Rates: Nominal Versus Real

I was talking with my grandparents recently about the high interest rate environment of 1981.  Why didn’t everyone invest in high-yielding US Treasuries back then, the rates were over 15% for the 10 year, I asked? It was a bad deal, I was told. But that left me wanting to know why and how that could be.

Well, that 15% interest it turns out was the nominal rate, before any adjustments for the inflation rate.  And what if the inflation rate at the time was 10%, for illustrative purposes. The real interest rate is the nominal value (15%) less inflation (10%) is actually a 5%  return. In other words, you would get only five cents on the dollar in real terms, not the nominal fifteen cents on the dollar. 

And then I asked myself, what if a mistake was made and the inflation rate was actually at 20%? We would have been loaning a dollar and getting ninety-five cents back; not a great return on capital.  And let’s not forget that 20% inflation means it will take me 120% more money to buy the same thing in the future. 

So going forward, I will be mindful of nominal versus real interest rates which take into account the rate of inflation. And assume in your hurdle rates that inflation may be revised higher at later times, as has been the case many times over history.