A real interest rate is the interest rate on an investment or loan that is adjusted for inflation. Real interest rates measure the effects of inflation and an economy’s purchasing power.
Real interest rates are more reliable than a traditional interest rate, otherwise known as the nominal interest rate. Nominal interest rates are the rates advertised by financial institutions. For example, a bank may offer a promotional 5% interest rate for new applicants that open a high-yield savings account. However, the nominal rate is not entirely accurate because it does not take into account the rise of inflation. For this reason, the real interest rate is far more accurate and useful.
What Is Inflation?
Inflation is the general increase in prices and the decrease in the purchasing value of money. For example, if the cost of necessary items increases, then the purchasing power of a dollar decreases. A period of rising prices can occur due to demand-pull inflation or cost-pull inflation.
- Demand-Pull Inflation — This type of inflation occurs when the demand for products outpaces the production of supply. When more people have disposable income, demand-pull inflation can result in higher costs. Suppose everyone wants a PS5, but Sony only has a few to sell. In that case, the cost of a PS5 will increase.
- Cost-Pull Inflation — This type of inflation occurs when overall prices increase due to a rise in the cost of raw materials, wages, or manufacturing. When the demand for products and services doesn’t change during cost-pull inflation, then prices will increase, but the wages people earn won’t.
During a period of inflation, governments may raise taxes to curb consumption or spend more on infrastructure to improve productivity. The Federal Reserve, the central bank of the United States, has recently been raising interest rates. Higher interest rates can help slow down the economy, which may result in lower prices and less consumption.
Why Is Inflation Affecting So Many Economies Right Now?
Inflation is affecting more countries than just the United States, but why? Due to the COVID-19 pandemic, many industries were and continue to be negatively affected by supply chain issues and a renewed spending boom. Many manufacturing centers are trying to meet high demands with limited supply, and as such, demand-pull inflation is affecting various economies across the world.
What Is the Inflation Rate and How Does It Measure Inflation?
The inflation rate is a measurement of price changes over time, expressed as a percentage. Inflation rates measure the true change in actual purchasing power. Financial institutions use different indexes to measure inflation.
These are the three main measures of inflation in the United States:
- The Consumer Price Index (CPI)
- The Federal Funds Rate
- The Producer Price Index (PPI)
- The Personal Consumption Expenditures Price Index (PCE)
The Consumer Price Index (CPI) is typically the main index used to gauge inflation. The Bureau of Labor Statistics has been reporting the CPI every month since 1931. But how is the CPI calculated?
The Bureau fills an imaginary shopping car with various items and services. Approximately 94,000 products and services are sampled to accurately estimate changes in prices. The prices are evaluated, and any changes are recorded monthly.
The rate of inflation reflects the pace of rising prices. Suppose a bag of chips cost $1 last year but the cost increases by $0.05 this year. In that case, the chip inflation would be 5%. The expected inflation rate can help provide a better picture of the overall increase in prices. Inflation expectations directly influence how financial institutions adjust their nominal interest rates.
How To Calculate Real Interest Rates
In order to calculate the real interest rate, you must know the nominal interest rate and the inflation rate. By subtracting the nominal rate from the inflation rate, you can calculate the real interest rate.
Suppose a consumer deposits $1,000 into a savings account that has a 4% nominal interest rate with the hope of benefiting from high-interest payments. But when you subtract the 4% nominal rate from a 3% inflation rate, then the result is a 0% interest rate. This calculation means that the depositor does not gain or lose any additional purchasing power. During a period of inflation, account holders may not see remarkable growth in their savings accounts.
Can Interest Rates Turn Negative During Inflation?
Yes! It is possible for real interest rates to be negative. Real interest rates become negative when inflation rates exceed nominal rates.
Negative real interest rates negatively impact financial institutions and their account holders. A negative real interest rate can significantly reduce the total interest payment amount a person earns from their savings account. Negative rates also reduce the amount banks receive in return for lending money through a loan.
