Question of the Week

At year-end 2004, the Federal Reserve reported moderate economic growth of 3%, a reduction of the unemployment rate to 3% and an inflation rate that was "well contained at 3%". Under these circumstances, the real interest rate of the 10% corporate bond you own is 7% this year. Which of the following economic factors would factor in to the real interest rate of your bond?

a) Unemployment at 3%
b) The Fed Funds rate
c) Inflation at 3%
d) Economic growth at 3%

Answer:

The correct answer is c).

The real interest rate, also referred to as the inflation-adjusted return, factors the eroding effect of inflation from an investment's return.

The formula is: Yield plus or minus inflation rate = real interest rate/inflation-adjusted return.

The Fed Funds rate is the market rate that banks charge each other on overnight loans of reserves.