The Real Deal on Rates and Inflation – Guidance Financial Services

Falling interest rates are celebrated by those with a mortgage. But there are plenty of people on the other side of the ledger, with accumulated savings. For them, lower interest rates means less income. 

But looking at the headline rate alone isn’t telling the full story. Interest rates and the inflation rate are tightly linked. An understanding of the concept known as “real return”, is worth getting your head around. Without it, there is the potential to make investment mistakes. 

So without further ado, let’s dive into this week’s post – The Real Deal on Rates and Inflation. 

18 months or so ago, you could get an almost risk free 5.5% return on your term deposit. Today, 4% would be a great result. 

For term deposit investors then, You’ve taken a hit in terms of your investment return. Or have you? 

Inflation spiked as we bounced out of COVID, due to the enormous amounts of government cash pumped into the economy to keep things ticking over during this unprecedented period. Lots of money chasing a limited amount of goods and services meant that prices went up rapidly, something most of us certainly experienced at the supermarket, and in our daily lives. 

Interest rates were lifted in an effort to soak up some of this excess cash. The theory goes that higher interest rates mean those with debt have to pay more to the bank, and therefore have less money to spend at the shops, hopefully bringing supply and demand into equilibrium. As discussed previously, how well this actually works today is the source of considerable debate. As the proportion of our population who are retired grows, and our retirement system requires that everyone hold investments and be self-funded, there is a very reasonable argument that in fact raising and lowering interest rates only serves to alter who does the spending, rather than changing the total level. High interest rates mean retirees spend more, while those in their 20s 30s and 40s cut back. As interest rates drop, the reverse happens. 

But this is a digression. Let’s focus back on the investor with the term deposit. Let’s say they have $1 million in a term deposit, which represents the proceeds from the sale of a property. As a starting point, they want this pool of money to maintain its purchasing power. 10 years from now, if all the interest was compounded back into the term deposit, it may not necessarily be worth the same as the property, because the property has required ongoing expenses to maintain, that the term deposit has not. But nonetheless you would want some degree of equivalency. Maintaining your purchasing power, means keeping pace with inflation. We all know that $100 bought you a lot more at the supermarket a decade ago than it does today. The price of everything goes up, and if your pool of money remains unchanged, then you effectively become poorer as your money is able to buy less and less. 

Our investments earning the rate of inflation then just ensures that we tread water. That we’re able to buy next year what we can afford to buy today. 

In order for our wealth to grow, and our position to improve, what we really are interested in then is how much return we can generate over and above the rate of inflation. This return above the rate of inflation is what is known as the real rate of return. 

If you earn 5.5% on your term deposit, whilst inflation is running at 4%, then your real rate of return is 1.5%, being the difference between these two. 

Today, inflation is running at about 2%. Therefore if you earn 4% on your term deposit, your real rate of return is 2%. Notice that this is higher than the previous example. And this is the key point that I wanted to flag in today’s episode. Whilst your headline term deposit rate has declined, it has done so in parallel with inflation dropping. Your real return therefore hasn’t worsened, and in fact may have improved. This outcome is quite imperfect. It takes a while for the Reserve Bank to alter interest rates, and the inflation data is a trailing indicator, that is we only know what it is a month or two after the spending has occurred. But nonetheless, there is always some degree of relationship between interest rates and inflation, and as such, a focus on the headline rate alone can lead to false impressions, and potentially investment mistakes. By mistakes, what I mean is people feeling that they need to exit their term deposit and shift to a more risky investment because the return in the term deposit is no longer adequate. Now there may well be a case for moving from term deposit to a more growth oriented investment, but this should be informed by changes to the real rate of return, as well as your investment objective and risk appetite. The headline interest rate declining in isolation is not enough to prove this necessity for a change.