Real or nominal rates? - BBH

Analysts at Brown Brothers Harriman explained the difference between nominal and real interest rates.

Key Quotes:

"Real interest rates are nominal rates adjusted for inflation expectations. Inflation expectations are tricky to measure. The Federal Reserve identifies two broad metrics. There are surveys, like the University of Michigan's consumer confidence survey, and the Fed conducts a  regular survey of professional forecasters. There are also market-based measures, like the breakevens, which compare the conventional yield to the inflation-linked, or protected security (TIPS). 

When an investor buys a bond, they are securing a nominal yield. Nominal interest rate differentials also drive the cost of hedging, and we argue often are a key driver of foreign exchange prices. 

However, some economists emphasize real yields instead of nominal yields. We have several theoretical and practical problems with such an approach. First, real yields are difficult to measure. There are not surveys, or inflation-protected securities for all countries. Second, what do real rates mean for a foreign investor? They earn nominal rates. Real rates are important for policymakers to assess if rates are stimulative or not. Real rates of return are an important metric of wealth accumulation. Real rates may also shape the hurdle rate on new investments. 

Third, if survey expectations are used to discount nominal rates to derive the real rate, the surveys are conducted monthly or quarterly, and the results are not as volatile as the foreign exchange market. Fourth, the inflation-linked securities do not have the liquidity of the conventional note and bonds. This often results in the inflation-linked instruments are more volatile than conventional instruments. 

This means that in a falling rate environment, the inflation-protected security yield falls faster or more than the conventional security. In a rising rate environment, the yield of the inflation-protected security typically rises faster. This means that in a period of rising interest rates inflation expectations often rise and in a period of falling rates, inflation expectations ease. This is to say that the liquidity issue tends to be sensitive to the underlying direction of interest rates."