Real Interest Rates, and Why Traders Watch Them

A real interest rate is a nominal interest rate adjusted for inflation. The nominal rate is the quoted one. The real rate is what that return is worth in goods and services once rising prices have taken their share.

It is the more honest of the two numbers. A saver earning a nominal rate below inflation is getting poorer in the terms that matter, even while the account balance goes up.

The approximation and the exact formula

The quick version is subtraction. Real rate is about equal to the nominal rate minus inflation.

The exact version divides. If n is the nominal rate and i is inflation, both as decimals, the real rate is (1 + n) / (1 + i) - 1.

At low rates the two methods land close together. As rates and inflation climb, the gap grows, which is why the subtraction is fine for a rough sense and the division is what to use when the figures are large or you are comparing results carefully.

Expected versus realized

There are two kinds of real rate, and they answer different questions.

A realized real rate looks back. You take the nominal return you actually earned over a period and adjust it for the inflation that actually happened. That tells you what your cash or bonds did for your purchasing power.

An expected real rate looks forward. It uses the inflation people anticipate over the life of the investment, and that is the one that affects decisions today, because anyone lending money, buying a bond or valuing a company has to guess what inflation will be before it happens, and the guess is what goes into the price.

The two can differ a lot. Inflation that turns out higher than expected hurts lenders and holders of fixed-rate bonds. It helps borrowers. Nobody knows the future figure in advance.

Why traders watch real rates

Cash and bonds compete with stocks for your money.

When the real return on safe assets is low or negative, holding cash costs you purchasing power, and the case for owning riskier assets looks stronger by comparison. When real returns on cash and high-quality bonds rise, investors can earn something after inflation without owning stocks at all, and stocks have to offer more to attract money.

Real rates also feed into valuation. A company’s worth rests on profits expected years from now, and the rate used to bring those future profits back to today includes a real component, so a change in real rates can change what investors will pay for the same forecast of earnings. This is qualitative. How much any stock responds depends on far more than one rate.

For your own account, the same idea applies to a margin loan, where the cost you pay is the interest rate itself, covered in how a rate change shows up in your margin interest.

Where to see a market measure

Treasury inflation-protected securities, or TIPS, are US government bonds whose principal adjusts with an official inflation index. Their yield is quoted in real terms. That makes it one market measure of real rates. Comparing it with the yield on an ordinary Treasury of similar maturity gives a rough market reading of expected inflation, often called the breakeven rate. That reading also reflects other factors, including how easily each bond trades, so treat it as a gauge.

Checking your own cash

The realized version is easy to run on your own account. Say the cash in your account earned a hypothetical 4% over a year while the price index you follow rose a hypothetical 3%. The exact real return is 1.04 / 1.03 - 1, about 0.97%. Small, but positive. Had the index risen 5%, the same cash would have lost ground: 1.04 / 1.05 - 1 is about -0.95%. Run it once a year. Use the actual rate your broker paid, from your statements.

Central bank policy moves nominal rates directly and real rates through expectations, which is why the language of policy statements matters so much; see hawkish and dovish explained. For the effect on your returns, how inflation eats trading returns works through the arithmetic for a trading account.