# Real interest rate - getting it right

People read that inflation in Slovakia is close to 9%. Slovak retail banks are offering 6-7% interest rates on crown deposits. Does it mean that only a fool would deposit his/her money in the bank?
Economics deals with the question by offering a real interest rate concept. People often simplify the concept and guess the real interest rate by simply subtracting headline inflation from the interest rate. If the number is negative, the conclusion is that it does not make sense to save, but rather one should borrow and spend as much money as possible since the money loses its value faster than it grows at the bank. This simplification is fair for developed countries most of the time, however, it has serious flaws for emerging countries in general.
Let's refer to the proper definition of real interest rate. The real interest rate concept addresses the issue of whether one should consume and borrow, or instead save. Let's assume that I want to buy a TV in one year's time.

Ján Tóth

People read that inflation in Slovakia is close to 9%. Slovak retail banks are offering 6-7% interest rates on crown deposits. Does it mean that only a fool would deposit his/her money in the bank?

Economics deals with the question by offering a real interest rate concept. People often simplify the concept and guess the real interest rate by simply subtracting headline inflation from the interest rate. If the number is negative, the conclusion is that it does not make sense to save, but rather one should borrow and spend as much money as possible since the money loses its value faster than it grows at the bank. This simplification is fair for developed countries most of the time, however, it has serious flaws for emerging countries in general.

Let's refer to the proper definition of real interest rate. The real interest rate concept addresses the issue of whether one should consume and borrow, or instead save. Let's assume that I want to buy a TV in one year's time. There are two options. Either I can borrow money at a given interest rate and pay today's TV price (and store the TV for one year) or rather save today's income, get interest, and pay next year's TV price. This 'arbitrage across time' assumes that:

- goods are storable (hence, utilities and housing and food in general does not apply)

- I do not necessarily need to buy it (hence, e.g. petrol for my car does not apply).

Therefore, to get the proper price index for real interest rate calculation, one has to exclude utilities (ie, virtually exclude price deregulation), gasoline, and food. Due to price deregulation and rising crown prices of fuels, the remaining inflation (economists refer to it as ex-food ex-fuel core inflation) is very different - today it is much lower than the 9% headline rate. In fact, this narrower concept of inflation has shown a mere 3.6% rise over the last 12 months.

The last problem with computing the real interest rate is that one should adjust interest rates for expected inflation, rather than the inflation over the last 12 months (the usual year-on-year concept). We can skip this problem by assuming that in developing countries people form their future inflation expectations according to today's development. To put more weight on the present, one could annualise only the most recent months. The inflation that we would get has recently been only around 2%.

What is the conclusion? I am getting paid 6-7% on my deposit account while facing 2% inflation of storable goods. The real interest rate then comes to 4-5%. Is it enough? The rate should be similar to real GDP growth and therefore today's 4-5% real interest rate might not be a bad deal, afterall.

Ján Tóth is Chief Economist at Dutch investment bank ING Barings in Bratislava.

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