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