Everything you wanted to know about negative real rates
The Reserve Bank of India, in its latest monetary policy review, forecast retail price inflation to stand at 5.3% for 2021-2022. Although this figure is lower than its previous projection of 5.7%, if the inflation estimate holds true, investors may have to worry about gaining negative real rates.
The real rate of return on an investment is its real rate of return minus the prevailing rate of inflation. To get the real interest rate, all you have to do is subtract the inflation rate during the period of your investment from the return you get on it.
In the current scenario, take the one-year FD from SBI which offers 5% interest. If inflation over the next year turns out to be 5.3 percent, the real interest rate you earn on your money would be minus 0.3 percent (five minus the expected inflation rate. 5.3 percent). The real rate would be even worse if taxes on interest income were taken into account.
Unless the return on your investments exceeds inflation, it doesn’t make sense to postpone your consumption or save for the future. Let’s say you plan to buy a refrigerator for 20,000.
But instead, you’ve decided to save up and invest that amount to buy a better version next year. If you invest those 20,000 in a fixed income instrument that pays 5% interest, your investment will be worth 21,000 by the end of the year.
If the price inflation for refrigerators over the next year turns out to be 6%, the price of the refrigerator you plan to buy becomes 21,200. Not to mention buying a better version, the amount of your investment won’t be enough to buy even the old model because you can’t afford it anymore! This is what negative real interest rates do to your purchasing power!
By understanding the concept of negative real interest, you may want to buy the refrigerator now, instead of waiting a year.
Now, central banks around the world raise interest rates when inflation starts to rise above the desired threshold. But since economic growth needs a lower interest rate regime to initiate investment, central banks may decide to keep rates lower or increase at a slower pace in the future. This may lead to the continuation of a scenario of lower real interest rates in the short to medium term.
Interest rates in India are now at an all time high. This makes negative real returns a significant risk to your investments.
Almost all public sector banks and most private sector banks currently offer interest of 5 to 5.5 percent per annum on a one-year term deposit, while inflation is 5 to 6 percent. hundred.
If you depend on income from bank term deposits, you need to prepare for negative real rates with safer instruments. Remember, to get higher real rates, you shouldn’t go for investments that don’t match your risk appetite.
To make sure that inflation doesn’t exceed your returns, you can also consider floating rate instruments, whose interest rates are tied to changes in interest rates in the economy.
Some of them are Floating Rate Savings Bonds (FRSB) 2020 with payment option, PPF and Sukanya Samriddhi Yojana.
Gold is also seen as a bet against inflation. As inflation increases, the value of silver decreases, but the price of bullion increases. However, gold returns are subject to volatility.
Even safe investments can erode your capital if they offer negative real returns.
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