What Are “Real” Interest Rates and Why Do They Matter?

The real interest rate is the amount of interest you earn or pay adjusted for inflation.

By factoring out the impacts of inflation the real interest rate reflects the "real" cost of funds borrowed and yields earned.

In other words, the real interest rate reflects the change in actual purchasing power gained by an investor or given up by a borrower.

Real interest rates equal the nominal rate (the numbers quoted on the news) minus CPI.

As an example, consider a 10-year Treasury bond. Let's say the nominal yield is 3%. If the CPI is 2%, the real interest rate is 1%  (3-2=1). When adjusted for inflation, you are actually earning or paying 1%, not the 3% inferred from the nominal rate.

When CPI is high, it is possible to lose purchasing power even though your are earning interest. For example, let's say our 10-year Treasury bond has a 3% yield but the CPI is 5%. Your real interest rate is -2% (3-5=-2).

As you can see, it's important to consider real interest rates when making investing decision.

For example, whenever interest rates tick up slightly, the mainstream is quick to inform us that “rising interest rates increase the opportunity cost of holding gold.”

So, what exactly is the mainstream thinking here?

Holding gold does not generate interest income like a bond or a bank account. If interest rates rise and you’re holding gold, you’re forgoing the interest income you could earn if you instead owned a bond or put dollars in a money market account. That’s why rising interest rates tend to create headwinds for gold. People sell thinking that they will lose potential income holding gold.

But you can't just look at rising nominal rates and conclude it's time to sell gold. It is quite possible for nominal rates to rise while the real rate remains negative.

For example, if interest rates rise from 2% to 4% and the CPI holds steady at 8%, that means the real interest rate rose from -6% to -4%. Inevitably, some people will sell gold claiming "rates are rising!"

But to state the obvious, there is no “opportunity cost” in holding gold when real rates are still deeply negative -- even if nominal rates are rising. You are losing real money holding bonds that aren’t yielding enough interest income to keep up with inflation.

When making borrowing or investing decisions, it's imperative to keep real interest rates in mind.