All you wanted to know about negative real rates

Satya Sontanam | Updated on October 18, 2021

The Reserve Bank of India in its latest monetary policy review has projected retail inflation to be at 5.3 per cent for 2021-22. While this is lower than its earlier projection of 5.7 per cent, should the inflation estimate turn out to be true, investors may need to worry about earning negative real rates.

What is it?

The real rate of return on an investment is its actual rate of return minus the prevailing inflation rate. To get at the real interest rate, you simply subtract the rate of inflation during the period of your investment, from the return you earn on it.

In the current scenario, take SBI’s one-year FD that is offering an interest of 5 per cent. If inflation in the next one year turns out to be 5.3 per cent, the real rate of interest you earn on your money would be a negative 0.3 per cent (five minus the expected inflation rate of 5.3 per cent). The real rate would be even worse, if taxes on interest income are considered.

Why is it important?

Unless the return on your investments beat inflation, it isn’t logical to postpone your consumption or to save for the future. Say, you plan to buy a refrigerator for ₹20,000.

But instead, you decided to save and invest that amount to buy a better version next year. If you invest that ₹20,000 in a fixed-income instrument that pays 5 per cent interest, your investment will be worth ₹21,000 by year-end.

If the inflation in the prices of refrigerators over the next one year turns out to be 6 per cent, the price of the refrigerator which you are planning to buy, becomes ₹21,200. Let alone buying a better version, your investment amount won’t be sufficient to buy even the older model, as you can no longer afford it! This is what negative real interest rates do to your purchasing power!

By understanding the concept of negative real interest, you may wish to buy the refrigerator right now, instead of waiting for a year.

Now central banks around the world increase interest rates when inflation begins to exceed their desired threshold. But as economic growth needs a lower interest rate regime to kick-off investments, central banks may decide to keep the rates lower or hike at lower pace going ahead. This may lead to continuation of lower real interest rate scenario in the short to medium term.

Why should I care?

Interest rates in India are now at a record low. This makes negative real returns a significant risk to your investments.

Almost all the public sector banks and most private sector banks currently offer interest of 5 to 5.5 per cent per annum on a one-year fixed deposit, while inflation is at 5-6 per cent.

If you are depending on the income from bank fixed deposits, you need to brace for negative real rates with safer instruments. Remember, for the sake of earning higher real rates, you should not go for investments that do not fit your risk appetite.

To ensure that inflation doesn’t overtake your returns, you may also consider floating-rate instruments, coupon rates on which are linked to interest rate movements in the economy.

Some of them are Floating Rate Savings Bonds (FRSB) 2020 with pay-out option, the PPF and the Sukanya Samriddhi Yojana.

Gold is also considered to be a bet against inflation. As inflation rises, the value of money comes down but price of bullion goes up. However, gold returns are subject to volatility.

The bottomline

Even safe investments can erode your capital if they offer negative real returns.

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Published on October 18, 2021

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