Navigating The Real And Cash-Flow Effects Of Higher Interest Rates
Money Exchanging Hands, created on Craiyon
When interest rates rise, this causes great consternation to households, cash flow problems to some indebted businesses, and dilemmas to the Federal Reserve officials, who, even if partly responsible, worry about their consequent effect on the economy.
Examining this broad topic could require several books. Here I want to concentrate on the difference between the real and nominal interest rate. When that distinction is missing from media stories, they only add to public confusion. Understanding that difference is crucial for you to make sound financial decisions and for understanding more broadly what is going on in the broader economy.
Consider the simple choice between buying stocks and interest-bearing accounts or bonds. When interest rates rose recently, many people started putting more money into those interest-bearing assets. To the extent, however, that the higher nominal returns merely reflected higher inflation—that is, the real rate of return didn’t change—they weren’t earning any more than before. Their real taxes on non-retirement account returns also went up, because now they must pay taxes on additional inflationary or imaginary gains. Meanwhile, the nominal value of the underlying assets of businesses probably went up with inflation, but that inflationary return—unlike the interest return—won’t likely be reflected in dividend (cash flow) rate paid out by the corporation. As a result, comparing interest and dividend rates is of very limited use in deciding how to allocate money in, say, a 401(k) account.
In point of fact, the real return on new interest-bearing assets did go up from 2020 to mid-2023, as reflected in the return on inflation-adjusted 5-year Treasury securities going from a negative to a positive number.
Moreover, the choice between stocks and interest-bearing assets is much more complicated than the simple story above. An economic downturn might accompany the interest rate rise. Inflation can distort business and household decisions, something we discovered in spades during years when stagnation accompanied high inflation. The simple point is that any investor must try to figure out what is happening to total real returns, not just cash flow, from investments.
Next, consider how higher interest rates create a lot of winners, not just losers. In fact, in a pure accounting sense—ignoring possible effects on real economic activity—a higher interest rate creates the same amount of winnings as losses. Any higher cost to debtors equals the higher income to lenders. The main problem for the economy as a whole comes when more debtors can’t pay. Then the lenders can’t receive money they are owed, and they, in turn, may hurt someone else when they can’t pay their own debts or buy as many goods and services.
This gets especially sticky when thinking about real estate. If you have a mortgage with a 3 percent interest rate when that rate suddenly rises to 5 percent, you might feel pretty good about things. The household seeking a home and now needing to pay 5 percent and no longer 3 percent on a new mortgage is feeling pretty lousy, especially when house prices don’t fall enough to make a purchase possible.
And here’s where it gets quite tricky. Among the things we also need to figure out who wins and losses are the effects on the real value of the home and the mortgage. To do that, we have to separate out the inflationary component of any return rate from its real component, or what is about the same calculation, the total cash flow from the total real return.
Suppose in our previous example that the rise from 3 to 5 percent in the interest rate is due to an increase in inflation from 3 to 5 percent and the real interest rate remained at 0 percent. Suppose further that the real value of the house doesn’t change. Then the borrower is now ahead with a mortgage at a 3 percent nominal rate, equivalent to a minus 2 percent real interest charge and a value of house keeping up with inflation. A new buyer paying 5 percent in such a world is not necessarily a loser, either, since the real mortgage rate is still zero and the real cost of the house also remains the same.
There is a loser: the previous lender who now earns a minus 2 percent on the loan. Indirectly that may be you, if you had previously bought a long-term certificate of deposit at the bank. You may be stuck, as some are now, with a certificate still paying you something like a 1 or 2 percent nominal interest rate. The bank may also be a loser to the extent its profits go down when it must now pay a higher interest rate on new deposits and certificates, but it is stuck with low yielding (e.g., 3 percent) loans or older government securities. Without going into detail, this is much of what happened with some recent bank failures.
However, I skipped over another sticky detail when I said that the new buyer may not be a loser in real terms. The mortgage system operates almost entirely on a cash flow, not real, basis. To determine a household’s eligibility for a loan, a bank compares its wage and other income with the mortgage payments that would be due. In fact, with a higher inflation rate, the lender would be paying down the real value of the mortgage much more quickly. A $200,000 loan at an annual 5 percent inflation rate would decline in real terms to $190,000 the following year even if no principal were also paid. But the bank doesn’t count on that $10,000 gain in income, as that gain doesn’t come in the form of cash income immediately available to cover the cost of paying off the loan.
Of course, this is more than a sticky detail. Because the mortgage market operates on a cash flow basis, much of the impact of Federal Reserve policies to raise interest rates works its way through it impact on home building and ownership. This happens even when real rates don’t rise and sometimes fall—that is, when the Fed only increases nominal interest rates no more than the increase in the inflation rate.
In many ways, this way of conducting economic policy is highly inefficient. Many economists believe that tax or fiscal policy is a much better instrument for constraining demand in an inflationary economy, as it doesn’t depend upon targeting the mortgage market (more broadly, markets with a lot of debt) and creating a lot of losers, lending constraints, and risks that then reverberate out of that market into the broader economy.
There’s a lot of wonkish detail here. For now, just remember not to confuse real with nominal interest rates, or cash flow with real returns, when making personal financial decisions or reading stories about the economic effects of inflation.