Real Interest Rates Reveal the Real Picture

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  • 09 May 2023

“What… 500 Rs?! Beta, in our times, we watched movies at just Rs 5!” We have all heard our parents rant about their inexpensive childhoods. Well, it’s not their fault. It’s the doing of Mr. Inflation.

That is why investors calculate the real interest while investing, to secure against Mr. Inflation. Real interest is the interest that you get after deducting inflation and other expenses. Confused? To understand the importance of real interest rates, you have to first understand inflation.

Inflation is Nothing but Mehengaayi

What our parents are essentially talking about is Inflation or Mehengaayi. Inflation is a rise in the general price level in an economy. The costs of goods and services are usually cheaper today than they will be tomorrow. Be it the 5 Rs movie tickets that cost 500 Rs now or 20 Rs McAloo Tikki Burger that cost Rs 45 now. We see Mr. Inflation at work. Inflation changes the purchasing power of money.

Being an investor, you might have faced a similar situation as well. You might be expecting certain returns, but what you actually receive does not feel enough! Why is that? Let me ask you while investing, do you look at the ‘REAL’ rate of interest?

The Right Interest Rate

Interest rates refer to the cost someone pays for the use of someone else's money. What you need to know is the rate at which you will be compensated rightly. When talking about interest rates, ‘real’ and ‘nominal’ interest rates are used to distinguish between rates.

When you look at your credit card statements, loan documents, or savings account, you're usually seeing the nominal interest rate. The nominal interest rate is not adjusted for inflation, but the real interest rate is adjusted for inflation. To calculate a real interest rate, you subtract the inflation rate from the nominal interest rate.

Don’t Get Fooled. Get Real

The nominal rate will tell you how fast your investment will increase over time, the real rate will tell you how fast your purchasing power will increase. If inflation is higher than your interest rate, you actually are losing purchasing power. Let’s take a hypothetical example of Ms. Sanjana’s investments.

Real Interest Shows True Picture

Sanjana's Investments Fixed Deposit (FD) Systematic Investment Plan (Equities)
Investment Horizon
5
5
Nominal Interest Rate Per Annum
5%
10%
Inflation Rate
6%
6%
Real Interest Rate Per Annum
-1%
4%

You see? If Sanjana simply built her portfolio based on nominal return, she might have been fooled. Note, you also need to consider the tax, other fees, etc., to arrive at the exact rate of return.

Real Interest Rates’ Impact on Economy and Stock Markets

Real interest rates are majorly impacted by supply and demand in the economy. Central bank’s monetary policies are also aimed at tackling real interest rates. There are many economic theories surrounding at what impacts real interest rates. Very low or negative real interest rates reflect pessimism about economic growth. The unprecedented low real interest rates boost riskier assets like stock markets, which currently is the case in Indian stock markets some believe. Which makes sense, as you saw in the Sanjana’s example, that when inflation is high, riskier assets offer better returns.

Currently, inflation is on the rise in many countries, including India and developed markets having higher negative real rates. In addition, capital flows to emerging markets could be at risk. While we will not get into the nitty-gritties of this, what you as an investor should focus on is accounting it in your calculations.

Why Should You Care About It Now?

Interest rates in India are now at a record low. This makes negative real returns a major risk to investments. Most banks currently offer interest of 5% to 5.5% per annum on a one-year FD, while inflation is at 5-6%. So, even safe investments can erode your capital if they offer negative real returns.

All in all, negative real interest rates are good for borrowers but bad news for savers. Investors at such times can look for better options that offer positive real interest.

References: Hindu Business Online

[Investopedia](https://www.investopedia.com/ask/answers/032515/what-difference-between-real-and-nominal-interest-rates.asp}

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