An interest rate of 5 per cent sounds generous. But if prices are rising by 4 per cent a year, your money is only growing by about 1 per cent in terms of what it can actually buy. That gap between the headline rate and inflation is the real interest rate, and it is one of the most important ideas in markets. It helps explain everything from the price of gold to the strength of a currency.
Nominal versus real
The interest rate you see quoted on a savings account, a mortgage or a government bond is the nominal rate. It is simply the percentage return or cost in money terms. The real interest rate adjusts that figure for inflation. In its simplest form:
Real interest rate is roughly equal to the nominal interest rate minus inflation.
So a 5 per cent savings rate with 3 per cent inflation gives a real return of about 2 per cent. A 4 per cent rate with 6 per cent inflation gives a real return of about minus 2 per cent. In that case, savers are losing purchasing power even though their balance is rising.
Looking backwards and forwards
There are two ways to measure it. You can subtract the latest inflation figure from today’s interest rate, which gives a backward-looking view. Or you can subtract expected future inflation, which is what matters for decisions about borrowing and investing.
Markets offer a direct measure of the forward-looking version. In the UK, index-linked gilts pay returns that rise with inflation, so their yield is effectively a real yield. In the US, the equivalent bonds are called TIPS. Comparing those yields with normal government bonds also gives the market’s implied inflation expectation, known as the breakeven rate. Our guide to index-linked gilts explains how they work.
Why real rates matter
For savers and borrowers. Positive real rates reward saving and make borrowing more expensive in real terms. Negative real rates do the opposite, quietly eroding savings and easing the burden of debt.
For central banks. Policymakers think about whether their rates are high enough to slow the economy. A rate that looks high in nominal terms may still be loose if inflation is higher. Our explainer on the neutral rate covers the level that neither speeds up nor slows down the economy.
For gold. Gold pays no interest. When real yields are high, investors give up a meaningful real return to hold it, which can weigh on demand. When real yields fall or turn negative, the cost of holding gold drops. The link is not perfect, as central bank buying and fear can override it, but it is closely watched. Our piece on how gold behaves when real yields stay elevated goes further.
For shares. Higher real rates raise the return investors can get from safe bonds, which tends to put pressure on share valuations, particularly growth companies whose profits lie far in the future.
For currencies. Money tends to flow towards countries offering higher real returns, which can support their currencies. A country with high nominal rates but even higher inflation may not see that benefit.
The limits
Real rates depend on which inflation measure you use and on expectations, which can change quickly. Short-term real rates and long-term real yields can tell different stories. And markets can ignore real rates for long periods when other forces, such as fear, politics or supply shocks, dominate.
The bottom line
The real interest rate is the return after inflation, and it is often more useful than the headline rate for understanding what money is really worth. It helps explain why gold, growth shares and currencies react the way they do to changes in inflation and central bank policy. If you want a clear view of how well you connect big-picture ideas like this to your trading, take the free Samuel & Co Trading Trader Assessment.
