Interest – Inflation = #REF

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.

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.

1979 Cutlass vs. 2014 Camry

1979 Cutlass vs. 2014 Camry - Click to enlarge

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.

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.

 

Keith Weiner is president of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of the precious metals fund manager Monetary Metals. He created DiamondWare, a technology company that he sold to Nortel Networks in 2008. He has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona. In March 2015 he moved his Gold Standard column from Forbes to SNBCHF.com.
See more for YPP interest rate

Permanent link to this article: https://snbchf.com/gold-standard/interest-inflation/

8 comments

6 pings

Skip to comment form

  1. Greg Jaxon

    Keith,
    The real rate of return is not a meaningless or mythical construct.
    Running the 11.23% interest+ 14% COL-inflator as an iteration, Clarence lives 9 years.
    Larry, at .03% and -.01% inflation lasts 29 years.
    Clarence needed $405,319 to last that long, which, oddly is an amount that (at the 1979 “real rate of 2.77%) throws off $11,233 of “real” income.

    What you say might better be stated along the lines you use in your conclusion:
    To live forever, Larry needs $116M, what does Clarence need?

    -g-

    1. Keith Weiner

      Greg,

      Thanks for your comment.

      I acknowledge the debasement of Clarence’s money. That’s a separate issue, and in any case the rate of debasement is not simply the rate of prices increasing.

      One could summarize the situation of Clarence is: his savings are decaying. Vs. Larry: his assets don’t produce, his farm cannot grow food so he must liquidate his farm in order to buy groceries.

      I am not saying that Clarence’s situation is good. I am saying that Larry’s is totally unappreciated.

  2. Dave

    The car photo in your article is a 1973 Oldsmobile Delta 88 Royale Convertible. I enjoyed reading your article keep up the good work.

    1. Keith Weiner

      Dave,

      Thanks for the correction.

  3. Jack

    Is it realistic to think that Clarence might have had $100,000 saved up in 1979? What was the average pension pot at that time?

  4. mark b

    wouldn’t higher wages for workers and dumping the Fed/crushing interest save our economy? If people had some extra cash in their pockets , my retail business would flourish.

    1. Keith Weiner

      Lowering interest rates presses both profits and wages downwards. I wrote this article, for more detail:
      https://monetary-metals.com/falling-interest-causes-falling-wages/

  5. Ralph Corsi

    Did you mean 0.3% as the rate for a 3 month CD rather than 0.03%? Rates of over 1% are possible today e.g. Everbank.

  1. Open Letter to Alexis Tsipras |

    […] article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog […]

  2. Yield Purchasing Power: $100M Today Matches $100K in 1979 |

    […] wrote a story about poor Clarence who retired in 1979, and even poorer Larry who retired last year. I created […]

  3. The Cotton Candy Market |

    […] article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog […]

  4. Will a GDP Futures Market Be Liquid? |

    […] article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog […]

  5. A Free Market in Interest Rates |

    […] article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog […]

  6. Falling Interest Causes Falling Profits |

    […] article is from Keith Weiner’s weekly column, called The Gold Standard, at the Swiss National Bank and Swiss Franc Blog […]

Leave a Reply

Your email address will not be published.

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>