In this article I intend to explain the concepts of Nominal Interest rate, Inflation and Real Interest rate. I believe that the general public knows the first two concepts, however, I am not so sure about the third one. Therefore, the final goal is to understand this last concept by having a thorough view of all the concepts and observe their representation.

“Whatever it takes”

In 2012, the Eurozone was financially falling apart, getting deeper into its infamous “Eurozone debt crisis” after the bailouts of Ireland, Greece and Portugal, alongside multiple banks’ bailing out domestically. Then, in July 2012 Mario Draghi, who was the President of the European Central Bank (ECB) at the time, made a statement that will probably survive the test of time:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Draghi’s term as ECB’s president finished at the end of October 2019 and if one looks back to 2012, especially those who were living in a Southern Europe country, one will feel that Draghi kept his word on the above statement. Overall, the years that followed 2012 saw a slow-but-steady recovery of economic and financial conditions. However, this is a tale of two stories: with a dark side to this bright one, and that, as we will see, will come in the form of the Real Interest rate.

What is Interest rate?

Interest rate is a concept that most of the people who interacted with the banking system should have an idea about, but let’s recap:

Interest rate is the amount charged, expressed as a percentage of the principal, by a lender to a borrower for the use of assets.

Investopedia

In order to understand this concept in practice, think about how banks make money: it is mostly by the difference, the spread, between two interest rates:

• Interest rate on loans: they will charge an interest rate (on the requested monetary amount) when a client asks for a loan;
• Interest rate on deposits: they will pay an interest rate (on the deposited monetary amount) when someone makes a deposit.

Moving forward maybe one concept that is not so clear to the general public is: what influences these interest rates?

There are numerous factors that influence these two interest rates, but the “ground floor” is based on the Interests rates defined by the Central Bank of the country. After all, these are the interest rates that banks face when they need to finance their activities and the ones they earn on their deposits at the central bank.

The tool that Draghi had as president of the ECB was monetary policy. Therefore, when he mentioned that he would do “Whatever it takes to preserve the euro” the focus was on making sure that banks and governments would be financially stable, which was mostly done using the mentioned Central Bank interest rates. There is more to that story so if the reader is interested on getting a deeper insight, the ECB used a more complex strategy called “Quantitative Easing” (QE).

Now let’s understand better these dynamics: the ECB reduced its central bank’s interest rates, so the banks can now get “cheaper loans” and, therefore, they can also provide loans at lower interest rates to companies. When companies have more money to invest, they will hire more people, who will receive a salary and consume more, so the economy grows again. This is the bright side.

Nevertheless, with those lower rates a depositor that aims at earning extra money by depositing the earned salary in the bank will eventually receive lower interests than when interest rates were higher. Further to this, in the Eurozone we have been presented with close to 0% interest rates on deposits, which is indeed alarming for those who have cash in the bank and want to capitalize it without taking the risks of investing into risky assets, such as the stock market.

Further on that, what probably most of those depositors didn’t realize is that their situation in reality is slightly worse than they initially thought…

What’s Inflation?

Inflation is a concept that every person should be familiar with, even though its name may be unknow:

Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time

Investopedia

A straightforward way of looking at this concept is to look at transportation costs: if one drives a car the changes in gas prices will be felt in the user’s pocket; on the other hand, if one takes public transportations, it is easy to perceive the price changes in the transportation tickets over time.

Many may not reckon but inflation is a very important metric followed by central bankers and its value is part of their objectives. In fact, the ECB states that its primary objective is to maintain price stability and, therefore, maximum employment comes only in second place. On a different note, the Federal Reserve prioritizes maximum employment over inflation targeting. Still, there is one thing they have in common and that is the inflation target: both central banks agree that their target inflation rate is close to 2%.

What would it then represent to have an interest rate of 0% and inflation of 2%?

What is Real Inflation rate?

So far, we have been talking about interest rates without paying attention to whether these were Nominal or Real. The purpose of not making this distinction before was to avoid undesirable misunderstandings. Nonetheless, we reached a point where this must be explained and to clear all the doubts, when we were mentioning interest rates, those were Nominal Interest rates.

Real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.

Investopedia

Immersing in the topic, I would like to recall the Fisher Effect, which states that the Real Interest rate equals the Nominal Interest rate minus the expected Inflation rate. Unlike the nominal interest rate, the real interest rate considers purchasing power in the equation.

Finally, one can conclude that despite the non-negative deposit interest rates in the current market environment, due to positive inflation the real interest rate becomes negative. Thus, in real terms the depositor is losing money.

An example of this conclusion can be as follows: imagine a depositor who wants to buy a television but doesn’t have enough money now, so he expects to deposit his savings in a bank account to buy it in the future with the help of the earned interests. However, with an inflation rate higher than the deposits’ interest rate, next year the difference in the price of the television would be greater than the interests he earned. Thereafter, every year he would be further away from buying this television.

Below you will find a graph with the evolution of the three mentioned concepts for Portugal since 1985.

Tip: feel free to use all the graphs functionalities. Also when clicking a label it will stop the metric’s display.

Portugal evolution of Nominal Interest rates, Inflation and Real Interest rates

What I like so much about this graph is to see the differences in 3 periods: the 1985-2000, 2000-2010 and 2010-present:

• 1985-2000: many people thought they were making a big amount of money on their deposits but the truth was that they were only partially correct. For example, towards the end of the 80’s they were losing money.
• 2000-2010: this was the beginning of Eurozone and a period of fiscal discipline, so Portugal had to comply with that 2% inflation target. Only the second half started to get better but then… well you know what happened through 2008.
• 2010-present: the last decade was one of extreme challenges following the global financial crisis and the Eurozone debt crisis. Therefore, there were few moments with positive real interest rates.

To have a broader view of the historical evolution of the topics described, I compiled the historical data on multiple countries’ Real Interest Rates.

Multiple Countries evolution of Real Interest rates

Feel free to share your findings on the comments below.

Final comment

This article aims at solely clear the three mentioned metrics and educate the reader on their dynamics and influences. It has no intent whatsoever to present a critic on ECB’s monetary policy and its effects on society’s economic well-being.

Data source: OECD Data

Code source: GitHub Page

Extra concepts, food for thought:

• “IS-LM” and “AD-AS” models: these are economic models used to describe the relationships between interest rates, output (GDP output) and price level;
• “Paradox of Thrift”: Keynes Inflation Theory – shares an intuition on the reason inflation should be positive;
• “Quantitative Easing” and “Helicopter Money”;
• “Japanification of Europe” and “Liquidity Trap”.

Cover Image Credits: © No intentions of copyright infringement. Taken from https://steemit.com/steemit/@acassity/stay-calm-breath-in-breath-out-don-t-worry-about-steem-inflation

• Economy
• Money