Putting Interest Rates into Perspective

By Dale S. Lam, CPA / PFS, CFP®
July, 2015, Excerpt from Quarterly Client Commentary

One of the greatest challenges facing investors today is the low interest rate environment. We all love the low interest rates when we are financing our homes or borrowing funds to invest in our businesses. But when we focus on our long term financial security, those low interest rates result in low returns in our more conservative investments – fixed income securities. Those fixed income securities run the gamut from bank savings accounts to certificates of deposit (CD’s) to government and corporate bonds.

The lower rates are initially a boost to business profitability, and thus the stock (equity) market. But over time, the expected returns on equities are also lower if the interest rate environment remains low. The end result is that in a low rate environment, the expected returns for investors are lower than they would be in a higher interest rate environment.
So can low returns possibly be good for investors? The answer lies in inflation. What really matters is the “real” return that we receive on our portfolios, with the real return being defined as the return after inflation. This is in contrast to the actual return that you receive, which in financial terms is often referred to as the “nominal” return, which is the return before inflation.

We really need to protect and hopefully grow our purchasing power in our portfolios. To do so, we must get a nominal / actual return that is at least as high as inflation. Anything that we earn over and above inflation is what our “real” return is – that is, excess growth with which we can purchase more goods and services after considering inflation.

This chart summarizes inflation and the return on a very safe investment, 3 month CD’s, over the last 50 years.

Inflation vs 3 Month CD Rates - Strategent Financial

Source: World Bank, Inflation, consumer prices for the United States, retrieved from FRED, Federal Reserve Bank of St. Louis

Inflation (the black line in the chart) varies over time, but is currently at historically low rates at only 1.6% in the year just ended. But inflation does not always stay low. The early 1980’s were times of historically high inflation, with 1980 posting inflation of 13.5%. To get a real return of say 3% on your investments in 1980, you had to earn 16.5%. To achieve that same real return in 2014 you only needed to earn 4.6%. That’s a staggering difference in the actual return, but it is the exact same real return.

The lesson is – focus on the real return – it’s what matters most over long periods of time. Vanguard, one of the more reputable investment companies in my opinion, reported just last week in an advisor update that achieving a 4% real return is considered a good return for most long term investors. With inflation in the 1.6% range, a real return of 4% requires an actual return of 5.6%. Yes, that’s lower than the historical returns generated in the stock and bond markets over the last forty to fifty years, but it does provide a considerable increase in purchasing power for investors over and above inflation.

Past performance is not a guarantee of future results.  Any indices referenced are unmanaged and cannot be invested in directly.  See Disclosures.