The Fisher equation and why it matters
Irving Fisher’s insight (1930) was that lenders and borrowers care about real returns, not nominal ones. If I lend you £100 at 5% for a year, I get back £105. But if inflation is 4%, the £105 I receive next year only buys what £100.96 could buy today — my real return is barely 1%. For this reason, nominal interest rates tend to move with inflation expectations: when markets expect higher inflation, they demand higher nominal rates to compensate, such that real rates remain roughly constant. Central banks set nominal policy rates but care about the real rate’s effect on economic activity — a 5% rate in a 1% inflation environment (4% real) is far more restrictive than 5% in a 6% inflation environment (−1% real).
Real rates and investment decisions
Real rates drive key economic decisions. When real rates are low or negative, borrowing is cheap in purchasing-power terms and saving is penalised — this stimulates spending and investment. When real rates are high, saving is rewarded and borrowing is expensive — this slows the economy. This is precisely how monetary policy transmission works: the Bank of England raises nominal rates to push real rates higher, discouraging borrowing, slowing demand, and eventually reducing inflation. For investors, real rates matter because they determine the true return on cash and bonds. In the 2010s, real rates in the UK and US were often negative — holding bonds and cash was a guaranteed purchasing power loss — which pushed investors into equities and property in search of positive real returns.
“Always think in real terms. A savings rate that sounds attractive may be destroying your purchasing power. A mortgage rate that sounds alarming may be genuinely cheap after inflation.”
What this means for you
When evaluating whether a savings account, bond, or any fixed-income return is attractive, always subtract current inflation (CPI) to get the real return. In 2022–2023 when UK inflation was 10%+ and even 5% savings accounts existed, cash savings were still losing purchasing power in real terms. Index-linked government bonds (UK index-linked gilts, US TIPS) offer a direct real-rate return adjusted for inflation and are the purest way to protect purchasing power within the fixed income universe. As a rule of thumb: cash that earns below the inflation rate is a guaranteed, slow erosion of your wealth — and should be invested rather than accumulated.