What is... | January 6, 2012

What is “in real terms”?

The phrase “in real terms” is often found in newspaper money sections and on investment policies. The term has a specific meaning in financial circles – and it can be important for ordinary investors to understand.

Adjusted for inflation
In short, “real terms” means that a value has been adjusted to take inflation into account. While it sounds simple, the term is hugely important as inflation can eat away at money over time – having big implications for retirement planning, wage negotiations and more. Sometimes the phrase “adjusted for inflation” is used instead of “in real terms”. In more technical documents, such as statistics office releases, the terms “constant” and “current” prices are often used instead of real and nominal.

Nominally true
The phrase “in real terms” is used to show how measures such as economic growth, savings or wages change after inflation, while “nominal terms” is used when the adjustment has not been made. Taking a worker’s wage, for example, a three percent increase might sound generous. But if inflation also rises three percent that year, the earner may actually be no better off financially from the pay rise.

On the positive side, their buying power didn’t fall – but it’s important to consider “real terms” when making spending plans for the year. If they worked a three percent rise into their budget, they could well fall short. In nominal terms, the wage rise was three percent but “in real terms” it was zero. The same holds true for interest rate offerings at financial institutions, bond and share returns and elsewhere.

For real?
Getting to grips with real terms can be difficult partly because of what economists call money illusion. This is the tendency to think of money at its face value rather than what can be bought with it. It is the reason to praise the elderly for reminiscing about prices in years gone by “back in my day”. As inflation often adds up by small amounts over time, it can be easy to fall into the trap of overlooking the long term effect (which can be large). An eZonomics poll showed that only about a third of respondents understood the importance of money illusion for managing money.

Monetary mugger
As we have seen, inflation can eat away at the “real” value of household wealth.

Former US president Ronald Reagan described inflation as being as “violent as a mugger, as frightening as an armed robber and as deadly as a hit man”. An eZonomics video has tips on how to protect your savings from inflation and index-linking investments to inflation is another option. If choosing between an index-linked account and an ordinary account, investors need to decide how fast they expect inflation to rise.

Bottom line
The difference between nominal values and real values will also depend on which index of rises in prices is used. Different countries use different methods to calculate inflation, so be careful when comparing across boarders. And even within nations, a variety of measures can be used.

Whichever index is used, the bottom line is that savers and investors need to be aware that their wealth may shrink “in real terms” – even if it increases in terms of euros and cents.

InvestingSavingJobsInflationMoney illusion

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics