Real interest rate

What it means

The real interest rate is the nominal interest rate minus inflation. It shows whether money on deposit is really growing or losing purchasing power. If the bank pays 3 % and inflation is 5 %, the real return is roughly minus 2 % and the saver is in fact getting poorer.

For borrowers it is the opposite: with a negative real rate, debt shrinks in real terms because it is repaid with money worth less than when it was borrowed. Periods of high inflation and low rates therefore favour borrowers and penalise savers.

There is an ex ante real rate, calculated from expected inflation, and an ex post rate based on actual inflation. For decisions on loans or investments, expected inflation is what matters, though it is always uncertain.

How it works in practice

When comparing investments, it pays to think in real terms. A term deposit paying below inflation protects the nominal amount but not the value of the money. A company with a long-term cash reserve should decide how much must be instantly available and how much can be invested for a higher return.

In long-term contracts such as leases or supply agreements, inflation risk is handled through price indexation. With fixed-rate loans the borrower bears the risk of inflation falling; with floating rates, the risk of it rising, which shows up as higher repayments.

Real rates also influence company valuations and investment decisions. When real rates are low, long-payback investments look more attractive; when they are high, companies become more cautious and favour projects with quick returns.

What to watch out for

Simple subtraction is only an approximation. The exact formula divides nominal growth by price growth, and at high inflation the results differ noticeably. At normal levels the approximation is good enough.

Official inflation is an economy-wide average and may not match a particular company's costs. For a business, inflation in its own inputs, such as energy, wages or materials, may matter more and can differ significantly from the headline figure.