Nominal Versus Real Interest Rates
To fully understand how inflation can be a savers worst enemy, we need to first discuss the differences between “nominal” and “real” interest rates. Before we do that though, let me quickly remind everyone what “inflation” actual is.
Inflation is the rate at which the prices of goods and services in the economy are rising, which reduces the purchasing power (what you can actually buy with a dollar) of local currency. If we say the inflation rate in the United States is 2% this year, that means the general price of goods and services in the U.S has increased by 2%. Or looking at it the other way, the purchasing power of a U.S dollar to buy local goods has decreased by 2%.
The Fisher Equation
OK, now that we are all on the same page of what we mean by inflation, let's discuss how that impacts your savings. The economist, Irving Fisher summarized the impact of inflation on savings in the simplest terms which has been since called the “Fisher Equation”.
i = r + π
i= nominal interest rate
r= real savings rate
At face value, this does not seem to help us understand very much at all. The nominal interest rate is equal to the “real” interest rate plus inflation? If there is a real interest rate, does that mean there is a “fake” interest rate? Kinda!
The nominal interest rate is the interest rate that is posted on your savings account. If the bank advertises that their savings account provides 2% interest, the nominal rate is 2%. Fisher pointed out that the real interest rate is actually equal to the nominal interest rate minus inflation.
r = i — π
The fisher equation for “real” interest tells us what the new purchasing power of your savings are after taking interest and inflation into account. To illustrate, let's say that you have $10,000 saved in an account earning 1% interest and that inflation in the economy was 2%. What would the “real” value of your savings be after 1 year?
First, we need to calculate the “real” interest your money is earning in that savings account.
Real interest= 1% minus 2%
Real Interest = negative 1%
$10,000 + ($10,000 x-1%)= $9,900
Since inflation was greater than the interest you received on your savings, you actually had a negative return when put in “real” terms. Inflation has eaten away at your purchasing power at a faster rate than the interest you earned on your savings.
Does that mean you are better off NOT saving? Of course not! Even a 1% interest is better than 0% interest. Even if you are losing 1% a year in “real” interest, the rule of 72 tells us that it would take a VERY long time to have the purchasing power of your savings cut in half.
If inflation were to reach 10%-20% per year, you can imagine what that would do to peoples savings. That is why in many advanced economies around the world, central banks have focused on keeping inflation low (usually below 3%).
Bonus: Need support to start taking action on your finances? Join the 30-day money challenge where you will be given a new action item to take every day for 30 days. You also get access to the private Facebook group of people who are in the same boat as you.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions