Letters to the Editor: Real and Nominal Borrowing Costs
Three cheers for David Ranson ("If Real Interest Rates Haven't Changed," editorial page, April 3). He has clearly demonstrated one more time the relationship between real and nominal interest rates as determined by inflation and expectations of future inflation. Historically over the years the zero-risk real cost of money (interest rate) has varied relatively little from three to four percent. Traditionally, rate "surcharges" are added to offset, or insure against, perceived risks in a given investment opportunity; the higher the inherent risk, the higher the nominal rate demanded.</br></br>Then came the steeply rising inflation of the recent past. These years taught investors a painful lesson. The "surcharge" added to cover the risk of expected inflation was grossly and routinely underestimated, and real interest rates actually went negative. While lenders suffered losses, borrowers loved their bonanza and have come to expect that it should continue to their benefit.</br></br>Lenders have good reason to be gun-shy. It matters not what scares the lender, be it large deficits or something else real or imagined. Each lender judgmentally sets his perception of the proper minimum add-on to cover expected inflation within the life of the investment, and fixes his acceptable rates accordingly. For the most part investor collective judgment will be borne out (or will be adjusted with time) except under conditions of steep change; i.e., runaway inflation or a bust.</br></br>Real interest rates are not high; they change little. It is lender analysis of risk that sets the pattern of nominal rates. Currently it is the fear and anticipation of future inflation that is at the center of lender thinking. Tax rates are hardly relevant. And the idea of lenders being willing to accept rates which may give negative real returns is only for fairy tales.</br></br>R.E. Morrison