Real interest rates can indeed be negative. When real interest rates are negative, it means that the inflation rate is larger than the nominal interest rate. Measuring the real interest rate lets investors determine if they are actually making money and growing purchasing power on an investment. If the real interest rate is not larger than inflation, the investor is losing money. Likewise, lenders can gauge if they are making money on loans they write by measuring the real interest rate. Unless the lender charges a rate above the inflation rate, it does not make money on the loan.

As of July 2016, U.S. real interest rates on the 10-year Treasury fell below 0 for the first time since 2012. Treasury-bills (T-bills) are short-term obligations issued by the U.S. government with terms of four weeks, 13 weeks or 26 weeks. Given an average long-term inflation rate in the United States of 1.5 to 2%, whenever the T-bill rate drops below 1.5%, the real interest rate is negative.

How to Calculate Real Interest Rates

Economist Irving Fisher created an economic theory, now known as the Fisher effect, which identifies the relationship between real interest rates, nominal interest rates and the inflation rate. Basically, the real interest rate and the inflation rate combined equal the nominal interest rate. Because of this relationship, if nominal rates stay static, the real interest rate increases as inflation decreases, and the real interest rate decreases as inflation increases.

In practice, there are two methods to compute the real interest rate using Fisher's idea. The first is a linear approximation. The second is the more precise version that geometrically links the interest rates together. With the linear approximation, the inflation rate plus the real interest rate equals the nominal interest rate, as discussed above. Thus, the real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. For example:

Nominal interest rate = 12%

Inflation rate = 4%

Real interest rate = 12% - 4% = 8%

The more precise version of the formula geometrically links the interest rates together as follows:

n = (1 + i) x (1 + r) - 1

Nominal interest rate = n

Inflation rate = i

Real interest rate = r

Rearranging this formula to solve for the real interest rate looks like this:

r = (1 + n) / (1 + i) - 1

Using the numbers from the above example, the more accurate value of the real interest rate is:

r = (1 + 12%) / (1 + 4%) - 1 = 7.69%

Fisher's equation is important in monetary policy because it shows that, if a central bank's actions increase inflation by a certain number of percentage points, the nominal rates rise in tandem.

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