Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 27

Nominal and real interest rates matter in different ways

Interest rates can be viewed in either of two ways: in nominal or real terms.

It’s the nominal interest rates (or nominal yields) paid on deposits and bonds that determine the cash returns investors receive from their interest-bearing investments. And it’s nominal interest rates that determine how much borrowers pay on their debts.  Current examples of nominal rates in Australia include 3.9% on a two year term deposit and 3.6% on a ten year government bond.

Nominal interest rates are important for another reason: changes in them are the main influence on the market prices of bonds (bond prices move inversely with nominal yields) and other financial assets traded on financial markets.

Real interest rates (or real yields) are nominal rates adjusted for inflation. A real interest rate is usually calculated by taking the relevant nominal interest rate and deducting the inflation rate recorded over the preceding 12 months.

An alternative is to calculate an expected real interest rate – by taking the relevant nominal interest rate and subtracting the expected rate of inflation. The problem is we don’t have good measures of expected inflation.

Think in real terms

Real interest rates are important. They measure the percentage return from an investment in terms of what it does to the purchasing power of the investor – and they also show how the percentage cost of paying interest on a loan in terms of the purchasing power of the borrower.

Real interest rates are also a useful guide to whether monetary policy is easy or tight. For example, low (or negative) real interest rates suggest that monetary policy is accommodative or stimulatory; high real interest rates suggest that monetary policy is tight.

The chart shows the history of two important real interest rates in Australia, those on three month bank bills and ten year government bonds. These real rates, which fluctuate widely over time, are affected by moves in nominal interest rates and by inflation. Real interest rates have generally been high when inflation was falling (1920s, 1930s and 1990s) and low or negative when inflation was rising (early 1950s, 1970s).

AO Real yields

AO Real yields

Since 1990, Australian real rates have trended markedly lower – that’s because nominal interest rates have declined by more than inflation. Some real interest rates have fallen from over 8% – how good was that for savers but how tough on borrowers! - to less than 1.5%.

Around the world, real interest rates are now unusually low or even negative. That’s the aim of the policies of the major central banks, with the exception of China. The US central bank has kept its nominal cash rate close to zero for almost five years and frequently reiterated its ‘forward guidance’ that it will maintain the ultra-low cash rate ‘for an extended period’; it’s been buying US bonds at the rate of US$1 trillion a year and expects to ‘taper’ that programme only as the economy gains strength; and via ‘operation twist’, it is lowering long-term real yields by purchasing long-dated bonds and selling bonds with shorter-dated maturities.

My guess is that the central banks of the US, Japan and Europe will continue to maintain real yields at quite low levels - often accepting negative ones - as they try to nurture their economic recoveries.  (Yes, even Europe now has some ‘green shoots’ of recovery).

Hunt for real yield a preoccupation

This means the hunt for real yield that’s become a preoccupation of investors both here and abroad is likely to remain a dominant feature of investment markets for several years at least.

People with savings will need to continue to seek out the higher real yields that quality corporate bonds can offer relative to the low real yields available on government bonds.   Savers should also be prepared to ‘shop around’ for the best deals on term deposits and at-call deposits to ensure they are getting the best possible real returns on these assets.  And shares paying good and growing dividends – especially those carrying franking credits – will have enhanced appeal to investors keen to earn an attractive rate of real returns.

Anyone thinking about what might happen to real interest rates over the medium-term and beyond may have to allow for what might be another powerful influence keeping real interest rates at low and at times negative levels.

Governments and central banks in debt-laden countries seem likely to be more tolerant of inflation than they’ve been in recent decades. As Pictet Asset Management observed recently,

“Policy makers in advanced countries are not the strict disciplinarians they once were … Higher inflation and negative real interest rates present heavily-indebted countries with a less disruptive way to reduce the real value of government debt compared with alternatives such as sovereign default or deep spending cuts.”

