Real interest rates are nominal rates minus inflation.
For example, if the real Bank of Canada policy rate is 5.00% and the year-ahead outlook for inflation is 2.5%, the real policy rate is 2.5%.
Real rates are crucial in economic policymaking and analysis because they:
- measure the real cost of borrowing, which dictates purchasing power
- alter the incentive to save versus spend
- affect investors' and businesses' return on capital
- allow for consistent comparison of monetary conditions over time
- signal the central bank's stance on monetary policy (higher real rates indicate tighter monetary policy, and vice versa).
Real rates are important because, in periods of significant inflation volatility, nominal rates alone might not provide a complete economic picture.
In short, while nominal rates tell us where the policy rate is set, real rates tell us how much effect that policy may have.