A Flawed View

I have to admit that I derive some pleasure in taking on hoary old myths. For example, some economists assert that the interest rate you see on the Treasury bond is not real. You see, it’s only nominal. To calculate the real rate, they say you must adjust the nominal rate by inflation.

Real Interest Rate = Nominal Interest – Inflation

It seems to make sense. Suppose you have enough cash to feed your family for 2,000 days. Then the general price level increases by 15%. You still have the same dollars, but now you can only buy groceries for 1,700 days. You’ve been robbed, some of your purchasing power stolen. Therefore you want to earn enough interest to overcome this loss. This view is flawed.

 

interest-rate-manImage via stealthflation.org

 

Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.

Now, let’s examine this idea of correcting the interest rate using the Consumer Price Index, or CPI. We’ll skip over the problems in trying to measure prices, and avoid the controversy over whether CPI does a good job. We’ll just compare two retirees from two different eras.

Clarence was retired way back in 1979. Suppose he had $100,000 saved up. According to the St. Louis Fed, the CPI was 68.5 on January 1, 1979 and it rose to 78.0 one year later. This means prices rose by about 14%—what most people call inflation. Also according to the St. Louis Fed, a 3-month certificate of deposit offered 11.23%. There are many interest rates, but let’s use this one for simplicity.

The popular view focuses on his lost purchasing power. He begins the year with $100,000. That amount could buy some meat and potatoes. Clarence ends the year with $111,230 in principal + interest. Liquidating that larger amount buys less hamburger and fewer fries at the higher prices at the end of the year. Therefore Clarence had a loss, and the loss is interest – CPI, or 2.77% of $100,000, which $2,770.

I suggest another view. The interest afforded Clarence $11,230 worth of food. According to the U.S. Census Bureau, the median income in 1979 was $16,841. Clarence made 2/3 of his former income. That’s about right for a retiree without a mortgage or commuting expenses. He could eat pretty well. Although the falling dollar did erode his wealth, we’re focusing on how Clarence experiences interest in the real world.

 

coverdale 1975-bDeep Purple lead singer David Coverdale in 1975. Had he taken the money he made from the DP albums he was part of from 1973-1975 (with credits for co-writing most songs) and bought US treasury bonds in 1979, he could have done more than just eat well with his interest income.

Photo via taringa.net

 

Poor Larry, the Rich Man

Now, consider Larry, a recent retiree. Larry has $1,000,000 in savings. CPI actually fell over the past year. Interest on a 3-month CD is negligible—0.03%. Again, we’re not focused on whether CPI is accurate. Just grant for the sake of argument, that some prices dropped and this was matched by a rise in others.

In the standard view Larry appears to be better off than ol’ Clarence. Larry lost no purchasing power, unlike Clarence’s loss of almost 3%. This is deceptive and misleading.

The stark reality is that Larry earns a scant $300 in interest. He can’t afford groceries on this paltry sum, so he is spending down his savings. The median income was $52,250 in 2013 (the latest year available). To earn 2/3 of that—and match Clarence—poor Larry would need over $116 million.

The notion of nominal interest paints a misleading picture of Clarence losing purchasing power and Larry keeping even. If you look at what they can buy with the interest on their savings—Yield purchasing power—you see that Clarence was living well while Larry is quickly spending down his life’s savings.

 

100-41010 year treasury note yield, 1962 to today – at the peak, the market attempted to discount an even bigger rise in CPI, which was a miscalculation in this case (traders should have watched money supply data more closely) – via StockCharts, click to enlarge.

 

This article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.

 

Image captions by PT

 

 

 

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One Response to “Interest – Inflation = #REF”

  • HardMoney:

    Keith,

    Clarence is able to make ends meet since he is consuming capital – which may be ok given his life expectancy and other goals.

    Larry is free to do the same – it is just that in his case you cannot disguise this with inflation (of the price variety).

    Or as conventional thinking would have it – Clarence is earning a negative real rate and eating into his savings. Larry is too ‘dumb’ to figure out he can do the same by reducing his nominal savings.

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