Everything, they say, has its price. Well perhaps not family, love or friendship but certainly most things do! And it turns out that even money itself has a price – and we refer to that price as the “interest rate.” Interest rates gauge the level of our “interest” in obtaining (or lending) money. When money is in high demand, as when borrowers really want to take out new loans, interest rates tend to rise, making the “price” of money that much higher. In contrast, when money is plentiful, or demand for new loans falls, interest rates tend to decline, reflecting our diminished demand for money.
When most people think about interest rates, they usually consider the low rates they’re currently getting on their bank CD’s, or perhaps where mortgage rates are or maybe the current yield on their bond portfolio. And those all definitely fit the definition of an interest rate. But even though they are all expressed as a single number, did you know that they are actually comprised of four separate components?
- The “real” rate of interest. This is your return after inflation is subtracted out. For example, if you buy a one year CD from your bank yielding 2.5%, and inflation runs at 2% over the course of that year, your “real” return or “real” rate of interest is 0.5%.
- The expected inflation rate. Embedded within the stated rate of interest (called the “nominal” rate) is the market’s expectations for future inflation. Expressed another way, the “real” rate plus the expected inflation rate = the nominal (or stated) rate of interest.
- For all but the very shortest durations, interest rates include a “term” premium as well. Have you noticed that long term interest rates are usually higher than short term interest rates? Lending (or investing) for longer terms introduces far more uncertainty about the future state of the world. Unsurprisingly, investors demand to be compensated for bearing that extra risk with a higher rate.
- For most borrowers (other than very stable governments), there is also a “credit” or “default risk” premium embedded in the interest rate. As there is always a risk that a loan will not be repaid, or that a bond will default before maturity, investors require a higher interest rate as protection against such risk. That level of risk is determined by the “credit-worthiness” of the borrower with higher default risks associated with higher interest rates. This is why our personal credit scores matter a great deal to the rates we pay on our home and auto loans.
Until fairly recently, financial market participants had no clear way to break apart nominal interest rates into their four components in order to study each one independently. Inflation expectations were particularly difficult to measure — the only tools available were basically crude and imperfect surveys. Academics desperately wanted to study market-based expectations of future inflation – using price data from liquid securities that trade every day. Their pleas were finally answered by the US government in 1997 with the introduction of Treasury Inflation-Protected Securities or “TIPS”.
For the first time ever, a security that was, in essence, a pure play on the “real” rate of interest became available. Because the interest paid on TIPS is determined by the Consumer Price Index, both default risk and inflation risk are eliminated. The yield on TIPS securities is thus an unfiltered expression of the real rate of interest. Academics and market participants need only subtract the TIPS yield from the yield of a standard US Treasury bond and voila! – we have the market’s expectation of future inflation.
So what does this simple calculation look like today? I’m glad you asked:
And so, we can see that inflation is expected to remain just about where it is today — right around 2% per year. This turns out to be very pertinent information for financial planning since a key component of a successful investment plan is to maintain the client’s purchasing power throughout their entire time horizon. Knowing where inflation is expected to head in future years can aid in the design of the right portfolio mix and help to ensure this important goal is met.
Yield source data: https://www.bloomberg.com/markets/rates-bonds/government-bonds/us