However, loan borrowers may benefit when a real interest rate is negative! Suppose you are repaying a 30-year mortgage loan that has a 6% nominal interest rate. If the inflation rate is more than the nominal rate, for example, 7%, then the real interest rate would be -1%. In that case, you could save a lot on your mortgage through record-low interest rates!
During a period of negative rates, loans may be easier to get, and interest rates may be exceptionally low. But remember that if you have a variable-rate loan, your monthly payment amount can increase significantly if the inflation rate decreases. Variable rates may help borrowers save money on interest payments, but if the economy starts doing well, rates can increase unexpectedly, and the borrower may find it challenging to pay a higher bill.
How To Increase Your Purchasing Power During Inflation
Purchasing power is the value a currency has in terms of buying goods and services. During times of inflation, the purchasing power decreases because the general price of everyday expenses increases, and you are able to get less with the same amount of money as before. Low-income families feel the sting of inflation the most, but there are ways to make a dollar stretch further and thus increase your purchasing power.
These are five helpful tips to start combating inflation:
Reanalyze Your Monthly Budget
During a period of inflation, it becomes necessary to reanalyze your monthly budget. Take a look at your spending habits to see where your money goes every month. Knowing how much you spend on certain items and services may help you cut down expenses. Suppose you are spending $100 on a gym membership but no longer make working out a priority. In that case, it may be better to end your subscription and use that money for other necessary expenses.
If you do not yet have a monthly budget plan, now is the perfect time to make one! Budgeting requires effort and consistency, but it can increase your purchasing power and help you build better spending habits.
In order to start a budget plan, you need to follow these three essential steps:
Step 1: Calculate Your Income
The first step of starting a budget plan is to calculate your monthly take-home pay. Do not use your gross monthly pay (income before taxes), as this amount is inaccurate. Your take-home pay is the amount you actually receive after taxes and other payroll deductions. If you receive recurring income, then you can simply add up your weekly or bi-weekly paychecks. But if you do not receive consistent income, then you will have to calculate the average to start budgeting with irregular income.
To calculate your average monthly income:
- Add up the multiple income amounts for the past month.
- Divide the total income by the number of pay periods.
- Get your monthly income estimate!
Step 2: Track Your Monthly Spending
Tracking your monthly spending helps you see exactly where your money goes. To understand how much you spent this past month, look at bank and credit card statements. Make a list of each expense and the amount. Once you have a complete list of your monthly expenses, split them into these two categories: fixed and variable.
A fixed expense does not change month-to-month such as mortgage or car payments. Variable expenses change every month, such as gas and grocery purchases. Variable expenses are typically easier to cut back on, so think about the best ways to reduce your variable expenses.
Step 3: Choose a Budget Method
Once you know how much you earn and spend within a given month, it’s time to pick a budget method. There are different budget strategies, so consider what your financial goals are and what you want to prioritize.
Remember that budgeting your money is a difficult habit to start. You may potentially spend more than you originally intended and feel disheartened. But remember that consistency is key! Spending a little too much last month does not necessarily have to affect this month or the upcoming year.
The Debt Avalanche Method
If you have a lot of loans, such as mortgage or auto loans, you may want to focus on debt repayment. The debt avalanche method helps borrowers pay down their high-interest debt first. Borrowers pay the minimum on all their debts except for the one with the highest interest rate; All excess income should go toward repaying that one specific debt. Speeding up the repayment process results in fewer interest fees, reducing the overall cost of borrowing.
The 50/30/20 Rule
If you just want to improve your personal finance, you can use the 50/30/20 rule. The 50/30/20 rule helps you avoid spending more than a specific percentage on various costs, which can help you grow your emergency fund.
Through this budgeting method, you must spend no more than 50% on needs (rent, bills, etc.), 30% on wants (entertainment, takeout, etc.), and 20% on savings. The 50/30/20 rule is a great starting point because it can be adjusted. Suppose your necessary expenses exceed 50% of your income. In that case, you can change the percentages. For example, you can follow a 70/20/10 rule instead.
