Nominal and Real Interest Rates

After the completion of this module students will be able to:
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how nominal and real interest rates change in value over time.
4. Assess the evolution of real and nominal interest rates during economic expansions and contractions.

Ideally, this module should be directed to an intermediate macroeconomics or financial economics class; if the course syllabus has room for it, the data plotting can be used in an economics principles course as well. It can be used as either (a) an instructor-led example in a large lecture or (b) student groups can be assigned to replicate it outside of class as a basis for a short assignment. Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on the difference between expected and actual inflation and on why, sometimes, real interest rates are negative.

Note that a more advanced treatment of this topic may compute real interest rates for different types of bank assets and liabilities (e.g. the Federal Funds Rate, the Primary Credit Rate...) or employing different price indexes (e.g. the GDP Deflator, the Producer Price Index). These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct.

Prerequisite skills: Graph literacy
Prerequisite concepts: Interest rates; Inflation rates; the Fisher equation

The following is a description of this activity being used as an instructor-led example. For a basic step-by-step description of this activity –also suitable for a student-led exploration of the topic– please see the Handout Activity Handout for Nominal and Real Interest Rates (Microsoft Word 28kB Jun27 14).

Within a lecture discussing interest rates, an instructor will use this module to help students understand the concepts of real interest rates and the Fisher equation and to guide a discussion of their quantification.

(Step 1)
The instructor will first present a graph of the 30-Year Conventional Mortgage Rate (MORTG) (Category: Money, Banking & Finance > Interest Rates > Mortgage Rates)

The instructor should point out that after 1981 the trend value of the nominal interest rate on a 30-year conventional mortgage has been declining. Narrowing the range of the data set to 1990-present will make that pattern more obvious. Special attention should be paid to the lack of an apparent cyclical behavior. This fact will become relevant when introducing an additional data series. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.

(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the Consumer Price Index for All Urban Consumers (CPIAUCSL) (Category: Prices > Consumer Price Indexes > Consumer Price Index for All Urban Consumers: All Items)

Note
- The instructor should "Edit Data Series 2 > Units" and select "Percent Change From Year Ago", transforming the Consumer Price Index into the CPI Inflation Rate allows for both series to be plotted in the same units.

The instructor should point out that the nominal interest rate series is above the inflation rate series. The instructor can ask students to review the relationship between nominal and real interest rates through the concept of the Fisher equation, discussing how the inflation rate itself is generally procyclical. Having introduced the concept of the real interest rate, discussion should focus on how between mid-2008 and late 2011 the real interest rate was almost zero.

(Step 3)
The instructor will then "Edit Data Series 2" (Consumer Price Index for All Urban Consumers (CPIAUCSL)) by deleting it [click on trash can icon to the right of the series' name].

Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing the Consumer Price Index for All Urban Consumers (CPIAUCSL) (Category: Prices > Consumer Price Indexes > Consumer Price Index for All Urban Consumers: All Items)

Note
- As before, the instructor should "Edit Data Series 1 > (b) CPIAUCSL > Units" and select "Percent Change From Year Ago". Transforming the Consumer Price Index into the CPI Inflation Rate allows for both series to be plotted in the same units..

These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > a – b > Apply"

The graph now plots the difference between the nominal interest rate on conventional 30-year mortgages and the inflation rate, a computation of the real interest rate on conventional 30-year mortgages.

(Step 4)
Last, the instructor will add the 30-Year Conventional Mortgage Rate (MORTG) (Category: Money, Banking & Finance > Interest Rates > Mortgage Rates) to the graph by "Add a Data Series > Add New Series". This way the nominal and the real interest rate can be directly compared.

The following is a list of questions that could be asked:
- How did the real cost of a mortgage during the 2001-2008 expansion compare to the real cost of a mortgage during the 1991-2000 expansion? What are the implications of low real interest rates for real estate markets?
- How did the nominal cost of a mortgage change during the 2008-2009 financial crisis? How did the real cost of a mortgage change during the 2008-2009 financial crisis? How can you explain that difference? What are the implications of high real interest rates for real estate markets?

Further sophistication:
- Plot the difference between the Effective Federal Funds Rate (FEDFUNDS) and the growth rate of the Consumer Price Index for All Urban Consumers (CPIAUCSL). Compare with the previous graph. Discuss how the monetary policy target drives the cost of borrowing and where the monetary policy target, in real terms, stands today.

There is an ever-growing trove of Economic Letters by the Federal Reserve Bank of San Francisco discussing the quantification of inflation expectations across countries and the analysis of inflation forecasting efforts (see full references under Resources). These are great resources to carry the discussion further.

The recommended method for assessment for an intermediate macroeconomics or financial economics class would be to have students write up a short memo where they discuss the historical evolution of different classes of nominal and real interest rates. This should be a take-home assignment.

"Why Do Measures of Inflation Disagree?" by Yifan Cao and Adam Hale Shapiro
Federal Reserve Bank of San Francisco Economic Letter 2013-37, December 9, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/december/inflation-measures-gap-personal-consumption-expenditures-pce-consumer-price-index-cpi/

"Consumer Inflation Views in Three Countries" by Bharat Trehan and Maura Lynch
Federal Reserve Bank of San Francisco Economic Letter 2013-35, November 5, 2013
http://www.frbsf.org/economic-research/publications/economic-letter/2013/november/consumer-inflation-expectations-us-uk-japan-oil-prices/