But there is little to be gained by comparing interest, which naturally delivers future returns, and inflation measurements, which are backward-looking and reflect the rise in the consumer price index over the previous twelve months. For savers and investors, the primary concern is whether interest rates keep pace with the rise in the price level over the term of their investment. By the same token, the real cost of borrowing depends on whether interest expense is greater or less than the rise in the price level over the loan term.
This difference becomes particularly clear when the outlook is for a relatively rapid decline in inflation, as is generally expected now according to most expectations metrics, the breakeven inflation rate in the bond market, and inflation forecasts.
Here is an example. We forecast that the nominal policy rate will be 6% until mid-2023 and then be lowered to 5.5% by end-2023. According to this forecast, the policy rate will average 5.8% over the next twelve months, with returns right around 6% after factoring in compound interest. For 2023, we forecast inflation over the year – i.e., twelve-month inflation in December 2023 – at 4.8%. By that measure, the real policy rate will be just over 1%.
Indexed interest rates on the rise
The real rate that matters for households, businesses, and the public sector is almost always the fixed indexed rate over a term of several years, whether applied to financing costs or returns on savings. This rate has developed broadly in line with the real policy rate. For example, indexed Treasury bond yields fell to a trough in late summer 2020, actually turning negative for some bond series. They have risen markedly since this past spring, however, and are now around 1.9%. Indexed base interest rates by this measure are roughly at the mid-2018 level.