The Fugazi Rate

Real versus Nominal Interest Rates

“Yeah, fugazi, fogazi. It’s a wazi, it’s a woozi. It’s…fairy dust. It doesn’t exist, it’s never landed, it is no matter, it’s not on the elemental chart. It’s not **** real. Right?”

Matthew McConaughey, from The Wolf of Wall Street

As readers of this blog know, a couple weeks ago the Fed raised its target interest rate 0.25% and stated it would raise that target multiple times in 2022. Judging by the updated forecast the Fed released, that target interest rate—the Federal Funds Rate—will be 1.9 percent by the of 2022 and in a couple years, up to 2.8 percent. Here is a snippet of their published forecast:

However, as some astute macroeconomists have pointed out, such numbers are not real. Literally. 

As such—those astute observers claim—the Fed is kidding themselves and all of us, if they think hiking the rate from 0.25 to 1.9 percent is going to cool the wild rates of inflation we are experiencing. More on that claim in a bit.

First, why are these rates not “real”?

It is because those interest rates are “nominal” interest rates. A nominal interest rate is what is quoted in financial markets. If you go to bankrate.com, the rates you see there are nominal. The interest rate on your mortgage statement? Nominal. The interest rate on your savings account? Nominal.

The real interest rate is the interest rate that takes into account the rate of inflation. The real interest rate is the purchasing power on the money you are earning via that interest rate. The real interest rate can be written as follows:

How does this equation matter for your life? Let’s say you have a certificate of deposit (CD) that matures in one year, and your bank is paying you 3 percent on that CD (hard to find these days, but let’s pretend you could get that rate somewhere). If the rate of inflation over the course of that year is zero percent, then you earn 3 percent interest in terms of the purchasing power of those earnings. But, if the rate of inflation that year is equal to 3 percent, then your real rate is as follows:

That is, your earnings are zero. Your earnings are “fugazi.” Let’s say you initially put $100 into that CD. You do, in fact, walk away with $103 dollars at the end of the year. However, those $103 dollars now buy the same amount of stuff that $100 could have purchased a year ago. You are no better off having saved your money for a year.

What if, say, the rate of inflation averages 8 percent over that year? Your real rate is now,

Your savings has lost value over the course of the year. Yes, you will still walk away with $103 dollars—that extra $3 is what the nominal rate earns you—but those dollars have lost 8 percent of their purchasing power. You are worse off having saved your money for a year.  You can buy less stuff than you could have a year ago.

That is the importance of the distinction between the real interest rate and the nominal interest rate.

The linkages between the nominal interest rate, the real interest rate, and the rate of inflation have been discussed for decades. In textbooks you’ll find the relationship credited to Irving Fisher, an economist that ruled the intellectual landscape in the 1920s and 1930s (technically the expected rate of inflation matters for the linkages, but the equation above is sufficient to understand the importance of the issue).

What does this have to do with the Fed? According to the macroeconomists that I alluded to earlier, the Fed has apparently forgotten about the distinction.

For example, prominent economist Lawrence Summers has pointed this out recently. The gist of his argument is that the increase in the nominal interest rate that the Fed is planning for 2022 is not enough when you consider the real interest rate. What matters to our spending behavior, and our saving and/or investing behavior, is the real interest rate, not the nominal.

In the same forecast I link to above, the Fed is now forecasting the “core” rate of inflation to be 4.1 percent by the end of 2022. That implies the Fed is forecasting the following for the real interest rate:

Summers point is that a negative real interest rate isn’t going to slow down anything. This point has also been argued by another macroeconomist and prolific blogger, Scott Sumner. Sumner has been “shouting from the rooftops” on this point for weeks.

(Sumner’s blog is TheMoneyIllusion, and he has a recent book by the same name. I read the blog and have read the book. I recommend both to anyone that wants to get into the weeds of monetary economics and understanding the Fed. And, FYI, this is not some sort of sponsored endorsement; I do not know him, nor does he know me.)

The point is that in order to cool off the economy, we need the nominal interest to be higher than the rate of inflation. If that is the case, then the real interest rate will be positive. And, importantly, we need that real rate to be positive and increasing to slow down inflation. Unfortunately, given current rates of inflation, that is not what an increase in the nominal interest rate to 1.9 percent will give us. 

Again, the distinction between the nominal and the real rate has been well-known for a long time. A related concept is the “Taylor Rule,” which provides a prescription for what the real interest rate needs to be to slow down inflation. I’ll touch on that idea in a later post (here’s a basic description for anyone interested now).

One last aside before I end the post. One nice thing about inflation is that if you owe money, inflation erodes the value of your debt. For example, if you have a mortgage with a 4.0 percent fixed interest rate, and we finish 2022 with an average rate of inflation at 8 percent, the real interest rate you pay over 2022 is -4.0 percent. With a negative real rate of -4.0 percent your lender, in a sense, has paid you to borrow the money.

In general, inflation erodes away the value of your mortgage payments. In that sense, as a borrower you “win” from inflation since you get the money up front (to buy the house), yet the purchasing power of the money you pay back for the next 15 or 30 years becomes less and less in real terms. An important part of this is to have a fixed nominal rate on that debt. (And by the way, lenders are no dummies. If they think inflation will increase they raise their offered rates—that’s why mortgage interest rates were sky-high in the late-1970s and into the 1980s, and are ticking up now.)

One more last (unimportant) aside: technically the quote from The Wolf of Wall Street at the beginning of the post is about the stock market. But it’s such a great quote, I couldn’t resist using it for the ideas in this post.