Inflation trims deposit returns

Fixed-income investors may be feeling cheerful, of late, with deposit rates firming up again. But they may not feel as good if they knew that inflation can erode their returns significantly.

The motivation of a fixed-deposit investor is to protect capital while making some nominal return. However, data available for the last five years shows that investors have not really been able to protect their capital, thanks to the impact of inflation.

Returns fail to beat inflation

For this analysis, we compared one-year deposit rates of SBI, the largest bank in terms of deposits, with the consumer price index for industrial workers (CPI-IW) a year later. We considered monthly data from 2000 onwards. The findings are as follows:

Since May 2005, four out of five times, a depositor would have lost value on his investment on an inflation-adjusted basis, thanks to high consumer inflation.

Rates of deposits invested since June 2008 have continuously been lower than inflation.

Prior to 2005, depositors were making a positive return adjusting for inflation. During the period 2000-2005 depositors were earnings similar deposit rates as they are now. However, the consumer price inflation was also low during that time.

Consumer Price Index-Industrial Workers (CPI-IW) average inflation rate during the six years ended March 2005 was 3.96 per cent. However, over the next five years, the inflation has been an average 8.1 per cent. The sharp rise in CPI rate since 2009 has increased the average of the last five years.

This means a one-year deposit rate after 2005 has to be more than 8.1 per cent to protect deposits against inflation. The SBI's one-year deposit was yielding an average return of only 6.8 per cent during the same period.

Two- and three-year deposits have also been giving negative real return in recent past, but the sample size is small.

The rise in inflation was more pronounced in recent times, as the shortfall in food supply and spike in fuel prices stoked prices. Growing domestic consumption has exacerbated the problem.

Other asset classes

Though fixed-deposit instruments failed to protect the value of savings, investors would have benefitted from their equity investment. The BSE Sensex returns outpaced inflation, more than 75 per cent of the time and delivered an average 14.9 per cent on a one-year rolling return basis since 2005. Gold too was able to beat inflation more than 92 per cent of the time.

Depositors have all along been actively managing their deposits by investing when the rates are high and refraining from doing so when the rates are really low, as shown by the RBI's data on deposit flows. However, the above data shows that depositors need to keep an eye on inflation too, while making savings decisions.

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