Tuesday, November 08, 2005

Negative Real Interest Rates--A Sign of the Inflationary Times

Can you identify with my dilemma? I was tired of my bank accounts paying as little as 0.75 percent interest. What to do? Hit the Internet, of course, and search for a safe alternative that offered a more appealing interest rate.

The real interest rate is computed as: nominal interest rate minus inflation rate. With inflation recently running at about 5 percent as measured by the CPI, and the nominal rates (the rates as stated by the bank) on my accounts at about one percent on average, then the real interest rate I've been receiving has been about minus 4 percent.

Inflation is like a thief, robbing a person's savings of its purchasing power. How to foil the thief was the question to which I needed a solution.

After looking high and low at various mutual funds and other alternatives, I found the Series I savings bond page on the Internet. These bonds absolutely guarantee the purchaser that the real rate of interest will be positive (although modestly so). How can that guarantee be made? The government adjusts the nominal interest rate on the series I bonds by adding the inflation rate over the last six months to a modest real interest rate. From November 1, 2005 until April 1, 2006 the I bonds will pay 6.73 percent interest. I couldn't find a secure investment with a better return.

The interest rate will be reset next April 1. If the inflation rate is lower, then the interest on my bonds will be lower. If the inflation rate is higher, then the interest rate on my bonds will be higher. I wish I could lock in the 6.73 interest rate for several years, but that's not the way these bonds work.

I bonds are an example of indexing for inflation. The U.S. Treasury also offers individuals another indexed bond called TIPS (Treasury Inflation Protected Security). You can read about the differences between TIPs bonds and I bonds on the TreasuryDirect web page. In a nutshell, the TIPS is a marketable bond whose price might be higher or lower than the price you paid for it when you bought it. That price will be higher if interest rates turn lower in the future, but will be lower if interest rates go higher. Changes in the price of the bond compensate bond purchasers for changes in interest rates. There are also differences in the tax treatment of interest earnings between TIPs bonds and I bonds that made the I bonds more attractive to me.

Bottom line question: How much longer will banks get away with paying negative real interest rates to savers?



At 7:50 PM, Blogger Nochman said...

Interesting. I'd like to know if the "modest real interest rate" (that is added to the inflation rate) is constant or not?


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