Real Interest Rates: The Mystery of Low to Non-Existent Real Returns

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In recent months we’ve heard many financial advisers comment on how higher interest rates will be good for their income-oriented investors. While this may seem intuitively true, we believe it is not necessarily correct. For an investor’s standard of living to be improved, they need a higher “real” interest rate. “Real” interest rate takes into account the negative effect of inflation on purchasing power. Real interest rates have been historically low for the past ten years. Much has been written recently on the persistence of low inflation, but outside of a few academics, there has been limited discussion of why real returns have stayed persistently low during recent years. This paper will explore that subject and discuss why they may continue to stay low for the foreseeable future, further supporting the views in our earlier paper, titled “Interest Rate Outlook: Old Normal”, in which we detailed an expectation that interest rates would stay low for a long time.

Let’s begin by discussing how interest rates are generally constructed. Famed economist Irving Fisher was instrumental in developing the concept of “real” interest rates over 100 years ago. Based on the work he advanced, real interest rates can be described as:

“…an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate:

Real Interest Rate = Nominal Interest Rate - Inflation (Expected or Actual)” 1

Accordingly, interest rates are composed of inflation plus the real interest rate. If rates are driven higher by inflation, investors do not gain purchasing power. It is real interest rates that represent improved purchasing power and a higher standard of living for those receiving interest income from investments.

Real interest rates on medium-term 10-year U.S. Treasuries have historically averaged around 2%; however, in recent years these have been negative to 1%. Since 2008 they have averaged 0.70%. See the table below:

As you can see, real interest rates have made a dramatic shift downward in the past decade. Let’s take a look at what might explain this and assess if those conditions could remain intact looking forward.

Much of the recent work on this subject suggests the downward shift in real rates has been due to a reduction in longterm expectations for the safe, short-term real interest rate or so-called “equilibrium” or “natural” rate of interest. One may ask what is the equilibrium rate? The equilibrium rate is defined by economists and central bankers as the interest rate where the demand for a particular amount of money equals the supply of money. The equilibrium interest rate changes as economic conditions and Federal Reserve monetary policy changes. One example of a changing economic condition would be income, both personal and corporate. As income increases, the demand for money increases. This increase in demand raises the equilibrium interest rate. Inflation is another example of a changing economic condition. Inflation, an increase in the prices of goods and services, has a similar impact on the equilibrium interest rate; as it rises, so does the equilibrium rate, and vice versa. With regard to monetary policy, when the Federal Reserve sets an interest rate higher than the equilibrium interest rate, the supply of money (i.e.: the amount of money circulating in the economy), exceeds what individuals and companies want to retain in cash. Households and businesses then decrease their cash holdings, encouraged to purchase bonds by the higher interest rate they can earn.

Let’s take a look at supply and demand for “safe assets”, or assets paying something close to the equilibrium rate. In a paper written in 2005, former Federal Reserve Chairman Ben Bernanke hypothesized that a global saving glut was developing:

“I have presented today a somewhat unconventional explanation of the high and rising U.S. current account deficit. That explanation holds that one of the factors driving recent developments in the U.S. current account has been the very substantial shift in the current accounts of developing and emerging-market nations, a shift that has transformed these countries from net borrowers on international capital markets to large net lenders. This shift by developing nations, together with the high saving propensities of Germany, Japan, and some other major industrial nations, has resulted in a global saving glut.” 2

The savers referenced by Bernanke would primarily be acquiring U.S. Treasury bonds due to their liquidity and safety. Global interest rates, along with U.S. Treasury rates, would be driven lower by this global increase in demand for bonds. A recent study would seem to further confirm this position.

In their summer 2017 paper entitled “The Safe Assets Shortage Conundrum,”3 Caballero, Farhi and Gourinchas discuss how the global demand for “safe assets”, defined as debt instruments that are expected to preserve their value during adverse systematic events, has increased at the same time their supply has fallen. They argue that with the onset of the financial crisis in 2007-2008, the collapse in the supply of safe assets and the increase in demand pushed down the natural safe rate (i.e. equilibrium rate) - that is, the short-term real interest rate.

Source: Barclays Capital (2012). Data came from Federal Reserve Flow of Funds, Haver Analytics, and Barclays Capital. Note: Numbers are struck through if they are believed to have lost their “safe haven” status after 2007.

GSE: “government-sponsored enterprise.”, ABS: “asset-backed security.”

Yi and Zhang in their 2016 paper, “Real Interest Rates over the Long Run – Decline and Convergence Since the 1980s”4 also add to this discussion by identifying that the trend in global fixed investment has been downward. Fixed investment refers to investment in fixed capital assets, such as machinery, land, and buildings. As less investment is made in fixed assets, there is less demand to borrow money to purchase these assets. They argue that, in addition to the global saving glut, the forces of reduced global investment demand may have been even more important in the decline in real return. Figure 1 comes from their paper and shows the history of long-run real interest rates since the 1960s.

