1. Interest Rates, Bonds & Inflation
Real vs. Nominal Interest Rates

2. Bonds
Bonds: are a loan to a Gov’t or business where you earn interest every year until you are paid back.
If the company goes bankrupt => you usually will not be paid back!
You buy
a Bond
U.S. Gov’t
5-Year Bond
$1,000,000 cash
Gov’t pays you 2% interest per year
$20,000 per year
Plus $1 million in 5 years
$1.0 million turns into $1.1 over 5 Years

3. Bond Prices U.S. Government sells bonds to “borrow money”
Bond prices move inversely with interest rates!
Interest rates ↓ => Bond Prices ↑
You buy
a Bond
U.S. Gov’t
5-Year Bond
$1,000,000 cash
$20,000 interest per year

4. Interest Rates
Reflects the cost of borrowing money (or benefit of saving it!)
There are short term & long term interest rates
Low interest rates are critical for a healthy economy (GDP)
As interest rates ↑ => cost of borrowing money ↑ => Investment (I) ↓

5. Short Term Interest Rates
The Federal Reserve only “controls” short term interest rates
Used by banks & currently = 0.0%
Federal Funds Rate changes over time to regulate GDP & inflation

6. What does the Fed policy do to savers?
Janet Yellen leaves rates at ZERO
What does the Fed
policy do to savers?
0.0%

7. Long Term Interest Rates
Long term interest rates are determined by inflation expectations
Currently = 1.50% (10-year government bond)
As Expected Inflation ↑ => long term interest rates ↑
Bond prices move inverse to interest rates.
bond prices ↓ => interest rate ↑

8. Investments & Inflation
Inflation directly affects your real return on any investment
If a bond pays 2.5% interest, what is your real return?
“It Depends” on the rate of inflation!

9. Adjusting Interest Rates for Inflation
Nominal Interest Rate = Real Interest Rate + Expected Inflation
Reworking above formula: Real = Nominal – Expected Inflation
10-year Gov’t Bond Purchase $1,000,000
Nominal Interest Rate %
Nominal dollars per year: $25,000 (interest per year)
In 10-years: $1,000,000 principal paid back
If expected inflation = 2.0%:
The real interest rate is 0.5% (2.5% - 2%)
Purchasing Power ↑ $5,000 per year

10. Interest Rate Test