What it means
Every quoted interest rate is a nominal rate: the percentage a lender charges or a saver earns in cash terms. The real rate strips out inflation to answer a different question, which is how much more the money will buy at the end of the period than it did at the start.
It matters because business decisions are made in goods, services and capacity, not in dollars. A borrower paying 8% while its own selling prices rise 6% is really paying about 2%, and a project that clears a nominal hurdle rate can fail once the cash flows and the discount rate are expressed on the same basis.
The quick version subtracts inflation from the nominal rate, which is close enough when both numbers are small. The exact version, known as the Fisher relationship, divides rather than subtracts, and the difference becomes material once inflation reaches double figures.
Two flavours get confused in conversation. An ex ante real rate uses expected inflation and is what a lender prices into a loan today, while an ex post real rate uses the inflation that actually occurred and can only be worked out afterwards, and only the second is a fact rather than a forecast.
Negative real rates are neither rare nor academic. They quietly transfer value from savers and bondholders to borrowers, they discourage holding cash, and they make long-dated fixed-rate debt attractive to any company that believes inflation will persist.
In practice
Real-world examples
Example 1
A packaging company borrows at a fixed 7% for ten years just before an inflationary stretch in which it raises its own prices 9% a year. Revenue and profits rise in cash terms while the repayment stays fixed, so the real cost of the loan is roughly -1.8% and the debt becomes easier to service each year.
Example 2
A charity keeps $2,000,000 in a deposit account paying 1.5% during a year when inflation reaches 8%. It earns $30,000 of interest but loses about 6% of its purchasing power, roughly $120,000 in real terms, and the trustees move the reserve into short-dated index-linked bonds.
Example 3
A family compares a 5.5% fixed mortgage with expected inflation of 3%. The real cost is about 2.4%, and their adviser points out that if wages track prices, the monthly payment shrinks relative to income every year even though the number on the statement never changes.
Think of it
Think of nominal interest as the number of steps you take on a moving walkway, while the real interest rate is how far forward you actually move once you factor in the walkway moving backward.
Formula
Calculation
Approximate: Real rate = Nominal rate - Inflation rate
Exact, using the Fisher relationship: Real rate = (1 + Nominal rate) / (1 + Inflation rate) - 1
A business places $50,000 on deposit for a year at a nominal 6% while inflation runs at 4%. The approximation gives 6% - 4% = 2%. The exact calculation gives 1.06 / 1.04 - 1 = 0.0192, or 1.92%. In dollars, the deposit grows to $50,000 x 1.06 = $53,000, while a basket of goods that cost $50,000 at the start of the year now costs $50,000 x 1.04 = $52,000. Restated in start-of-year money, the $53,000 is worth $53,000 / 1.04 = $50,961.54, a real gain of $961.54 on $50,000, which is the same 1.92%.Case study
Seen in the real world
Tanner Valley Foods is a fictional regional food producer, offered here as an illustrative case. Its treasurer had built up $8,000,000 of cash for a possible acquisition and parked it in an instant access account paying 2%, which felt prudent while the deal was uncertain.
Inflation that year came in at 7%. The account paid $160,000 of interest, taking the balance to $8,160,000, but restated in start-of-year money that was worth $8,160,000 / 1.07 = $7,626,168, a real loss of about $374,000. Expressed as a rate, the real return was 1.02 / 1.07 - 1, or -4.7%.
The board's reaction was to treat idle cash as a decision rather than a default. It committed $3,000,000 to a warehouse extension that had been scheduled for two years later, moved $4,000,000 into short-dated index-linked notes, and kept only $1,000,000 in instant access for working capital.
Watch out
Common mistakes
- Assuming a positive nominal rate means the money is growing. If inflation is higher than the rate paid, the balance grows while the purchasing power shrinks.
- Mixing nominal and real numbers in the same appraisal. Discounting real cash flows at a nominal rate, or the reverse, produces an answer that can be wrong by several percentage points.
- Treating the real rate as fixed once a loan is signed. The nominal rate may be fixed, but the real rate moves every time inflation does, which is the whole point of the measure.
Questions
People also ask
What does a negative real interest rate mean in practice?
It means lenders and savers are being paid back in money that buys less than the money they parted with, so borrowers gain at their expense.
Should a company use the real rate or the nominal rate to appraise a project?
Either, as long as it is consistent: real cash flows with a real discount rate, or nominal cash flows including price rises with a nominal discount rate.
Which inflation measure should be used?
The consumer price index is the usual default, but a business is often better served by an index that reflects its own input and output prices, because that is the inflation it actually faces.