What interest rate on a government guaranteed, risk-free term deposit would you prefer? 4.5 per cent or 6.0 per cent?
This is not a trick question, but the answer must be dependent on what the expected rate of inflation is and will be. With just the interest rate option, no one should be able to give a firm answer.
If 4.5 per cent was being offered when the inflation rate was likely to remain around 2.5 per cent or even a little less over the medium term, versus the 6.0 per cent which was being offered in the context of inflation running at, say, 7.0 per cent over the medium term, the answer should be very clear.
The 4.5 per cent wins by a mile.
In each example, let’s start with the working assumption that you have $100,000 on deposit and you have a fixed basket of goods and services that you buy each year, largely from the interest.
In example one, after one year with the 4.5 per cent deposit rate and 2.5 per cent inflation rate, you have earned $4,500 in interest and the basket of goods and services that you buy has risen by 2.5 per cent. Assuming you spend the interest only, you will have $2,000 left over at the end of the year for having exactly the same level of consumption. If you reinvest that excess cash, after five years you will have approximately $113,150 in your account and you will have have enjoyed exactly the same living standard on the items you buy.
In example two, after one year you have earned a superficially appealing $6,000 in interest, but to buy the same bask as goods and services that you did last year, you actually need to take $1,000 out of the principal to maintain your consumption levels. This is because inflation boosted prices by 7.0 per cent. You now have only $99,000 on deposit and even though you are earning a 6.0 per cent interest rate, you will be eating into the your principal each year. Indeed, over five years, if you maintain your consumption on the same basket of goods and services, you will be left with around $93,550, some 20 per cent less than in the low interest rate, low inflation example.
This shows that inflation is the greatest problem for savers or those who live off the interest on their savings, rather than the level of interest rates.
It shows a money illusion and how hard it is to remind people they are actually doing reasonably well as long as deposit rates remain above the rate of inflation.
Of course, there will be cases where people increase their consumption and blame low interest rates for their perception of cost of living pressures. Or it could be that they haven’t saved enough in the past and the interest they earn does not cover consumption patterns.
In neither of these cases are interest rates the main problem – rather it is either excess consumption or inadequate savings, and the latter can be seen as excess consumption in prior years.
Which comes to the here and now of yesterday’s interest rate cut from the RBA.
There were some vocal critiques of the decision. Those being critical of the rate cuts gave scant attention to the support for economic growth and job creation from easier monetary policy. The criticism is very much from the perspective of lower interest income for savers and some self-funded retirees.
But this misses the point.
A quick google reveals a stack of banks and financial institutions offering government guaranteed deposit interest rates of 4.5 per cent or even a touch more. Indeed, deposit rates were around 6 per cent just a year or so ago, so the falls in interest rates through 2012 need to be put in that context.
When looking at the run of inflation data since the start of 2009 shows that not once has the annual increase in the CPI been above 3.5 per cent. Indeed, the average rise in the annual CPI since the March quarter 2009 has been just 2.4 per cent, meaning that those with deposits have been boosting their purchasing power year in and year out.
Low inflation is a form of income support. For those with fixed incomes, it is a source of comfort to see inflation hovering around 2.5 per cent, even when there is the illusion of weaker growth in nominal incomes when interest rates are similarly low.
The RBA reckons that inflation will remain within its 2 to 3 per cent target for the next couple of years which is almost certainly correct. This means the current 4.5 per cent deposits rates on offer are still very good for those living off their interest income. Their purchasing power keeps on going up and up as long as they don’t over consume.
Long live low inflation!