The short term real interest rate

Holding cash at the bank or in short-term fixed deposits can be seen as a safe way to store money. At the least, in nominal terms, if you add 100 SEK to your bank account and do not spend it, you will still have 100 SEK the next time you check your balance. The money is still there and you might even get interest on your money, so you will have more money than what you started with.

The purpose of having money, however, is to eventually convert it into goods and services: spending and consumption. The question becomes: what can I buy with this money? You would hope you can buy at least as much as you could at the time you deposited the money into your account, that is: that your purchasing power has been preserved.

To this end we can value our money in terms of what it can buy. A consumer price price index (CPI) is a measure of the price of a basket of goods and services in an economy. We can use this to measure the relative value of our money and the interest we gain by putting our money into cash equivalent assets such as short term deposits at the bank or by investing in short-term treasury yields.

For our measure of CPI and inflation we will use KPIF-XE and for the interest on cash we will use the yield on 3 month treasury bills by the swedish government.

Using these measures we can define the real short term interest rate as the nominal yield we receive from holding cash minus the change in the CPI. The real interest rate tells us whether our money is earning a return that allows us to buy more goods and services or if our purchasing power is being depleted over time.

From the above graphs we notice a couple of things: 1. There have been time periods in which being invested in cash and cash equivalents have preserved or increased purchasing power and other times during which holding cash has destroyed purchasing power. 2. While inflation has roughly stayed around the same levels, the nominal short term rate has been on a gradual decline since mid 1990s. 3. Real rates have been negative since 2015 but have recently risen to rates similar years around 2005.

Investing in cash and cash equivalent

To better understand the preservation of purchasing power and the attractiveness of holding cash as a local investor we can simulate the change in wealth from holding a long-cash only portfolio.

# We pass monthly returns to my portfolio tool for simulation
p = Portfolio('cash_portfolio', return_streams=pd.DataFrame({'rf': rf}, index=rf.index), weights={'rf': 1.0}, cpi=cpi.dropna(),
start=f'{data.index.min().year}', end=f'{data.index.max().year}')

In this plot we see the difference between considering real returns and nominal returns. In nominal terms our wealth has mostly increased whereas in real terms our wealth increased from 90s to 2010 and then been flat or on a decline since 2010.

To get a different perspective we look at the rolling real returns. The rolling returns tell us from any date, looking forward X years, what was our annualized return: meaning if we had invested at point Y and stayed invested for X years, how much return per year would we get.

The graphs paint a clear picture: From the 90s to 2008 a cash saver/investor would increased his or her purchasing power by a couple of percent each year whereas after 2008 your purchasing power have consistently decreased.

Forward Expectations and yields.

We can also consider the expectations moving forward. One simple gauge of this is to use the current short term treasury yield and the inflation forecast from the swedish riksbank.

Current yield is at 1.98% and forecasted inflation is expected to be a little bit more than 2% over the next years. This implies (assuming yields stay same) that the purchasing power of a swedish local cash holder would just about be preserved . That is, the real short rate is expected to be low.

Summary

Holding cash at the bank in a deposit or in short-term government securities and the like is typically considered safe in that they are liquid (you can use your cash on short-notice) and in that you do not experience direct nominal price fluctuations similar to say stock investments. However as the analysis from above has shown, money and money-like assets do have a changing value, especially over time and this can be positive or negative. If you had saved only in cash and cash equivalents since 2010 you would have lost purchasing power.

This post touched on just one measure of money and interest and whether saving in local currency can provide an attractive return over time. There are many more ideas and concepts that can be considered. Cash (currency) is just one type of asset (a debt asset) and we could and should also consider its value in relation to other assets such as gold, stocks and even the value of homes in addition to the CPI measure. In fact, all currencies have had large devaluations against gold and other assets although this does not directly show up when measuring against inflation using CPI.

The real rate also has other implications for the economy, particularly spending and borrowing. Having low real rates is typically considered stimulative for the economy as it is cheaper to borrow and easier to pay debt service. One can also consider rates of different maturities and the breakeven implied inflation rate.