are used to distinguish between rates that do and don't take inflation into account.
96. 4:18A nominal interest rate is the rate that banks and financial institutions quote or
97. 4:22state.
98. 4:23It does not consider inflation.
99. 4:25It is the actual rate paid.
100. 4:27For example, the interest rate paid to you on a
101. 4:28For example, the interest rate paid to you on a
102. 4:31savings account is a nominal interest rate.
103. 4:33A real interest rate is an interest rate that has been adjusted for inflation.
104. 4:38To calculate a real interest rate, you subtract the inflation
105. 4:42rate from the nominal interest rate.
106. 4:44In mathematical terms, we would phrase it this way.
107. 4:47The real interest rate equals the nominal interest rate minus the inflation rate.
108. 4:52Now let's go back to your $1,000 deposit.
109. 4:56Using the formula, a 3% nominal interest rate minus a
110. 4:593% inflation rate equals a real interest rate of 0%.
111. 5:05So, in real terms, as a
112. 5:07depositor, you have not gained any purchasing power,
113. 5:11nor have you lost any purchasing power.
114. 5:13Stated differently, any extra purchasing power you might have earned
115. 5:18in interest was cancelled out by inflation.
116. 5:22Well, if I'm not earning any real interest,
117. 5:24why shouldn't I just keep my money in a shoebox under my bed?
118. 5:27Well, let's figure out what the real interest rate is
119. 5:30on a deposit in a shoebox.
120. 5:32You don't receive interest at the bank of you, so
121. 5:35the nominal interest rate on that money is 0%.
122. 5:38But let's say the inflation rate is still 3%.
123. 5:41The real interest rate you would earn at the bank of you is negative
124. 5:463%.
125. 5:47So you would actually lose purchasing power.
126. 5:51Other reasons to keep your money in the bank are that banks are safe
127. 5:53and deposits kept at a bank are insured by the FDIC,
128. 5:57whereas deposits at the bank of you are not.
129. 6:00You are likely better off depositing your money in a bank even if the
130. 6:03real interest rate is 0%.
131. 6:06Thanks for the info.
132. 6:07I'm definitely going to keep my money in a bank account.
133. 6:09I'm also going to keep an eye on inflation to check the purchasing power
134. 6:12of my money.
135. 6:13Take care, and remember to keep it real.
136. 6:17So far, we've discussed interest rates from the perspective of
137. 6:20a depositor.
138. 6:20But they're also important to borrowers.
139. 6:23Let's see if we have any borrowers calling in.
140. 6:26Duluth, Minnesota.
141. 6:27Hello.
142. 6:29Hey!
143. 6:29I'm Jasmine, and I have a loan with a 5%
144. 6:32nominal interest rate.
145. 6:34Currently, the inflation rate is 3%.
146. 6:37So according to your equation, let's see,
147. 6:41nominal interest rate of 5% minus inflation rate of 3%,
148. 6:44I'd be paying a real interest rate of 2%, correct?
149. 6:49Correct.
150. 6:49But if inflation increases to 5%, I'm paying a real
151. 6:53interest rate of 0%?
152. 6:55Yes, well done.
153. 6:57You'll notice two things here.
154. 6:59First, the nominal interest rate did not change at all,
155. 7:02but the higher inflation rate reduced the real interest rate from 2% to 0%.
156. 7:08Second, at the higher inflation rate,
157. 7:11the borrower benefits from a lower real interest rate.
158. 7:15Essentially, the money would be borrowed interest-free once we
159. 7:19adjust for inflation.
160. 7:20However, the bank that made the loan would receive no
161. 7:23real return on the loan.
162. 7:25Thanks for clearing that up for me.
163. 7:27No problem.
164. 7:29We've got time for one more caller.
165. 7:31Buelton, California.
166. 7:32Hello.
167. 7:34Hi Mike, thanks for having me on the show.
168. 7:37It seems like some people gain from inflation while others are worse off.
169. 7:41So does inflation create winners and losers?
170. 7:44You are correct, especially when inflation is unexpected.
171. 7:48What's the unexpected part?
172. 7:50Well, if banks knew that inflation was going to happen,
173. 7:53they'd adjust the interest rate for the inflation rate to make sure that they
174. 7:57are a real return on the loan.
175. 7:59But when it's unexpected, they don't have the chance to
176. 8:03make an adjustment.
177. 8:04Okay, that makes sense.
178. 8:05So who wins and who loses when inflation is unexpected?
179. 8:10Unexpected inflation creates winners and losers, and borrowers definitely benefit
180. 8:14when unexpected inflation results in them paying lower real interest rates.
181. 8:20Lenders, on the other hand, are
182. 8:21the losers in this case and are not satisfied with the lower real rate.
183. 8:26This assumes that the interest rate is fixed.
184. 8:29Otherwise, banks would increase the interest rate along with the
185. 8:33inflation rate.
186. 8:34That makes sense too.
187. 8:36Can you give an example?
188. 8:37Sure.
189. 8:38Take, for example, a 15-year
190. 8:40mortgage with a 6% nominal interest rate.
191. 8:44With a 3% inflation rate, the real interest rate will
192. 8:48be 3%.
193. 8:49But if the inflation rate were to unexpectedly rise to 7%,
194. 8:54the real interest rate would become negative 1%.
195. 8:58In this instance, the borrower would benefit,
196. 8:58In this instance, the borrower would benefit,
197. 9:01but the bank would earn a negative real interest rate on the loan.
198. 9:05On the other hand, if the inflation rate dropped to
199. 9:081%, the real interest rate would increase from 3% to
200. 9:125%, making the borrower worse off and the lender better
201. 9:16off.
202. 9:17You can see that a stable, predictable inflation rate can
203. 9:20take much of the guesswork out of the decision to save,
204. 9:24borrow, or lend.
205. 9:24In the United States, the Federal Reserve System has been
206. 9:25In the United States, the Federal Reserve System has been
207. 9:28charged by Congress to maintain price stability and maximum employment.
208. 9:33Price stability means a low and stable inflation rate, and
209. 9:37the Fed uses monetary policy to achieve this goal.
210. 9:40How low is low and stable?
211. 9:43I'm glad you asked.
212. 9:45The Fed's goal is to maintain a 2% inflation rate over the longer run.
213. 9:49Savers, borrowers, and lenders all benefit
214. 9:52when inflation remains low and stable.
215. 9:55They can conduct their transactions without having to consider whether a high or rapidly
216. 9:59changing inflation rate might impact their finances in real terms.
217. 10:06Well, it looks like we're out of time.
218. 10:07Thanks for listening, and remember to keep it real.