Nominal v. Real Interest Rates

If you buy a “fixed income” investment such as a government bond, you will have a good idea of what the interest rate is.  If you put your money into a bank CD, for example, your banker will tell you the rate.  As of this writing, CDs are paying rates right around 1.00%.  That is the nominal rate.  The word nominal means “name,” which we should interpret as “in name only.”  We call it that to point out that you are not making that much in terms of what you can do with your money when you actually get it back.

Let’s say you invest $1000 in a bank CD for one year with an APR of 1%.  At the end of that year, you should get your $1000 back plus the princely sum of $10 that you earned in interest (and are liable for income taxes on).  The problem is that with a 2% rate of inflation, you lost about $20 in buying power.  To obtain your real rate of return, you need to subtract the inflation rate from the nominal rate.  Therefore, your CD is actually paying you negative 1.00% per year.  Any time you see a negative sign associated with a real rate, you are losing money.  This beats the -2.00% you would earn from your mattress, but it isn’t going to allow you to retire wealthy.  This subtraction process is critical when you are designing your portfolio, and the longer the period, the more important considering inflation losses become.  Investment products (other than “inflation-linked ones”) will usually fail to mention this effect.  Buyer beware!

Economists and financial advisors will often refer to the value of money in the future in terms of constant dollars.  Something computed in constant dollars is adjusted for the (usually predicted) loss due to inflation.  If your advisor (or software) predicts that your portfolio will yield $6,000 per month in retirement income, it is critical to know whether those dollars are constant dollars or unadjusted predictions.  You may find that you have $2,000 per month in buying power at retirement in terms of today’s dollars.

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