Defining Terms: What are 'Real Long-Term Interest Rates'?

Interest rates on bank savings accounts are quoted in nominal terms: Place $100 in a bank with a 3% per annum interest rate and your savings will amount to $103 at year’s end. If prices have been stable over the year, you can buy 3% more because you saved. However, if prices, say of books or food, have risen by 2%, you are only able to buy 1% more. If interest rates are 3% and inflation is 2%, your “real” interest rate is only 1%. Therefore, the real interest rate that you earn by saving is the nominal quoted interest rate less the rate of inflation over the year. So, when investors think about saving over the next one to five years, they look at the nominal interest rate minus the forecast, or expected, rate of inflation.

This calculation applies to short-term interest rates, where investors lock their money up for three or six months, and to longer-term interest rates, where investors lock their money up for three, five or even 10 years (see Appendix 1 for more detail).

Longer-term interest rates are usually higher than short-term rates because investors get a “term premium” for locking up their money for a longer period. The term premium applies to nominal quoted interest rates and real inflation-adjusted interest rates.

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