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.

## 4 comments:

Harry, as you asked for comments and qualifications, here they are:

‘The expected interest rate is approximated in these calculations by some sort of measure of recent actual interest rates. 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’.

This is not quite right. You should make a distinction between the expected (ex-ante) real IR and the realized (ex-post) IR. Then if you want to calculate the former you use some measure of inflation expectations and the latter by using past inflation (ie this is not an approximation, just a different concept).

Also, you may want to include a risk premium in your Fisher equation. This is important in understanding the reduction in real IR over the past two decades: the leading views is that the risk premium has decreased due to the reduction in the volatility of virtually all macro variables (which is sometimes called the Great moderation).

‘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’

This is because we have been growing faster on average than other industrial countries. Real IR reflects the fundamentals. This is yet another reason why higher interest rates are not necessarily a bad news (in addition to the fact you mention that the net lenders are happy).

‘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’

You are missing the real growth of the house price – that should be correlated with economic growth and hence your real IR. So out of the 8+% IR you are really paying 3% ‘extra’, not 6%.

‘But since the early 1990s real interest rates have barely fallen and it is wrong of JWH to suggest they have’

He has not suggesting that at all. He was referring to nominal IR (and these have fallen as you mention). This is because in the 2004 campaign the claim that nominal IR would be higher under Labour was based on the assumption that either inflation would be higher (if the RBA monetized the deficit they implied Labour would run) or the risk premium would go up (higher risk of default due to real debt accumulation if the RBA did not monetize).

Jan, In para 2 'interest rate' should be 'inflation rate'. It was a typo now corrected.

Real interest rates have barely fallen since the early 1990s.

I didn't follow your 'real growth of the house price' argument. If prices of all goods (including house assets) are rising by 3% then that can be deduced from your cost of borrowing.

If other capital gains are being enjoyed on housing - because housing is getting relatively more expensive - then costs of borrowing are lower still. But this has nothing to real with the real/nominal dictotomy - it has to do with luck in securing good capital gains.

James Farrell's point is that JWH has exaggerated the extent to which borrowing costs have fallen. On this I think he is right.

Harry,

The difference between a real IR of 4% (say the 80s) and 3% (say now) may be small in absolute terms but substantial in relative terms.

Furthermore, as I explained you need to see the real IR in the context of the economy's growth: 4% with 1.5% GDP growth is very different to 4% (let alone 3%) with a 3% growth.

That point about hous prices was just a minor one: if you think of a house as investment (capital good rather than consumption good which is arguably appropriate in Australia) then its price is expected to rise, ON AVERAGE, as other financial assets, ie by inflation (your 3%) PLUS economic growth (say 3% which you did not factor in). This is on average, ie without any capital gains (or losses) that may occur. And hence as you say 'then costs of borrowing are lower still'.

Not many people know the difference between nominal interest rate and real interest rate, so this kind of posts can only be helpful for citizens.

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