In the early years after the Second World War and again in the 1970s, governments of many industrialised countries, including Australia, tolerated inflation and negative real interest rates to reduce the huge increase in the real value of the government debt they’d issued and the interest costs of servicing those swollen borrowings. Investors holding deposits and bonds suffered badly, as the graph reminds us.

Recently, Japan has adopted a policy of ‘let’s have inflation’. If the US and Europe, both of which also have much-increased levels of public debt, follow this lead, investors around the world might have to cope with rising inflation and low or negative real interest rates in the medium term. That would be a worry for investors – particularly self-funded retirees.

Don Stammer is former Director, Investment Strategy at Deutsche Bank Australia and is currently an adviser to the Third Link Growth Fund, Altius Asset Management and Philo Capital. The views expressed are his alone.


 

Leave a Comment:

     

RELATED ARTICLES

Residential investment property fails simple valuation test

Should investors brace for uncomfortably high inflation?

Are income funds just arbitrage funds?

banner

Most viewed in recent weeks

Lessons when a fund manager of the year is down 25%

Every successful fund manager suffers periods of underperformance, and investors who jump from fund to fund chasing results are likely to do badly. Selecting a manager is a long-term decision but what else?

2022 election survey results: disillusion and disappointment

In almost 1,000 responses, our readers differ in voting intentions versus polling of the general population, but they have little doubt who will win and there is widespread disappointment with our politics.

Welcome to Firstlinks Election Edition 458

At around 10.30pm on Saturday night, Scott Morrison called Anthony Albanese to concede defeat in the 2022 election. As voting continued the next day, it became likely that Labor would reach the magic number of 76 seats to form a majority government.   

  • 19 May 2022

Betting markets as election predictors

Believe it or not, betting agencies are in the business of making money, not predicting outcomes. Is there anything we can learn from the current odds on the election results?

Keep mandatory super pension drawdowns halved

The Transfer Balance Cap limits the tax concessions available in super pension funds, removing the need for large, compulsory drawdowns. Plus there are no requirements to draw money out of an accumulation fund.

Welcome to Firstlinks Edition 454 with weekend update

Before the last Federal election, these pages were filled with policy discussions and articles generating hundreds of comments as Labor ran a large target agenda. We all know how that ended. Most Australians distrust government and media, and this campaign will be handouts, spin and personality attacks. Will Australia emerge more divided than ever?

  • 14 April 2022

Latest Updates

In praise of our unique democracy and its sausage

For all the shortcomings of our political campaigns, our election process is the best. We are blessed with honest administrators and procedures that we all trust to hand over power peacefully, with a big snag. 

Investment strategies

Is the investing landscape really different this time?

Many market analysts argue that the pandemic has changed everything but we must judge whether the circumstances are as drastic as billed. A quick review of four major events helps decide if this time is different.

Economy

Comparing generations and the nine dimensions of our well-being

Using the nine dimensions of well-being used by the OECD, and dividing Australians into Baby Boomers, Generation Xers or Millennials, it is surprisingly easy to identify the winners and losers for most dimensions.

Retirement

When will I retire? Economic impact of an ageing population

About 39% of the labour force is aged over 45. Intergenerational reports highlight the challenges of an ageing population and the impacts on consumption patterns, dependencies, public finances and economic growth.

The real story behind the crypto crash

The recent sell-off in the crypto market and its trigger - the collapse of the Terra UST coin - has affected many institutions either holding or trading crypto assets, including crypto fund managers.

Investment strategies

Cash is the nightingale, the bird in the hand

The bird in the hand is worth two in the bush, and it's an apt metaphor for investment choices. In 2021, as investors hunted in the bush for decent returns, demand overwhelmed supply. Cash is the bird in the hand.

Strategy

Book review of 'Putin’s People' and his motivation for war

Author Catherine Belton argues Putin’s sole ambition is to hold onto power. Her book seeks to understand why Putin invaded Ukraine after he became isolated and out of touch with reality during the pandemic.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.