Calculating Real Interest Rates

One of the reasons analysts have been quoting as being behind BNM’s increase of the OPR last month was negative real interest rates.

What is that? Essentially, it’s the rate of interest on any particular deposit or debt instrument, less then rate of inflation.

The intuition behind this simple: what you’re trying to get at is a measure of the real purchasing power behind a deposit or investment. If you have a positive real interest rate, you can buy more goods and services when the deposit is withdrawn or the debt matures than you did at the start. If you have negative real interest rates, you can get less. A negative real interest rates means that you could be gaining more money, but the amount of goods and services you can buy could be less than when you started.

That has obvious implications for the way people behave when saving and investing. A higher positive return prompts people to save and invest more, while a negative rate of return results in the opposite. A negative real interest rate also means that borrowing is effectively costless, since you’re borrowing in today’s money, but paying back tomorrow with money that has less purchasing power, even after taking into account interest costs.

So for over much of the past year, Malaysia has been experiencing negative real interest rates, because of the reductions in subsidies and hikes in electricity tariffs and duties on alcohol and tobacco. Therefore, the narrative goes, BNM has had to raise interest rates to provide an incentive for people to save and to reduce the risks of people and companies from over-borrowing.

But this narrative is based on a false premise – that the CPI, or more precisely the annual percentage change in the CPI, accurately reflects the loss of purchasing power over time and at all times. This is simply not true. The idea is accurate when year-on-year CPI inflation represents continuous price changes; but not when it comes from discontinuous, one-time price shocks.

I’ve touched on this problem before, but I’d thought I’d better go over it again, and in a lot more detail.

Best way to see this issue is with an example (all numbers are illustrative, not real). Let’s say I’m a saver/investor, who wants to sock away RM10,000 for a month. The prevailing interest rate is 3.0% and the prevailing rate of inflation is 2.5%. In monthly terms, this amounts to 0.25% in interest earnings and 0.2% in inflation. I’m totally ignoring here transaction costs and the way banks actually calculate interest, because neither really changes anything material but mainly because I’m too lazy to look it up.

In this example, assuming both the interest rate and inflation rates are stable, my nominal rate of return for those three months is about RM25 (10000 x 0.0025), give or take a few sen. The loss of purchasing power I suffer is RM20 (10000 x 0.002). So I get a net return of RM5 in real terms i.e. I could have purchased the equivalent of RM5 more in terms of goods and services in terms of the same purchasing power my money had at the beginning of the month.

Now let’s assume that there’s a one off increase in the price level (subsidy reduction, tariff increase whatever), such that the calculated annual inflation rate increases to 3.5% (or 0.287% a month), but there are no other changes to the underlying rate of inflation or the prevailing rate of interest.

Now my nominal rate of return remains the same (RM25), but my loss of purchasing power over the same period is RM28.7 (10000 x 0.00287). I’ve now suffered a real loss of RM3.7. In other words, I’m actually worse off then when I started, and would probably go around muttering about greedy blood-sucking banks and uncaring politicians.

That’s the kind of impact that economists and analysts are thinking about when they talk about negative real interest rates.

But wait, there’s more.

Let’s say I put in a deposit in the month after the change in the price level. At this point, both my nominal rate of return and my loss of purchasing power are exactly the same as in the month before the price hikes i.e. a positive real rate of return. This is despite the annual rate of inflation remaining at elevated levels due to the base effect (see here and here). The only period where I’d suffer a negative return would be during the month when those extra price increases occurred.

More generally, you’d only suffer a negative real rate of return if the span of your deposit or investment overlaps that of the period when the price adjustments happened, and only for the returns you gain during that particular month. Outside that period, you’d still be earning positive rates of return.

That’s the situation we have in Malaysia today – all those subsidy cuts, tariff and duty increases that took place from Sept-13 to Jan-14 were really successive one time increases in the price level. We’ve already had nearly half a year of CPI data to look at since then, and without the impetus of these administrative changes, monthly changes in the CPI have reverted back to their “normal” levels. Put plainly, the real interest rate is and has been positive for some time, even without BNM raising the OPR:

Now if there was a shift in the monthly changes in the CPI, for example a permanent increase in monthly CPI growth beyond the equivalent monthly interest rate, then negative interest rates would indeed apply. You’d be continuously losing money under those circumstances, and there would be a strong incentive to start hunting for better returns – or start borrowing a lot more.

But that’s simply not the case right now. While all these one-time changes in the price level have certainly reduced the purchasing power of the Ringgit relative to last year, they have not changed the real rate of return on deposits or bonds or anything else.