Low interest rates not a cause of concern

A couple months back, there was an interesting graph showing how real rates has been reducing over the years. Many depositors would have recognized that their interest rates have reduced significantly over the years. So this poses a challenge for the retired who those who depend on interest income.

Nominal Vs Real Interest Rate

Low interest rates have become the norm across the world over the last few years and India has been no exception. It is, however, important that we understand some facts.

1. Nominal interest rates do not matter, what matters is the real interest rate. All economics is based on real variables. This means – we are not interested in our income but in what can be purchased using that income.
2. Prices become important and we put inflation into the picture.
3. Real interest rates are essentially interest rates minus the rate of inflation.

Look at interest rates with inflation rates

To give context, imagine you get an interest rate of 8% on your deposits. So your savings grow at 8 percent per annum. Now, if inflation is 12%, then prices are going up by 12%. This implies your savings are not growing fast enough to keep pace with inflation and you are worse off.

Now if inflation rate is, say, 6%, then your savings are growing faster than inflation, so you are better off.

Read the fine print

Many people focus only on the low savings rates which are nominal in nature. The primary reason why nominal rates have moderated has to do with the moderation in inflation rates over the last couple of years.

For instance, India had inflation rates as high as double digits in early 2010s. But this has moderated to under 5% over the last few years if one includes the recent months which have seen a higher inflation rate.

If we leave out these few months of high inflation rates, then the average drops to under 3 per cent.

The bottom line is that even though savings deposits rates have come down, so has inflation. This means real interest rates have been significantly higher than before over the last few months. Therefore, while people may think that they may be getting a lower amount of interest income, in real terms the value is higher than what is being perceived.

Inflation, Interest Rates & Investments

Inflation is likely going to be low over the coming few years despite recent spikes. What this implies is that we will have lower rates for the foreseeable future. It is this low interest rate environment that has triggered an interest in other financial instruments such as mutual funds or direct investment in bonds or equities as alternative financial assets.

The underlying tendency towards diversification across asset classes is only likely to intensify as nominal rates fall further. At the same time, we must also remember that it is real rates that truly matter.

We can expect greater participation of retail customers in our capital markets as people search for a higher return for their money, but we must remember that high return comes with a higher risk.

People must determine their asset allocation across savings accounts, bonds and equity depending on their risk-appetite and desired rate of return.

(The writer is a New Delhi-based economist & policy researcher)