The concept of inflation is familiar to almost everyone when spoken in the context of rising prices and its impact on our cost of living. However, people tend to ignore or care less about the impact of inflation on their savings and investments over long term.
In economics, inflation is defined as a general rise in prices. On the face of it, it may appear that a rise in prices should not have any impact on the money one has saved in a bank account or an asset in which he/she has invested. But in reality, every rise denominated in any currency simply means a debasing of that currency’s purchasing power.
This effectively means that the money one has saved over time will not buy same amount of goods in the future compared to the point in time the savings was made.
How inflation impacts value of money
Inflation is a measure of how fast the prices of goods and services are rising. It is calculated using different methodologies in different countries. Mostly, the measurement is known as the consumer price index or CPI. It tracks the change in prices of a shopping basket of goods and services. The basket items are chosen to represent what a typical consumer might buy.
The CPI in the UK, for example, is calculated monthly using 180,000 price quotations from multiple retailers for 700 different goods and services. This notional basket is usually updated quarterly to reflect changes in consumer preferences over time.
Very low or very high inflation is damaging to the economy. There is no uniform rate of inflation that can be said as an ideal level for all economies. However, inflation targeting by central banks across the world are aimed at achieving an optimal trade-off between economic growth and rise in prices. The objective in nutshell is to maintain a “Goldilocks Economy” – not too hot, not too cold.
What causes inflation?
Different theories try to answer why prices rise at different speeds over time, but there are two central explanations within economics. Consider the analogy of an auction room. If it is full of willing buyers with plenty of money then it is more likely that higher prices can be achieved for a particular lot being sold. In this case, the amount of money available, known as the “money supply”, will influence the likely level of prices. If there was less money available, then the bidding could not go as high. This is the view of the monetarists who believe that inflation can be controlled by changing the level of money that circulates in the economy.
Another view is held by Keynesian economists, followers of the theories of the British economist John Maynard Keynes. They believe that demand is the central reason for a change in prices. Revisiting our auction room again, if all the buyers believed that a particular item was in very short supply, then they would be willing to pay a higher price for fear of not being able to buy another. In the Keynesian view, this would mean that demand was higher for an item than the supply of that item, hence the price rises until there is a winner.
How inflation impacts bank savings
The prevailing purchasing power of a currency is central to the value of one’s savings. If inflation is higher than the interest rate paid on one’s savings and fixed deposit accounts, this essentially means that the value of your savings is set to fall over time.
In other words, if the rate of interest paid on one’s deposits is less than the prevailing rate of inflation in the country, the final value of the original principal plus the interest earned on maturity (of deposits) will be less than the money originally deposited. Thus the real gain on that deposit will be negative.
Let us consider the example of an Indian investor with a fixed bank deposit of Rs100,000. At the current fixed deposit rate of 5.9 per cent per annum offered by the State Bank of India, the largest Indian commercial bank, the depositor will earn Rs1,05,900 at maturity. Which translates into a nominal gain of Rs5,900 over a period of one year.
The current consumer price inflation in India is estimated at 6.6 per cent by the National Statistical Office (NSO) of India. This essentially means, over a period of one year, if the money was not invested in a fixed deposit that earned interest, its real value would have diminished to Rs93,400 (100000 – 6600 = 93,400). In this example, the real value (the nominal value minus inflation) on the deposit maturity will be Rs98,910.6 ( Rs105,900 - 6989.4 = 98,910.6). Although it appears, the depositor has gained Rs5900 in interest income, in real terms, he has a net negative real earning (or net real loss) of Rs1089.6 on his investment over a period of one year.
Inflation has greater impact on fixed income returns
Inflation can chip away any type of investment returns, unless investments’ returns are ahead of inflation rate. For example, an investment that returns 3 per cent in an environment of 3 per cent inflation will effectively return 0 per cent when adjusted for inflation.
The impact of inflation can be particularly harmful to fixed income returns. Fixed income investments, such as fixed deposits, bonds, aim to produce a stable income in the form of interest income. As these payments are fixed, if inflation rises, their purchasing power declines.
Despite inflation, why should one consider deposit products?
Bank deposits, particularly saving bank accounts and fixed deposits, are very popular entry level investment options for most investors across the world. Fixed deposits offer much higher interest rates than Savings Accounts.
Despite the fact that inflation can chip away most of the interest earnings, deposit products are must haves in personal portfolios because of their unique characteristics of greater capital protection and higher liquidity.
Fixed deposits are one of the safest investment options, especially when you compare them with stocks or any other market-linked instruments. With low volatility, the corpus that you set aside in FDs serves as a great way to ensure that your capital is safe. One can start early and multiply wealth with the power of compounding. A small amount can turn bigger with compounding; when the compounded interest is reinvested with the principal.
We all know that idle money yields no returns, which is why it needs to be invested as efficiently as possible. Savings Accounts come with a set of predefined features. Across the board, Savings Accounts tend to offer similar interest rates and offer little in the way of variations. Fixed Deposits, on the other hand can be customised to suit financial needs of all kinds, whether short-term or long-term.
There is a variety in tenure for Fixed Deposits (FDs), ranging from 7 days to 10 years, and the interest rates only get better the longer you choose you keep your money invested in them.
Fixed deposits vs savings accounts
- Savings Accounts provide more freedom in terms of withdrawing large sums of money from your deposited savings.
- Withdrawing your savings from a Fixed Deposit is likely to attract penalties.
Deposit products come with greater liquidity. One never knows when a financial emergency may strike. So, if you suddenly find yourself in need of immediate funds, which of these two options should you opt for? Between Fixed Deposits and Savings Accounts, the latter provides more freedom in terms of withdrawing large sums of money from your deposited savings. You can freely make withdrawals from a Savings Account, while withdrawing your savings from a Fixed Deposit is likely to attract penalties.
How to mitigate inflationary impact on portfolios
When it comes to mitigating impact of inflation and market risks, nothing can beat diversification of portfolios. For small savers, bank deposits and such other fixed return products comes with greater amount of security and simplicity. However, the returns on these products barely match the prevailing inflation, exposing the investor to losses in real terms over a period of time.
Thus it is advisable for these investors to diversify their investment portfolios into shares and equity-linked mutual funds. Investing in shares can potentially provide better protection against inflation than deposit accounts or bonds which aren’t index-linked. That’s because the companies that you invest in via shares or funds can often raise prices to cover higher costs – this should, in theory, enable them to grow at the same rate or higher than inflation over time. That said, equity investments come with their share of risk while offering the potential for higher returns.
While investing in equities and equity linked products, investors should keep in mind that not all companies will be able deliver consistent returns beating inflation. Some may see their profits fall or end up with losses that could even see them go out of business, presenting the investor with a greater danger of losing his capital.
Also, bear in mind that investing in the stock market carries a high risk of losses, so you must be prepared to accept that you could get back less than you put in, and that the value of your investment and any income from them may not keep up with inflation.
One of the options for fixed income investors seeking inflation-beating returns is index-linked bonds, which are government bonds whose interest payments and value at redemption are adjusted for inflation. However, if they are sold before their maturity, known as the ‘redemption date’, their value could have fallen as well as risen – bond prices can change, as bonds are bought and sold on the open market.