Is it real or not? Can investors make a real return today?
A big, and not just academic, debate in the financial markets today centers around this question: Is the real rate of interest today positive or negative? The answer has important implications for growth in the economy. Negative real interest rates distort incentives and disrupt financial markets.
Longstanding and widely accepted economic theory teaches that interest rates on bonds, certificates of deposits, or any other debt securities are made up of two parts. First, the interest rate compensates the lender for the possibility of inflation. If prices rise over the term of the contract, the lender loses purchasing power. Thus, the stated interest rate on a debt security includes a return for the expected inflation over the period.
The second component of an interest rate is the real return. This is the rate of return the investor is expected to make after adjusting for inflation. The stated interest rate is called the nominal interest rate. After adjusting for inflation, economists arrive at what is called the real rate of interest.
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For example, this week Western Capital Bank in Boise posted a 2 percent rate of interest on 5-year certificates of deposit. If one deposits $1,000 with Western Capital and agrees to leave it there for the next five years, he or she will earn, with compounding, about $104 in interest.
But if inflation runs at 2 percent a year for the next five years, the $104 in interest won’t mean much. The real return on this investment will be zero, as the interest earned just compensates for the lost purchasing power of dollars.
Since 1948 the average annual rate of change in the Consumer Price Index, the most widely used measure of inflation in the United States, has been 3.7 percent. In the last five years, the average change has been only 2.4 percent. Over the last 12 months, it has been 1 percent.
If depositors are currently willing to accept only 2 percent on a bank CD, they must expect that inflation will be much lower than average, or even negative. But recent bond market activity suggests inflation is soon to pick up.
This week investors bought Treasury Inflation Protected Securities, or TIPS, at an auction by the U.S. Treasury that, unless something changes, will require them to pay the government for the opportunity to lend it money. The price paid for these bonds at auction is such that the real interest rate will turn out to be negative if inflation doesn’t occur.
Can this really be true? Would people really lend at a negative interest rate?
The answer is no. U.S. Treasury bond investors don’t expect to lose money. They expect inflation to rise, and with it, the value of TIPS.
TIPS give an investor protection against inflation. The principal of this bond increases with a rising CPI, and decreases when the CPI falls. When the bond matures, the investor receives an amount greater than or equal to his or her original investment. TIPS pay interest twice a year, at a fixed rate. But the rate is applied to the adjusted principal, which rises or falls with actual inflation. So interest payments also rise with inflation and fall with deflation.
In the auction this week, investors paid about $1,050 for TIPS maturing roughly five years from now. The bond will begin paying interest at 0.5 percent per year and return $1,000 at maturity.
If there is no inflation over this period, these investors will net a negative annual return of 0.55 percent. But if inflation rises to around 2 percent, the investors will earn about the same rate of interest they could receive now on regular bonds with the same maturity date. If inflation moves back to its long-run average, these investors stand to earn much more.
The bond market says it’s real. The expected real return may be small, but nonetheless, inflation is forecasted to rise. Investors want to be compensated for it.
Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.