Learn with ETMarkets: Why real interest rates are crucial


The Reserve Bank of India has said it will aim at a real interest rate of 125 basis points in the next few years, instead of the earlier projection of 50 to 200 basis points, in line with the global rates. A basis point is a hundredth of a percentage point. ET explains the concept and relevance of real interest rates.

1. What is real interest rate?

It is the interest rate that an individual gets after adjusting the retail inflation. Simply put, it is determined after de ducting the rate of inflation from the rate you receive from government saving schemes.

2. How is it calculated?

In India, it is de rived by deducting inflation from one-year government Treasury bill, a sovereign security that currently offers 6.58% interest. But some people have a different view on what the benchmark should be. They say it could either be the repo or policy rate, now at 6.25%, or the one-year bank fixed deposit rate, which is close to 7%, or the base rate against which banks lend to their customers, which is currently a little over 9% .Globally too, the benchmarks vary .
3. Why is RBI talking of revising the ideal real rate?

Higher deposit or savings rates do not serve any purpose if inflation or higher prices eat into your savings. The central bank feels that the depositor should earn a reasonable inflation adjusted return. But around the time when the RBI started mulling adopting a formal monetary policy target in 2013, the then Governor Raghuram Rajan suggested 50-200 basis points or 0.5to 2% as real interestrate target. But the new Governor Urjit Patel, in his first media briefing after he took charge in September, lowered it to 125 basis points. This is supposed to be in alignment with the rate movements globally . More than $12 trillion worth of bonds are yielding less than zero, a sign of historically benign interest rates.

4. Why has this led to a public discussion on real interest rate?

High rate of inflation will help you earn higher interest rates.

For example, between 2012 and 2014, the average inflation was 8.22%, turning the real interest rate negative for most interest earnings for savers.Most people get carried away by nominal rates even if real rates are negative.They tend to save less when interest rates are lowered on account of slowdown in inflation even if if real rates are negative.They tend to save less when interest rates are lowered on account of slowdown in inflation even if real rates are high. This needed to be clarified, so that there is a general understanding that real rates matter more than nominal rates.
5. What does a narrowing real interest rate signify?

It essentially reflects the change in the balance of supply and demand in the global savings pool.The supply of savings has increased as central banks have had easy money policies while demand has not picked up at same pace. Short-term nominal interest rates are stuck at zero, or a little below zero.

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