Inflation and the Interest Rate, what's the deal?

So some of you have asked about the connection between interest rates and the rate of inflation. Why do the two always appear in the same sentence? Why do we care; what does it mean?

First, you have to understand that there are many definitions of the interest rate. What most people really mean whey the talk about the interest rate is the nominal rate. The nominal rate is actually the combination, itself, of a few things. Without getting too complicated, it's comprised of:

1. The real interest rate, and
2. The inflation rate

Ignoring other stuff, the nominal rate = the real rate + the inflation rate. Beginning to see the picture? No? That because you need to understand why you really care about the real interest rate, not the nominal rate.

The real interest rate is the return on your investment (or savings) that you expect to receive as compensation for letting others (banks, and borrowers from banks) use that money. Unfortunately, no one pays you real interest - they pay you nominal interest. The reason is that no one actually know the rate of inflation at a give point in time - only in hindsight and even then not all that accurately.

Let's say that the bank pays you 5% on your savings or investment(s) for one-year. Ignoring compounding for the time being, you expect to get $105 back a year later for an investment of $100. What if you find out a year later, however, that inflation over that period was 4% (like it is today!). An inflation rate of 4% means that it roughly costs you 4% more to buy the things you normally buy (your mortgage or rent, food, gasoline, etc.). So a year later you're only better off by 1%, right? ...actually, wrong!

We forgot about taxes. Yup, taxes.

It would be great if we got taxed on only the 1% that we're really getting a year later, but the government taxes us on the whole 5% (the nominal rate). To keep things simple, let's say that we get taxed at a marginal rate of 50%. Well, that would mean that our 5% has been reduced to 2.5%. So, now if we subtract the inflation rate (the rise in the cost of living), then we're really left with -1.5%. Yes, that's a negative sign ...sorry, it's not a typo.

So, now that we're clearer on what all the fuss is about, I hope that those boring discussions about interest rates and inflation will mean more to you... it should. Really.