Real Interest Rates & You

Gross domestic product growth is only possible if a component of the
economy deficit spends. This is necessitated by the lag between
production and sale of a product. The majority of the borrowing
shifts between sectors over time, as economic cycles and political
appetites wax and wane. From this perspective, debt serves a useful
purpose.

On a personal level, the same holds true: income expectations are
greater in the future for a recent college graduate. Therefore,
incurring debt allows the new worker the flexibility to establish a
base for future income.

However, the interest rate of the loan (price of money in a sense) is
not the only consideration when deciding to borrow money. A glance at
the work economist Irving Fisher provides a useful benchmark.

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%

The real interest rate in this case was -4%.

In today's economy, prices are falling (on a year over year basis) as
measured by the Consumer Price Index (this index is used to determine
changes in labor contracts and government assistance payments). In
this case, debt works against he borrower. In essence, the borrower
is taking in "cheap money" today and paying back "rich money"
tomorrow.

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. The last few CPI
releases 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 is 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.