Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 27

Nominal and real interest rates matter in different ways

Interest rates can be viewed in either of two ways: in nominal or real terms.

It’s the nominal interest rates (or nominal yields) paid on deposits and bonds that determine the cash returns investors receive from their interest-bearing investments. And it’s nominal interest rates that determine how much borrowers pay on their debts.  Current examples of nominal rates in Australia include 3.9% on a two year term deposit and 3.6% on a ten year government bond.

Nominal interest rates are important for another reason: changes in them are the main influence on the market prices of bonds (bond prices move inversely with nominal yields) and other financial assets traded on financial markets.

Real interest rates (or real yields) are nominal rates adjusted for inflation. A real interest rate is usually calculated by taking the relevant nominal interest rate and deducting the inflation rate recorded over the preceding 12 months.

An alternative is to calculate an expected real interest rate – by taking the relevant nominal interest rate and subtracting the expected rate of inflation. The problem is we don’t have good measures of expected inflation.

Think in real terms

Real interest rates are important. They measure the percentage return from an investment in terms of what it does to the purchasing power of the investor – and they also show how the percentage cost of paying interest on a loan in terms of the purchasing power of the borrower.

Real interest rates are also a useful guide to whether monetary policy is easy or tight. For example, low (or negative) real interest rates suggest that monetary policy is accommodative or stimulatory; high real interest rates suggest that monetary policy is tight.

The chart shows the history of two important real interest rates in Australia, those on three month bank bills and ten year government bonds. These real rates, which fluctuate widely over time, are affected by moves in nominal interest rates and by inflation. Real interest rates have generally been high when inflation was falling (1920s, 1930s and 1990s) and low or negative when inflation was rising (early 1950s, 1970s).

Since 1990, Australian real rates have trended markedly lower – that’s because nominal interest rates have declined by more than inflation. Some real interest rates have fallen from over 8% – how good was that for savers but how tough on borrowers! - to less than 1.5%.

Around the world, real interest rates are now unusually low or even negative. That’s the aim of the policies of the major central banks, with the exception of China. The US central bank has kept its nominal cash rate close to zero for almost five years and frequently reiterated its ‘forward guidance’ that it will maintain the ultra-low cash rate ‘for an extended period’; it’s been buying US bonds at the rate of US$1 trillion a year and expects to ‘taper’ that programme only as the economy gains strength; and via ‘operation twist’, it is lowering long-term real yields by purchasing long-dated bonds and selling bonds with shorter-dated maturities.

My guess is that the central banks of the US, Japan and Europe will continue to maintain real yields at quite low levels - often accepting negative ones - as they try to nurture their economic recoveries.  (Yes, even Europe now has some ‘green shoots’ of recovery).

Hunt for real yield a preoccupation

This means the hunt for real yield that’s become a preoccupation of investors both here and abroad is likely to remain a dominant feature of investment markets for several years at least.

People with savings will need to continue to seek out the higher real yields that quality corporate bonds can offer relative to the low real yields available on government bonds.   Savers should also be prepared to ‘shop around’ for the best deals on term deposits and at-call deposits to ensure they are getting the best possible real returns on these assets.  And shares paying good and growing dividends – especially those carrying franking credits – will have enhanced appeal to investors keen to earn an attractive rate of real returns.

Anyone thinking about what might happen to real interest rates over the medium-term and beyond may have to allow for what might be another powerful influence keeping real interest rates at low and at times negative levels.

Governments and central banks in debt-laden countries seem likely to be more tolerant of inflation than they’ve been in recent decades. As Pictet Asset Management observed recently,

“Policy makers in advanced countries are not the strict disciplinarians they once were … Higher inflation and negative real interest rates present heavily-indebted countries with a less disruptive way to reduce the real value of government debt compared with alternatives such as sovereign default or deep spending cuts.”

In the early years after the Second World War and again in the 1970s, governments of many industrialised countries, including Australia, tolerated inflation and negative real interest rates to reduce the huge increase in the real value of the government debt they’d issued and the interest costs of servicing those swollen borrowings. Investors holding deposits and bonds suffered badly, as the graph reminds us.

Recently, Japan has adopted a policy of ‘let’s have inflation’. If the US and Europe, both of which also have much-increased levels of public debt, follow this lead, investors around the world might have to cope with rising inflation and low or negative real interest rates in the medium term. That would be a worry for investors – particularly self-funded retirees.

 

Don Stammer is former Director, Investment Strategy at Deutsche Bank Australia and is currently an adviser to the Third Link Growth Fund, Altius Asset Management and Philo Capital. The views expressed are his alone.

 


 

Leave a Comment:

RELATED ARTICLES

Residential investment property fails simple valuation test

The potential and perils of increasing franking credits

The pros and cons of short-term versus long-term investing

banner

Most viewed in recent weeks

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Latest Updates

Investment strategies

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Investment strategies

Don't let Trump derail your wealth creation plans

If you want to build wealth over the long-term, trying to guess the stock market's next move is generally a bad idea. In a month where this might be more tempting than ever, here is what you should focus on instead.

Economics

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Investment strategies

Will China's EV boom end in tears?

China's EV dominance is reshaping global auto markets - but with soaring tariffs, overcapacity, and rising scrutiny, the industry’s meteoric rise may face a turbulent road ahead. Can China maintain its lead - or will it stall?

Investment strategies

REITs: a haven in a Trumpian world?

Equity markets have been lashed by Trump's tariff policies, yet REITs have outperformed. Not only are they largely unaffected by tariffs, but they offer a unique combination of growth, sound fundamentals, and value.

Shares

Why Europe is back on the global investor map

European equities are surging ahead of the U.S this year, driven by strong earnings, undervaluation, and fiscal stimulus. With quality founder-led firms and a strengthening Euro, Europe may be the next global investment hotspot.

Chalmers' disingenuous budget claims

The Treasurer often touts a $207 billion improvement in Australia's financial position. A deeper look at the numbers reveals something less impressive, caused far more by commodity price surprises than policy.

Fixed interest

Duration: Friend or foe in a defensive allocation?

Duration is back. After years in the doghouse, shifting markets and higher yields are restoring its role as a reliable diversifier and income source - offering defensive strength in today’s uncertain environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.