Financial questions: What is the relationship between real and nominal interest rates, short and long term rates and the inflation rate?

What is the relationship between inflation and interest rates?

It is an unfortunate fact that the relationship between interest rates and the inflation rate is complex, for each affects the other and they do so in different ways over different time spans. Many people also get confused by including inflation rates in interest rates as well, so perhaps it would be best to start by defining some terms. What we are actually interested in is the real interest rate, not the one that you usually see, which is the nominal rate.

Nominal interest rates are the numbers that you see on your bank account or loan statements. Perhaps a 5% interest rate as an example for borrowing from the bank, or another would be 17% interest rate on your credit card balance. What we really mean by “nominal” is the actual amount of cash you will have to hand over if you borrow at that rate. So a 5% nominal interest rate means you will have to pay $5 per year for every $100 you borrow, and 17% would mean $17 each year for every $100 you borrow.

What is the relationship between inflation and interest rates?

Real interest rates are nominal rates after we have taken account of inflation. These can be higher or lower than nominal rates. For example, if inflation is 10%, and nominal rates are 5%, then the real interest rate is -5%. If inflation is 1% and nominal rates are 5% then the real interest rate is 4%. When thinking about the impact of interest rates we should always consider the real, not nominal rate.

You have to remember two things about these two different types of interest rates. The first is that nominal interest rates cannot be less than zero, while real ones can be, indeed they were for much of the 1970’s. The second is that what is important for the economy is whatever the real interest rate is. The nominal rate is just a number, noise in the system if you wish, while the real rate influences the entire economy.

We also have to distinguish between short term and long term interest rates. Short term rates are those that are for loans of less than one year, while long term rates are for people borrowing for up to thirty years. Short term rates are decided by the Federal Reserve via their decisions on what is called Open Market Operations. Exactly how these work is an extremely complicated subject, so let’s just accept that this is so, and that interest rates on loans up to one year are essentially decided by a branch of the government. Long term interest rates are decided by the free market, there is no particular place or group of people that decide them, they simply emerge from the activities of millions of savers and borrowers trading loans between them.

High real interest rates have the effect of slowing down the economy. If it costs a lot to borrow money, less people will do so, so there will be fewer houses built, fewer people will take out loans to buy them, companies will borrow less money to expand and so on. This slowing down of the economy also reduces inflation. This is why you sometimes see in the newspaper that the Federal Reserve has raised interest rates to cool the economy. In the same manner, low or negative real interest rates make the economy grow faster, as it is now cheaper to borrow to invest in new production. This is what leads to the headlines saying that Greenspan has lowered rates to boost the economy. This is normally done when we are not worried about inflation, but we are worried about the lack of growth. So here we can see that interest rates affect the future rate of inflation.

Where all of this gets tricky is that as we noted above, the government only controls short term interest rates. It is the market that controls long term ones, and in the business of lending or borrowing money long term the biggest worry is inflation. So long term interest rates are not set in order to influence future inflation, as the short term ones are, they are actually an estimate by the market of what future inflation will be. If lenders think that inflation in ten years time will be high, they will insist on getting a high rate of interest for lending for longer than ten years. If they think that it will be low, they will be happy with a smaller rate. Of course, in real life there are always some people who think it will be high and others who think it will be low, which is precisely why we have markets in these things.

So there we have that complex relationship between interest rates and inflation. Short term interest rates are set in an attempt to influence what future inflation rates will be, while long term interest rates are a reflection of how successful people think that attempt will be. What makes it all difficult to understand is that we always talk about nominal interest rates, while it is the real interest rates, those after deducting inflation, that actually make the difference.

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