The Fed for the

fifth time this year lowered interest rates by 0.5 percentage points. This

brings the target nominal interest rate down to from 4.5% to 4%.

Today (4.26.01)

the labor department announced that for April (4.01) the consumer price

index rose by a seasonally adjusted 0.3%. This brought the rate of inflation

over the past 12 months to 3.3%.

With inflation

slightly up, and nominal interest rates down, I though it might be interesting

to take a fresh look at the patter of real interest rates over time. But

first a quick description of what a “real interest rate” means.

**Real Rates.**

Loosely speaking

the real interest rate is the real value of loan repayments. The nominal

interest rate is usually quoted in newspapers, and describes the amount

of money that must be repaid on a loan, but does not take into account

that the value of the repayment may be less due to inflation. The real

interest rate makes this inflation adjustment.

The Fisher equation

shows how one calculates the real interest rate (r) given the nominal interest

rate (i) and the inflation rate:

r = i – inflation

With inflation

running at over 3% per year, this means that current real rate of interest

is getting close to zero.

Here’s an example.

Suppose that you put $100 in the bank and earned a (nominal) interest rate

of equal to i. After 1 year you would have 100 * (1 + i).

So if i is 10%,

you would have $110. However, if there is some amount of inflation in the

economy, then this $110 would be worth a bit less. In particular, it would

be worth $110 (1 – inflation). So if inflation were 5%, then it would be

worth slightly less than $105.

$100 –> 1 year –> $100 (1 + i)

which is worth –>

$100 (1 + i ) (1 – inflation) = $100 ( 1 + i – inflation – i*inflation).

If both the interest

rate and the inflation rate are both small, then we can ignore i*inflation

and then we can write

$100 –> is next year worth –> $100 (1 + i – inflation) = $100 (1 + r),

where r = i –

inflation.

This again is

the Fisher equation.

Note that the

above is only true *ex post *– that is only after inflation has been

determined. The real interest rate for the coming year must take into account

expected inflation, since we are not exactly sure what inflation will be

in the future.

Since nominal

interest rates are often set in advance, if the inflation rate turns out

to be higher than expected, then the real interest rate will turn out to

be lower than expected. Since what people care about is the real exchange

rate, any unexpected inflation will benefit borrowers since the real rate

will turn out to be lower than anticipated – this is because the real value

of the payment, if not the actual number of dollars, will be less. For

the same reason, unexpected inflation will hurt lenders.

The graph below

shows the pattern of real interest rates over the past 50 years to so.

With real interest rates currently at about 1%, we will be dipping to levels

not seen since the last recession in the early ’90’s.

This would suggest

that the Fed has been taking a very aggressive stance towards what it feels

is a weakening economy. Will the recent interest rate changes do the trick?

Check back in about 6-15 months to find out.

Filed under: Economy, Monetary Policy