Real Interest Rate
We recommend you read our post on inflation, as the discussion there will be very helpful in understanding this article. Interest rate is one of the most common economic terms that we use in daily life. Simply put, interest rate is the return earned on money lent out. So if you lend Rs 100 to your friend and ask her to give back Rs 110 after one year, interest rate charged by you is 10%. Similarly, if you put Rs 100 in your bank account, the bank will pay interest as in this case it’s the bank who is taking money from you. If the bank offers an interest rate of 4%, then after one year you will get Rs 104 from the bank and will earn Rs 4 as interest.
This interest rate that we just discussed and the ones that we generally hear & read about is called the nominal interest rate. Now let’s see why nominal interest rate is not very relevant. The basic motive behind investing money is to earn returns/interest that allows us to retain purchasing power as well as to grow the savings kitty. This should allow us to improve our standard of living over a period of time. Let us consider an example. Suppose, you have Rs 1,00,000 and want to buy a high-end motor bike costing Rs 1,08,000. You decide to invest your money in a fixed deposit at 9% interest rate. You thought that you will have Rs 1,09,000 at the end of the year and will easily buy your favourite bike.
But after one year, you realize that the price of the bike has gone up to Rs 1,15,000 (increased by approx 6.5%). You are sad, as again you cannot buy the bike. What really happened here? Due to general inflation of around 6.5% in the economy, price of the bike increased proportionately during the course of the year. So in order to achieve your target of buying the bike you should have invested in an instrument that returned 15% after a year. That would have allowed you to beat inflation of 6.5% and in addition earn real returns of 8.5%.
Real Interest Rate = Nominal Interest Rate – Inflation Rate
In our example nominal interest rate is 9% and inflation is 6.5% and hence real interest rate is 2.5% (9%- 6.5%). When we invest our money, some part of what we are earning is always being eaten away by inflation.
Investors will be able to retain their purchasing power only when they earn returns equal to or more than the inflation rate. Suppose the inflation rate is 9% and interest rate is 8%, in real sense you will actually lose 1% of your money, rather than gain anything. So rather than being able to buy more things after a year, you won’t even be able to buy the same basket of goods bought earlier, as their market price will be higher than your investment kitty.
Compared to savings bank accounts, fixed deposits, bonds and other instruments, only equities as an asset class have generated positive real rate of return in the last decade. To make money in real sense over the long term, invest in equities.