Nominal rates have real effects

Economic jargon can be confusing. And the effect of economic policies can be hard to assess, given how much is occurring at any one time. That is why economic debates quickly descend into confusion and mutual incomprehension.

When most people think of an interest rate, they tend to focus on the headline rate, the 5% they pay on their mortgage or the 1% they get on their savings account. This is the nominal rate. But economists focus on the real, after-inflation, rate. Better to earn 3% nominal, when prices are rising 1% a year, than 5% nominal, if inflation is 6%. Not realising this, economists say, is “money illusion”.

In the real world, however, people find this very difficult to cope with. Back in the early 1990s, when I was personal finance editor of the Financial Times, interest rates were in the double digits. A lot of elderly people depended on their savings for income. With £100,000 in the savings account, a 10% nominal rate earned you £10,000.

Then rates fell sharply. That represented a substantial cut in their nominal incomes; at 5%, their savings income halved. Now an economist would say these people suffered from money illusion. A large part of the 10% return was compensation for inflation. Instead of spending this, they should have reinvested it. When rates fell, the cut in their income would not have been as great (and they would have more capital).

To which argument, a lot of elderly FT readers would have said “Fiddlesticks”. They were barely getting by as it was; reinvesting their interest income was not an attractive option. And while they knew the past rate of inflation, they did not know (and could not know) the future rate. Keeping the money in cash might have delivered a high real return, at least for a while.

Leap forward to today, and there is a debate going on about the impact of quantitative easing. The economist David McWilliams recently argued ( that QE had helped inspire millennial socialism; if trillions of dollars could be created to buy assets, and revive the economy, why not to fund social programmes? Furthermore, QE had pushed up asset prices, increasing inequality and making it harder for the young to afford house prices.

Having written about the QE/asset price link quite a lot, I endorse this view. But economists, while arguing that QE was necessary, seem reluctant to accept that it had negative effects. A prominent economist snapped back that QE had done little to reduce “real yields” since of course inflation has fallen a lot.

Again, however, I would argue that nominal rates have real effects. Let us divide the world into two: the middle-aged who own houses, financed by a mortgage, and the young who rent. For the former group, the fall in nominal rates boosted their income by cutting their mortgage costs. For those who were struggling, low nominal rates saved them from default. For those who had lots of home equity, they could afford to trade up in the housing market. Either way, house prices rose after the nitial wobble in 2008–2009. In London, the house price-to-earnings ratio is 9.2, while the peak before the crisis was 7.2, and the long-term average (since 1983) was 5.5. For the young, however, low rates are not much help since the typical deposit to buy a London property is over £100,000. That is out of reach for most people.

Real rates don’t mean much in this calculation. If your monthly mortgage payment falls from £1500 to £1200 because of lower nominal rates, what does it matter if the real rate is unchanged? To homeowners, the classic economics’ argument would seem, well, unreal.

Economist columnist, opinions generally my own, typos always my fault. Author of Paper Promises, The Last Vote and The Money Machine

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