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Suresh Krishnamurthy

A larger rise in interest rates may be on the cards now that inflation is threatening to stay firm. Retail lending rates may rise sooner. As for investment, a portfolio of small savings and mutual funds should help you deal with interest rate uncertainty.

TILL as recently as a couple of years ago, inflation data used to reach us by the beginning of a week on Monday morning.

Inflation data now reaches us by the end of a week. In recent times, they have also taken on the role of party spoiler on weekends.

The inflation rate that now leaps at our faces from newspapers is way above 6 per cent. At 7.5 per cent for the week ended July 24, it is also beyond the targets that the Government and the RBI have set for the year.

The substantial spike in inflation rate and developments such as possible hike in oil prices, enlargement of the service tax net, hike in service taxes and imposition of the education cess leaves little room for optimism on the inflation front.

This suggests that the expected round of increase in interest rates in the economy may not be limited to quarter or half a percentage point. It could turn out to be of a much larger magnitude.

On the rise: About six months ago, one of the foreign brokerages had indicated that the yield on the ten-year government security would rise to about 6.5 per cent.

The yield then was hovering below 5.5 per cent. Many, including bankers, then scoffed at the idea of such a large increase in interest rates.

They pointed to the surplus in the system, which was about Rs 50,000 crore then, and said interest rates may creep up but will not rise as steeply as that.

Now, surplus liquidity in the system has remained unchanged. For a brief while, the surplus even rose to the levels of Rs 60,000 crore. Undeterred, the yield on the ten-year government security has, however, steadily risen. It is now at 6.3 per cent.

Factors other than liquidity are also at work and, therefore, yield on ten-year paper may well reach 7 per cent, despite the continuing liquidity in the system.

Any steady increase in credit offtake, which will reduce liquidity, may only hasten the process.

What is less certain are the implications for retail lending and deposit rates. Until now, banks have steadfastly resisted any attempts to jack up deposit rates. They have also sat tight on lending rates.

Given the numbers of banks operating in the country, competition should ideally ensure that deposit rates rise more than lending rates.

But that may not happen. Lending rates may rise more and sooner than deposit rates. So, complete your borrowing programme now.

Small savings and funds: On the investment side, the uncertainty enveloping the interest rate scenario may make you wonder if you need to change your strategy.

You need not if you had till now been staying away from bank deposits and banking instead on a debt portfolio of small savings schemes and mutual funds.

That strategy will still deliver reasonable returns. Staying away from bank deposits continues to be vital. Long-term bank deposits continue to kill value even more now than in the past.

The revision in deposit rates by SBI on Saturday only serves to emphasise this. Mutual funds would deliver better returns than such term deposits.

A word about debt funds and debt fund managers. Fund managers have been reiterating since March-April that a mutual fund debt portfolio should consist predominantly of short-term income schemes, liquid schemes and floating rate funds.

They were alive to the threat of rising interest rates and advised accordingly. They were even more unequivocal since May after the surprise election verdict. They have also anticipated interest rates correctly in the past, too.

To gain value from their perspective, however, investors need to keep in regular contact with their broker and fund houses. If you did not get their message in April and stuck to diversified income funds or gilt funds, you would be sitting on losses now.

You could go a step further and invest in a fund of funds that invests only in debt funds. Before you explore fund of debt funds, however, you need to exhaust the small savings scheme option. That continues to offer the best value for your investment buck now.

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