The Real Interest Rate Risk

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

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.

When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers.

So, if the PBOC sets the interest rate on one year deposits at 3 , commercial banks can offer depositors a rate as high as 3.3 .

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 .

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

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

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 .

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

China s Interest Rate Challenge

And, in the United States, where inflation exceeds 2 , the Federal Reserve s benchmark federal funds rate remains at an historic low of 0 0.25 .

Under the current system, the fixed differentials between interest rates on deposits and those on loans translate into monopolistic profits for commercial banks.

Second, China s central bank still controls interest rates by enforcing a roughly three percentage point spread between deposit rates and lending rates.

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

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.

Lower interest rates are not a solution to this dilemma.

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.

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

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

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.

At present, the interest rate is less than 0.5 .

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.

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.

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.

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?

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

The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008.

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

Likewise, increasing the interest rates paid on bank deposits would enable savings to decline without loss of income.

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).

Low interest rates on deposits encourage savers, especially households, to invest in fixed assets, rather than keep their money in banks.

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.

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

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.

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

Indeed, the interest rate on inflation protected bonds has now become 0.5 , even for a five year maturity!

Given today s exceptionally low long term interest rates, the annual cost would be, well, peanuts.

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).

Thus, the market can establish the necessary interest differential only if interest rates on yuan assets fall below their dollar equivalents.