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Real Versus Nominal Interest Rates

February 1, 2023 | Commentary

  • The resurgence of inflation above 4% in 2021 has once again brought attention to the concept of real interest rates, the rate of return after adjusting for the purchasing power of money.  While inflation was running below the Federal Reserve’s target of 2%, real rates were easy to ignore.
  • T-bills are generally considered the safest asset available to U.S. investors.  Since 1960, the real 3-month T-bill rate has averaged about 0.6% per year.  That average includes over a decade since the Great Financial Crisis when T-bills earned almost nothing on a nominal basis and were negative after inflation.
  • With the Federal Reserve focused on higher policy rates to control inflation, T-bills are now earning more than 4.5% nominally, but are still lagging current inflation.  If the Fed is successful in bringing inflation back toward its target, and they do not go back to a zero interest rate policy, real interest rates will likely rise toward historical averages and stay there.
  • Expected returns on all other risk assets like investment grade and high yield bonds, equities and real estate typically have a meaningful premium above the risk-free rate.  As that rate stays in positive territory on a real basis the likelihood of a diversified portfolio beating inflation through time improves.

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