Reading Interest Rates: The Hidden Economic Reality Investors Often Miss

To understand an economy, one of the crucial factors to consider is the impact interest rates have on the economy—specifically, the underlying financial conditions. Many investors mistakenly focus solely on nominal interest rates, missing the critical insights provided by real rates—leading them into riskier investments.

Short-term versus Long-term Rates

To avoid falling into this trap, it is important to know there are two main sources of interest rates that can be interpreted. These are usually split into short term and long term rates.

In most cases in the US, when people refer to interest rates, they mean the United States Federal Reserve rate, which is set by the Federal Open Market Committee. By setting the Federal Funds Rate, the Fed seeks to influence short term interest rates and, by extension, financial conditions.

On the long end, interest rates are typically set by the bond market. If there is an over-issuance of bonds (either by government or corporations), the yield (rate) tends to increase as more funding is being demanded.

There is an inverse relationship between the price of bonds and the yield. As the price (or value) of the bond decreases, the yield increases—and vice versa.

The Fed can also indirectly suppress long term rates by buying all manner of bonds. The Fed is the largest buyer, and continual quantitative easing keeps bond prices high and yields (i.e., interest rates) low.

Therefore, it is important to combine a review of both central bank rates and the current bond yields in the market. These yields are also usually seen as the "risk-free" rate.

‘In nominal only’

As mentioned, when quoting the "interest rate," people generally refer to the Fed’s rate, which as of March 2025 is 4.25% to 4.50%. However, these are just nominal (or headline) rates. To truly understand the economic (or real) rate, we need to adjust for the rate of inflation.

For example, if we deposit $100,000 at the Fed, our return after twelve months would equate to $4,500. However, when inflation is present, we need to adjust for the change in purchasing power of that money. Essentially, we cannot purchase the same amount of goods and services at the end of twelve months due to the impact of price rises.

To take it a step further, assume inflation is 2.00%.

Using the following formula, we can calculate our real interest rate: Real interest rate = nominal interest rate – rate of inflation Real Interest Rate = 4.50% − 2.00% = 2.50%

Our real economic return using the above example would equate to $2,500 and not the headline $4,500.

The lower real rate compared to the nominal rate reflects the reduction in purchasing power over the course of the saving period.

What this means

The real interest rate is a critical figure because it reflects the actual return or purchasing power gained or lost by investors and savers. When inflation rises significantly, nominal returns can be misleading, creating the illusion of high returns that do not translate into increased buying power.

Understanding this difference is essential for investors and savers to make informed decisions, accounting for the erosion in purchasing power caused by inflation. It can also significantly adjust the risk-return equation undertaken by investors. Real rates are implicitly factored into the cost of capital.

Real Savings

Now that we know what the real interest rate is, we can assess how it determines and incentivises how the market—ultimately people and businesses—approach their saving decisions. The higher the real interest rate, the more likely people are to save as their principal generates a greater real reward.

Carrying our example forward, what would happen if the Fed Funds rate was 9.50% and inflation was 1.25%? In this case, our real rate and return would be 8.25% and $8,250 respectively. In this environment, far more people are likely to save than to consume.

The higher return or “reward,” the more likely one is to save as the opportunity cost of consumption is high. If real interest rates are too low, it disincentivises savings as there is little opportunity cost.

In short, nominal interest rates do not tell the whole story of financial conditions. Real rates guide investors in assessing the economic returns from an investment—or indeed consumers deciding to save.

Why Real Interest Rates Matter Today

Understanding these concepts allows us to assess financial conditions today. In today’s world, we are in a position where inflation is far greater than any nominal rate (both short and long term), which not only disincentivises savings but promotes borrowing, leading to unsustainable debt levels.

It also shows that holding instruments like bonds is a guaranteed way to lose capital, as the nominal interest rate will never be sufficient to compensate for the erosion in purchasing power.

This also goes some way to explaining why central bankers always say inflation is transitory or temporary—admitting anything else would result in a bond market crisis (which will come anyway once the whole market realises inflation is not going anywhere).

Therefore, understanding real rates is important for reading financial conditions and for assessing what type of investment will do well in the future. When real interest rates are negative, you want to be out of bonds and into things that the government can’t print (commodities, land, unencumbered real estate).

Key Takeaways

What:

Real interest rates, not nominal rates, accurately reflect how expensive or cheap borrowing and investing actually are.

Why: Nominal interest rates fail to account for inflation, thus overstating actual returns and misleading investors about true financial conditions.

What’s Next: Investors should regularly monitor real interest rates to identify negative real-rate environments, guiding them toward inflation-protective investments and better-informed financial decisions.