The Real Interest Rate Risk

And it is the real interest rate not the money rate that counts for economic growth.

But when prices are falling, the real interest rate exceeds the nominal rate.

Domestic deflation means that the real interest rate on Japanese bonds is higher than the nominal rate.

Deflation increases the real (inflation adjusted) debt burden, as well as the real interest rate.

When prices are rising, the real interest rate is less than the nominal rate since the borrower repays with dollars that are worth less.

Yes, there is a minus sign in front of that if you buy the five year TIPS, each year over the next five years the US Treasury will pay you in interest the past year s consumer inflation rate minus 1.02 .

Given the current expected inflation rate of 2 , the real rate on ten year bonds is still less than 1 .

China s Interest Rate Challenge

Past experience implies that the real rate will rise to at least 2 , taking the total nominal interest rate to more than 4 , even if expected inflation remains at just 2 .

Although it is difficult to anticipate how high long term interest rates will eventually rise, the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2 . A higher rate of expected inflation would also cause the total nominal rate to be greater than 5 .

Although it is difficult to anticipate how high long term interest rates will eventually rise, the large budget deficit and the rising level of the national debt suggest that the real rate will be higher than 2 .

America s Interest Rate Puzzle

Lower interest rates are not a solution to this dilemma.

Deflation increases the real (inflation adjusted) debt burden, as well as the real interest rate. Though there is little evidence of the importance of small changes in real interest rates, the effect of even mild deflation on real debt, year after year, can be significant.

At present, the interest rate is less than 0.5 .

There is huge room to maneuver between the extremes of targeting a specific level of the real exchange rate and disowning any interest in the real exchange rate.

Because the inflation rate is also about 2 , this implies a negative real interest rate, which is confirmed by the interest rate of 0.6 on ten year Treasury Inflation Protected Securities (TIPS), which adjust interest and principal payments for inflation.

However, this is no longer applied since the central bank started changing rates by 0.25 percentage points on October 19, 2010 (which was a rate increase).

In Japan, the ten year rate has drifted to below 0.8 .

And, due to rising consumer prices, the nominal interest rate will continue to rise.

In May 2006, the fairly free domestic interbank rate was just 1.62 , while the US Federal Funds rate was 5 .

But did Greenspan really expect interest rates to remain permanently at 1 a negative real interest rate? Did he not think about what would happen to poor Americans with variable rate mortgages if interest rates rose, as they almost surely would?

According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest.

But the interest rate that Greece must pay buyers of its government bonds has shot up to a record high level of nearly 9 5.9 percentage points above the benchmark rate paid by Germany.

The second adverse effect of deflation is to raise the real interest rate, that is, the difference between the nominal interest rate and the rate of inflation.

Since the interest rate set by the ECB is now less than 1 , there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment.

As a result, the interest rate for 12 month fixed deposits has reached 3.9 .

All the above assumes that the interest rate remains constant throughout the whole period.

The process of reducing interest rates anchored on a solid tax policy and enabled by the removal of institutional obstacles (such as the rule of remuneration of savings accounts) was extended to the second half of 2012, leading to a real annual rate under 2 .

The current small difference between the real interest rate on such bonds (2.1 for 30 year bonds) and the nominal interest rate on conventional 30 year Treasury bonds (now 4.6 ) implies that the market expects only about 2.5 inflation over the next three decades.

But such an insignificant rate hike will do little to relieve long term pressures, because investors will expect more rate hikes and move money into China, increasing upward pressure on the yuan s exchange rate.

Foreign investors then sent their money to New York to take advantage of the higher rates.

The first, the Secular Stagnation Hypothesis, has been proposed by Larry Summers. Its key premise is that the equilibrium interest rate at which demand would balance supply is currently below the actual interest rate.

The real exchange rate is of paramount importance here, as it determines the competitiveness and profitability of modern tradable activities.

Inflation did, indeed, come down but the real exchange rate rapidly became overvalued.

A direct effect of the higher interest rate would be to increase the budget deficit and the rate of growth of government debt.

And that is important, because a rise in the federal funds rate will cause other, somewhat longer interest rates to increase as well.

Monetary policy is now drawing on a more comprehensive toolkit, such as the policy rate, the interest rate corridor, required reserve ratios, and the reserve option mechanism.

Any change in the exchange rate of the dollar affects the purchasing power of these countries, and therefore their real income.

Under these conditions, the Fed will want to raise the interest rate to prevent an acceleration of inflation.

That way, limited interest rate spreads could do the work of its missing exchange rate mechanism.

Two diametrically opposed scenarios exist for what will happen to global real interest rates over the next generation.

In Brazil, the basic real interest rate hovers around 5 6 per year, the lowest level since Brazil introduced the modern real in 1994 (yet still among the highest in the world).

When interest rates go up, these payments will (when the rate is variable) also go up, possibly becoming unsustainable.