Real interest rates are nominal interest rates per annum less the expected rate of inflation per annum. The expected inflation rate is approximated in these calculations by some sort of measure of recent actual inflation rate. The idea is that the actual inflation rate evolves fairly gradually so the best forecast of the expected rate is some recent measure of the actual rate.
The idea is that buying an asset at a nominal interest rate r, when inflation is occurring at rate π, is really costing you r-π per period in interest since you are getting capital appreciation of about π simply because inflation is occurring. Thus in considering the real cost of borrowing it is claimed that what matters is the real rate.
That is true provided you are not budget-constrained. If you are buying a house for $300,000 and borrowing the lot at rate 8.25% when the inflation rate is 3% your real cost of borrowing is 5.25%. You actually have to find $24,750 in interest each year but of that $9,000 is an increase in the value of your capital assets so your real cost is $15,750.
But each year you do have to shell out $24,750 – this is tough if you are shelling out for school expenses and orthodontic work for your kids - but you should be getting $9000 of that back (eventually) when you come to sell the house assuming that its value increases by the rate of inflation. The truth is that we all worry about both nominal rates (which determine how much of current income we must dedicate to our borrowings) and real rates which measure the real cost of our capital asset acquisitions.
Politicians don’t like interest rate increases. It is often not clear why. An interest rate increase means that borrowers (e.g. the ‘young’ buying their first house) pay more while lenders (e.g. wealthy old pensioners, like my mum, with investments) get paid more. So that disliking high interest rates amounts to hatred of the old. More seriously, it probably indicates a dislike for increased earnings to owners of capital than increased costs for struggling wage slaves (you poor buggers!) trying to buy their first home.
So looking at those graphs cited in the hyperlink what has happened to interest rates over the recent past?
Real interest rates have moved steadily upward since 2003 but going back to 1989 the secular trend downwards has been very pronounced – the real cash rate now is
under 4% compared to 11% in 1989. But since the early 1990s real interest rates have barely fallen and it is wrong of JWH to suggest they have.
Nominal interest rate trends have followed real interest rates although these respective rates have moved together as inflation has fallen.
The yield curve is now essentially flat – long-term interest rates are similar to short-term interest rates. There is no risk premium for lending long.
Interest rates in Australia have been consistently higher than those in other countries such as the US though the differential has narrowed. Why? This is a major question that interests me. If capital flows are reasonably mobile internationally why should this be so? The Aussi dollar looks strong rather than weak so anticipated exchange rate devaluations cannot account for it.
Australian nominal housing interest rates now are about what they were in 1996 and in 2000. Life is still tough out there for homebuyers and interest rate costs on housing in Australia are not tax deductible.
Most small business interest rate contracts these days are variable not fixed rate contracts. Smart if you assume interest rates are likely to remain stable or to fall.
Corporate bond spreads – the differentials between corporate bond yields (generally riskier) and those on government debt have been pretty well trendless for almost two decades – and particularly since 2003. So there is no evidence of mounting risk premia. We are not showing evidence that corporate debt is becoming riskier.
I am not a macroeconomist so I welcome corrections and comments on these interpretations.