Real Interest Rate

A nominal rate minus expected inflation. Expectations are never observed, which is why the number is debated, and why it is still the one that changes what people actually do.

Nominal minus expected inflation

The nominal interest rate is the one printed on the loan. The real interest rate is that nominal rate minus the inflation expected over the same period. If a deposit pays 5% and prices are expected to rise 3%, the real return is about 2%. The arithmetic is a subtraction the reader can do by hand.

Expectations are unobservable

The subtraction needs a number nobody can observe: expected inflation. Surveys of inflation expectations, market prices and model estimates all try to measure it, and they disagree. That is why two analysts can look at the same nominal rate and report different real rates.

The uncertainty does not make the concept useless; it makes it a judgement. What matters is that borrowing and saving decisions are made against the real rate, because that is the rate at which the purchasing power of the repayment changes.

Why it changes behaviour

A borrower repays in future money. If inflation erodes that money faster than the loan's nominal rate, the real cost of borrowing falls, and it becomes rational to borrow more. A saver faces the mirror image: a high nominal rate paired with higher inflation can still be a poor real return.

One checkable use: before calling a rate high, subtract a measure of expected inflation from it. A nominal rate held below expected inflation is a negative real rate, which is the condition that loosens credit without any change in the headline number.

Related: CPI · Policy Rate · Real vs Nominal

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