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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, its 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. Youve 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 dont 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, lets examine this idea of correcting the interest rate using the Consumer
Price Index, or CPI. Well skip over the problems in trying to measure prices,
and avoid the controversy over whether CPI does a good job. Well 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
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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 lets 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. Thats about right for a retiree
without a mortgage or commuting expenses. He could eat pretty well.
Although the falling dollar did erode his wealth, were focusing on how
Clarence experiences interest in the real world.
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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 negligible0.03%.
Again, were 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 Clarences loss of almost 3%. This is
deceptive and misleading.
The stark reality is that Larry earns a scant $300 in interest. He cant 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 Clarencepoor 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 savingsYield purchasing poweryou see that
Clarence was living well while Larry is quickly spending down his lifes
savings.
This article is from Keith Weiners weekly column, called The Gold Standard,
at the Swiss National Bank and Swiss Franc Blog SNBCHF.com.
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