Money Illusion: How Inflation Reframes Three Common Rate Errors

Calling an interest rate “high” or “low” without the inflation context has no economic meaning. Money illusion, reasoning in nominal euros rather than purchasing power, distorts the analysis of households and commentators alike.

Three reasoning biases recur in nearly every commentary on rates: nominal reading, direction confusion, and historical comparison in nominal terms. Each one survives because it is anchored in a number that looks self-explanatory.

Inflation reframes how interest rates are read. The Eco3min framework on money illusion and the biases that distort economic analysis.

At 4% interest and 5% inflation, a saver loses 1% of purchasing power per year. At 1% interest and 0% inflation, the same saver gains 1%. The first rate looks “high”, the second “low”, yet only the second enriches. In August 2026, French consumer prices excluding tobacco rose 2.3% over the year, according to INSEE. The French Livret A, set at 1.7% since 1 August 2026, therefore returns about −0.6 point in real terms. The saver who feels remunerated is in fact losing purchasing power, a diagnosis the nominal figure alone cannot deliver. Further reading: our reference page on how monetary policy reaches corporate earnings.

The three biases that distort the reading

The first bias, money illusion, consists in reasoning in current euros rather than in purchasing power. A 3% nominal wage rise when inflation runs at 4% is a real pay cut. A loan repaid in inflation-eroded euros costs less than its nominal amount. The mechanism, described by Irving Fisher and revisited by Shafir, Diamond and Tversky in the 1990s, systematically distorts consumption, saving and investment decisions. Only the real-rate framework as a compass corrects the bias. It rests on the foundational nominal-versus-real distinction that any rigorous monetary reading takes as a starting point.

The second bias concerns the direction of the move. A cut in nominal rates is automatically read as easing. The same reading appears in the analysis of episodes where markets and recession signals diverge. Yet if inflation falls at the same time, and faster, the real rate can rise. That is what happened in the euro area between May and September 2024: the ECB cut its deposit rate by 50 basis points (from 4.00% to 3.50%), while HICP inflation receded by 90 basis points over the same window (from 2.6% to 1.7%, Eurostat). The ex post real rate, deposit rate minus inflation, rose from 1.4% to 1.8% despite the nominal easing. Only the real-rate framework picks up that kind of divergence; a purely nominal grid is structurally blind to it. That blindness is not a national quirk: it recurs wherever prices are quoted in current units, and that recurrence is the subject of money illusion as a cross-cultural regularity.

The third bias concerns historical comparison. Calling current rates “historically high” by reference to the nominal level alone ignores that US real rates in the 1980s were around 5%. The 10-year Treasury yield, which peaked at 15.3% as a monthly average in September 1981 (Federal Reserve), exceeded CPI inflation by 5.0 points on average from 1980 to 1989 (BLS). Current euro-area real rates remain moderate by that yardstick. In August 2026 the French 10-year OAT (4.00% monthly average, ECB) exceeded French HICP inflation (2.6%, Eurostat) by 1.4 points. The ECB deposit rate (2.50%) sits 1.3 points below September euro-area inflation (3.8%, flash estimate). The “historically high” claim collapses the moment inflation re-enters the equation.

What these biases cost in practice

For households, money illusion masks the erosion of purchasing power on cash balances during moderate inflation episodes. According to Banque de France data, French households’ overnight deposits amounted to €555 billion at end-August 2026, paid 0.04% on average. With inflation excluding tobacco at 2.3% over the year to August 2026 (INSEE), the annual purchasing-power loss on those balances comes close to €13 billion, an invisible drag that the nominal-only reading prevents from being perceived as such. For context, see the catalogue of common money and market misconceptions.

For public decision-makers, the same biases distort the assessment of financing conditions. Budget projections built on nominal rates overstate debt-service costs when inflation runs high, and understate them when it is low. The real cost of debt service, adjusted for inflation, is the only measure relevant to fiscal sustainability over the medium term. Correcting these biases yields a more faithful reading of the real financial conditions economic agents actually face.

Last updated — 8 October 2026