Figure 1 presents long-run real interest rates for the G7 countries. Two patterns are apparent. First, G7 real interest rates are now quite close to each other, especially in recent years. Second, there have been three broad trends since the early 1960s: (a) a decline extending until the mid-1970s, (b) an increase until the late 1980s, © a decline since the late 1980s.

Fig. 1 - Real Interest Rates in G7 Nations: Since Late 1980’s, Decline and Convergence

Source: IMF, Haver and author’s calculations
Note: 11-Year Centered Moving Average

Former Federal Reserve Chairman Bernanke in a March 1, 2013 speech spoke on long-term rates and investor outlook that is consistent with Yi and Zhang.

Quoting Bernanke, who was Chairman at the time:

“The fact that market yields currently incorporate an expectation of very low short-term real interest rates over the next 10 years suggests that market participants anticipate persistently slow growth and, consequently, low real returns to investment. In other words, the low level of expected real short rates may reflect not only investor expectations for a slow cyclical recovery but also some downgrading of longer-prospects.” 5

In an April 2017 paper, “The Effects of the Federal Reserve’s Holdings on Longer Term Interest Rates,” Bonis, Ihrig and Wei of the Federal Reserve concluded that the Fed’s large scale asset purchases had reduced the 10- year U.S. Treasury rate by as much as 100 basis points (1%) at its peak and that its effect would be 85 basis points by the end of 2017.6 They suggest over the next 4-5 years 10-year rates could increase, which would increase real interest rates. However, could this be thwarted by the increased demand for safe assets?

In their March 2017 paper “A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt”, Christiansen and Rudebusch of the Federal Reserve Bank of San Francisco conclude:

“We find that a lower expected short real rate has accounted for about 2% of the general downturn in yields over the past two decades and that this situation seems unlikely to reverse quickly.” 7

Based on the prospect for the continuation of a lower equilibrium rate and a decline in global fixed investment, we conclude real interest rates are likely to remain below their historical level of 2% for the foreseeable future. Over the next few years, as the Federal Reserve engages in reducing their balance sheet, there is the prospect for an increase of 50 - 75 basis points from recent low levels. However, this is not likely to take real interest rates above 1.0 - 1.5%. In addition, we believe interest rates will continue to remain low, in the 2.0 – 4.0% range for the U.S. 10-year Treasury, as we have previously stated.

While there may be some relief for real interest rates as the Federal Reserve progresses on its balance sheet unwind there may be sufficient appetite by other investors to offset this. In any event, it appears real interest rates will remain depressed from historical levels, suggesting continued purchasing power struggles for income-oriented investors.

To reiterate, in recent months we’ve heard many financial advisers comment on how higher interest rates will be good for their income-oriented investors. While this may seem intuitively true, it is not necessarily correct. For an investor’s standard of living to be improved they need a higher “real” interest rate (i.e. nominal interest rate minus inflation). Our conclusion is that investors should be cautious in their expectations for higher real rates in the near future.

1 Source:

2 Bernanke, Ben S., March 10, 2005, The Global Saving Glut and the U.S. Current Account Deficit, Remarks by Governor Ben S. Bernanke At the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia

3 Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas. 2017. “The Safe Asset Shortage Conundrum.” Journal of Economic Perspectives 31 (3): 29-46.

4 Yi, Kei-Mu, Zhang, Jing, September 19, 2016, Real Interest Rates over the Long Run: Decline and convergence since the 1980s

5 Bernanke, Ben S., March 01, 2013, Long-Term Interest Rates, remarks at the Annual Monetary/Macroeconomics Conference: The Past and Future of Monetary Policy, sponsored by Federal Reserve Bank of San Francisco, San Francisco, California

6 Bonis, Brian, Jane Ihrig, and Min Wei, April 20, 2017, “The Effect of the Federal Reserve’s Securities Holdings on Longer-term Interest Rates,” FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 20, 2017,

7 Christensen, Jens H. E, and Glenn D. Rudebusch, 2017, “A New Normal for Interest Rates? Evidence from Inflation-Indexed Debt,” Federal Reserve Bank of San Francisco Working Paper 2017-07

The data quoted represents past performance, which is no guarantee of future results.

Opinions and forecasts regarding sectors, industries, companies, countries and/or themes, and portfolio composition and holdings, are all subject to change at any time, based on market and other conditions, and should not be construed as a recommendation of any specific security, industry, or sector.

The Consumer Price Index (CPI) is a measure of the average change in prices over time of goods and services purchased by households. The CPIs are based on prices of food, clothing, shelter, fuels, transportation fares, charges for doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living.

Gross Domestic Product (GDP) is the total value of goods and services produced in the national economy in a given year. It is the primary indicator of economic growth.

The 10-year yield is the benchmark 10-year yield to maturity reflected by the current issue 10 year U.S. Treasury note.

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