Wednesday, April 15, 2009

All We Need to Know: Real Interest Rates

The Fisher Equation:

nominal interest rate = inflation rate + real interest rate + (real interest rate * inflation rate)

The last term is typically small and ignored when casually calculating the real interest rate. So:

real interest rate = nominal interest rate - inflation rate

This is important because the net impact of borrowing can only be calculated with this rate. For example, a consumer borrows $100 for 1 year at 6% simple interest. With the $100, the consumer buys a year's worth of groceries. In one year, the consumer needs to pay back a total of $106.

Let's say that over that year, prices were steadily increasing. If the consumer bought groceries over the course of the year, the average price would have been $110. The consumer benefited from borrowing and locking in prices at the beginning of the period.

In equation form: -4% = 6% - 10%

With regard to businesses, they will borrow money to produce goods if they can sell those goods at higher prices in the future. There is a production lag, of course. Goods that are being manufactured today usually aren't sold today.

Companies need more pricing power when interest rates are higher. As we know, corporate credit is terribly expensive. Today's CPI release shows us that they do not have the requisite pricing power to borrow at current rates. This is the danger of deflation. Why would a consumer borrow money to lock in prices if prices are going to fall? Why would a business borrow money to produce goods that will drop in price? No demand for debt........

Yet, real interest rates are not low by recent historical standards. The graph below tracks a bank lending rate (nominal proxy) versus an inflation rate (CPI). The government if failing miserably at creating an environment that will promote growth. THEY NEED TO STOP BEFORE THEY INSURE A DEPRESSION FOLLOWS. Let the savings rate rebound and suffer the pain of inventory and consumption correction. Issuing debt is only increasing real interest rates and cutting the recovery off at its knees.

1 comment:

MK said...

As a proxy, the real interest rate should represent the real growth rate of the economy. GDP is negative, the Fed needs to get the real intereest rate negative. They are limited by the zero bound on nominal interest rates, hence the use of "quantitative easing": inceasing institutional access to funds.