The Zero-Based Budget
The zero-based budget strategy requires every dollar you have to be “spent.” For example, if you have $500 left over at the end of the month, that money should have a purpose. You can choose to invest, build your savings, or pay down any outstanding debt. You should not have money left in your checking account by the end of the month.
The “No” Budget
The “No” Budget is a simple budget strategy for overspenders that want to start developing better spending habits. Suppose you want to spend money on unnecessary expenses, such as new clothes or takeout, when you just bought groceries. In that case, you tell yourself “No” and deny yourself the purchase. Over time, you may find it easier to spend less on goods and services you don’t need.
Reduce Your Monthly Expenses
Reducing the amount you spend monthly can help you keep more money in your pocket. Consumers can use leftover income to build an emergency fund, invest, or achieve financial goals. Suppose you want to qualify for a mortgage on a modern house. In that case, you may want to save up for a sizable down payment. Reducing your monthly expenses allows you to grow your savings and reach your long-term goal.
Take a look at your spending habits to determine how you can best cut costs. You can try switching to free subscription options, refinancing your high-interest loans, or lowering your utility costs. The best way to reduce spending differs depending on your priorities, so analyze your bank statements to determine the best money-saving options.
Use Coupons and Discounts
Taking advantage of coupons and limiting your spending to items on sale can increase your purchasing power during a period of inflation. Most grocery stores mail coupons and weekly sales papers. Using these items to plan your weekly purchases and meals can reduce the amount you spend on groceries. Shopping at discount stores, such as Marshalls or Ross, can help you get more for your dollar. Look for ways to save every time you make a run to the store or make a purchase to keep more money in your pocket.
Invest Your Money
Investing your money may be one of the best ways to counter the negative effects of inflation. You may think that investing is a risky decision during an inflation period, but there are low-risk investment options that may help you avoid a significant decrease in purchasing power.
Consider one of these investment options to grow your money:
- Savings Bonds — Investing in Series I savings bonds (I-Bonds) offered by the United States Treasury can help consumers earn interest payments. The interest is based on a fixed interest rate that changes every six months based on the current rate of inflation.
- Stocks — Stock index funds may be a low-risk investment option that helps you diversify your financial portfolio. A stock index fund, such as S&P 500 or Nasdaq 100, usually stands the test of time and provides a higher long-term average.
- Silver and Gold — Silver and gold are precious metals that have historically retained their value. Consumers can physically purchase silver or gold or invest in EFTs that track them.
- Treasury Inflation-Protected Securities — Treasury Inflation-Protected Securities (TIPS) are designed to be a low-risk investment option that protects investors from inflation. TIPS automatically adjusts the value of your investment based on the Consumer Price Index (CPI).
Take Up a Side Hustle
Increasing your income can help you combat inflation. There are various side hustles you can look into, depending on your skills, schedule, and assets. Need a few ideas on how to make extra income? Take a look at some potential side hustles below:
- Walk dogs in your neighborhood.
- Become a rideshare driver through Lyft or Uber.
- Deliver grocery orders through Instacart.
- Assemble Ikea furniture or help people move on TaskRabbit.
- Deliver takeout orders with a mobile ordering app.
- Have a yard sale and sell your unused items.
- Give music lessons for an instrument.
- Become a freelance writer or proofreader.
The Bottom Line: Real Interest Rates
The real interest rate is a rate that takes into account the projected rate of inflation, unlike the standard nominal interest rate. While it’s possible to predict future inflation using the average of past inflation rates, real interest rates are far more accurate. To calculate the real interest rate on a loan or an investment, subtract the nominal interest rate from the inflation rate.
Inflation can decrease the purchasing power of a currency, but there are ways to combat its effects. Consumers can reduce their spending, change their lifestyles, or invest their money in a low-risk investment product.
References:
What Is a Real Interest Rate?│The Street
Inflation explained: Everything you need to know in 3 minutes or less│New York Life
Real interest rate definition│Accounting Tools
6 Best Investments For Inflation│Entrepreneur