How To Estimate The Real Rate Of Interest And Why It MattersAuthor: John MasonLast Updated: September 12, 2013 There was a question to my last post concerning the relationship between the real rate of interest and the rate of growth of the economy. The question: why should these two rates be equal?This is a good question that I was going to address sometime …so let’s do it this week. The Real Rate of Interest and Economic Growth TheoryIt is a condition of economic equilibrium that the marginal product of capital, which is defined as the real return on the stock of capital, (and, consequently, is the real rate of interest), should, in equilibrium, be equal to the rate at which the stock of capital is increasing that, again, in equilibrium, should be equal to the rate at which the economy is growing.So, it is a theoretical concept that we try to put into practice in order to try and understand financial markets better. As I outlined in my last article, this theoretical concept is useful to bond investors, because it can help us understand where yields may head in the future. In attempting to come up with an estimate of what the real rate of interest should be we have to be creative, but pragmatic, to find something that works for us.Estimating the real rate of interestHistorically, before the period of the Great Recession, I assumed that the real rate of interest could be estimated by calculating the compound growth rate for real GDP over a period of eleven years. Thus, this “expected” real rate of interest was calculated over a long period of time and, therefore, did not change much over time, which is consistent with it being equal to the expected equilibrium growth rate for the economy.For many years, the estimate I used for the real interest rate was 3.00 percent. In practice, I rounded off the estimate to 3.00 percent because I didn’t believe that another 10 basis points or so, one way or another would impact my analysis to any degree.Two things were important to me. First, this helped me to develop an estimate of what participants in financial markets were thinking in terms of inflationary expectations. Because, for securities that are free of credit risk like US Treasury bonds, inflationary expectations can be defined as the difference between the nominal rate of interest in the market and an estimate of the expected real rate of interest. Therefore, if the nominal rate of interest is 6.00 percent and my estimate of the real rate of interest is 3.00 then I could say that market participants had built into market rates of interest a 3.00 adjustment for inflationary expectations.Then I could check this figure against the actual figures for inflation or discussions about what inflation might be in the future and make a judgment about whether or not this estimate of inflationary expectations made sense…or not. If there were significant differences between my “estimate” of inflationary expectations and actual inflation I could then dig deeper into my analysis to try and identify reasons why the differences existed. In this way I got to better understand what was going on and where opportunities may lie.The second reason I tried to estimate inflationary expectations is because it helped me to identify changes in market behavior. For example, if the nominal rate went up to 3.50, this meant that there was a fifty basis point change in inflationary expectations in the marketplace. This immediately led me to ask the question…Why? And then I would search for reasons.Using TIPS To Estimate The Real Rate of InterestIn more recent years, there appeared another “estimate” of the real rate of interest. This was the creation of the US Treasury Inflation Protected Securities or TIPS. This is how TIPS work. First, a coupon rate is set on an issue and it is fixed for the term of the issue. The principal value of this bond is adjusted semiannually so that the interest payment can be changed so as to continue to provide the owner of the bond the fixed coupon rate. The inflation adjustment to the principal is the non-seasonally adjusted U. S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U).Thus, a “real” interest rate is earned on this security because the coupon rate on an issue is the rate that the investor earns above the actual inflation rate used in the adjustment.Traded in the marketplace the TIPS yield is a market-determined rate. On Tuesday, September 10, the market yield on the 10-year TIPS was 0.844 percent. This bond matures on July 15, 2023, bears a coupon of 0.375 percent and its ask price in the marketplace was 95.18.The yield on TIPS can be used as an estimate of the “real” rate of interest but there are some cautions on its use. First, it is a market rate of interest and therefore it can vary. The conceptual idea behind the real rate of interest is that it is an expected rate that does not vary significantly over time. Thus, since the TIPS yield can vary quite a bit over a relatively short period of time it does not satisfy this quality we are looking for in an estimate of the real rate of interest.Secondly, being a market rate it can be impacted by current market events that may distort its use as an estimate of the real rate of interest. For example, the yield on 10-year TIPS dropped below 1.00 percent in March 2011 and even dropped into negative territory later that year. The yield remained below zero until March 2013. One reason for this behavior was that European money looking for a “safe haven” in which to invest moved large amounts of money into U. S. Treasury securities creating this aberration in the level of TIPS yields. Since then the rate has risen, but only to 0.84 percent.So where should the “real” rate of interest be these days?The growth rate of real GDP in the second quarter of this year was 1.6 percent, year-over-year. Most analysts are expecting that in the next year or two, real GDP growth should be in the 2.0 percent to 2.5 percent range. One could argue, then, that the expected “real” interest rate should be lower than the 3.00 percent I used earlier. Let’s just use the lower projected rate of 2.0 percent.Thus, if the yield on the 10-year Treasury bond is around 3.00 percent, this would mean that market participants were expecting that inflation to be in the 1.00 range over the next ten years.This seems low, particularly when current inflation is around 1.5 percent, year-over-year, as seen in the implicit price deflator of the GDP numbers.If one uses the 0.84 percent yield on TIPS, then one hypothesizes that with a 2.95 percent yield on the 10-year Treasury bond that the inflationary expectations built into the market are around 2.10 percent.Over a ten-year horizon the estimate of inflation being in the 2.00 percent range seems to me to be a little more believable than 1.00 range. So, that is my estimate, and why as I stated in my last article I anticipate 10 year treasury yields to rise above 4% in the next year or two.What’s the bottom line?The estimated real rate of interest is just what it says it is…an estimate. Thus, one needs to be careful with it and work with the numbers and study the situation as much as one can in order to be comfortable with the number that one uses. So, study the numbers and the environment as much as you need to in order to feel confident about your conclusion.About John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.