UAE: Did you know that inflation can shrink
earnings on your bank deposits? Yes,
here's how!
Deposit products come with lower risks, but are often slow in returns
Published: July 12, 2020 11:25 Last updated: August 12, 2020 11:40Babu Das Augustine, Business Editor
Every rise
denominated in any currency simply means a debasing of that currency’s purchasing
power.Image Credit: Gulf News Archives
The concept of inflation is familiar to almost everyone when spoken in the context of
rising prices and its impact on our cost of living. However, people tend to ignore or care
less about the impact of inflation on their savings and investments over long term.
In economics, inflation is defined as a general rise in prices. On the face of it, it may
appear that a rise in prices should not have any impact on the money one has saved in
a bank account or an asset in which he/she has invested. But in reality, every rise
denominated in any currency simply means a debasing of that currency’s purchasing
power.
This effectively means that the money one has saved over time will not buy same
amount of goods in the future compared to the point in time the savings was made.
How inflation impacts value of money
Inflation is a measure of how fast the prices of goods and services are rising. It is
calculated using different methodologies in different countries. Mostly, the measurement
is known as the consumer price index or CPI. It tracks the change in prices of a
shopping basket of goods and services. The basket items are chosen to represent what
a typical consumer might buy.
HOW INFLATION RATE IS CALCULATED?
Inflation tracks the change in prices of a shopping basket of goods and services. The
basket items are chosen to represent what a typical consumer might buy.
The CPI in the UK, for example, is calculated monthly using 180,000 price quotations
from multiple retailers for 700 different goods and services. This notional basket is
usually updated quarterly to reflect changes in consumer preferences over time.
Very low or very high inflation is damaging to the economy. There is no uniform rate of
inflation that can be said as an ideal level for all economies. However, inflation targeting
by central banks across the world are aimed at achieving an optimal trade-off between
economic growth and rise in prices. The objective in nutshell is to maintain a “Goldilocks
Economy” – not too hot, not too cold.
What causes inflation?
Different theories try to answer why prices rise at different speeds over time, but there
are two central explanations within economics. Consider the analogy of an auction
room. If it is full of willing buyers with plenty of money then it is more likely that higher
prices can be achieved for a particular lot being sold. In this case, the amount of money
available, known as the “money supply”, will influence the likely level of prices. If there
was less money available, then the bidding could not go as high. This is the view of the
monetarists who believe that inflation can be controlled by changing the level of money
that circulates in the economy.
Another view is held by Keynesian economists, followers of the theories of the British
economist John Maynard Keynes. They believe that demand is the central reason for a
change in prices. Revisiting our auction room again, if all the buyers believed that a
particular item was in very short supply, then they would be willing to pay a higher price
for fear of not being able to buy another. In the Keynesian view, this would mean that
demand was higher for an item than the supply of that item, hence the price rises until
there is a winner.
How inflation impacts bank savings
The prevailing purchasing power of a currency is central to the value of one’s savings. If
inflation is higher than the interest rate paid on one’s savings and fixed deposit
accounts, this essentially means that the value of your savings is set to fall over time.
In other words, if the rate of interest paid on one’s deposits is less than the prevailing
rate of inflation in the country, the final value of the original principal plus the interest
earned on maturity (of deposits) will be less than the money originally deposited. Thus
the real gain on that deposit will be negative.
HOW INFLATION ERODES EARNINGS
If the rate of interest paid on one’s deposits is less than the prevailing rate of inflation in
the country, the final value of the original principal plus the interest earned on maturity
(of deposits) will be less than the money originally deposited.
Let us consider the example of an Indian investor with a fixed bank deposit of
Rs100,000. At the current fixed deposit rate of 5.9 per cent per annum offered by the
State Bank of India, the largest Indian commercial bank, the depositor will earn
Rs1,05,900 at maturity. Which translates into a nominal gain of Rs5,900 over a period
of one year.
The current consumer price inflation in India is estimated at 6.6 per cent by the National
Statistical Office (NSO) of India. This essentially means, over a period of one year, if the
money was not invested in a fixed deposit that earned interest, its real value would have
diminished to Rs93,400 (100000 – 6600 = 93,400). In this example, the real value (the
nominal value minus inflation) on the deposit maturity will be Rs98,910.6 ( Rs105,900 6989.4 = 98,910.6). Although it appears, the depositor has gained Rs5900 in interest
income, in real terms, he has a net negative real earning (or net real loss) of Rs1089.6
on his investment over a period of one year.
Inflation has greater impact on fixed income returns
Inflation can chip away any type of investment returns, unless investments’ returns are
ahead of inflation rate. For example, an investment that returns 3 per cent in an
environment of 3 per cent inflation will effectively return 0 per cent when adjusted for
inflation.
The impact of inflation can be particularly harmful to fixed income returns. Fixed income
investments, such as fixed deposits, bonds, aim to produce a stable income in the form
of interest income. As these payments are fixed, if inflation rises, their purchasing power
declines.
Despite inflation, why should one consider deposit products?
Bank deposits, particularly saving bank accounts and fixed deposits, are very popular
entry level investment options for most investors across the world. Fixed deposits offer
much higher interest rates than Savings Accounts.
Despite the fact that inflation can chip away most of the interest earnings, deposit
products are must haves in personal portfolios because of their unique characteristics of
greater capital protection and higher liquidity.
Fixed deposits are one of the safest investment options, especially when you compare
them with stocks or any other market-linked instruments. With low volatility, the corpus
that you set aside in FDs serves as a great way to ensure that your capital is safe. One
can start early and multiply wealth with the power of compounding. A small amount can
turn bigger with compounding; when the compounded interest is reinvested with the
principal.
We all know that idle money yields no returns, which is why it needs to be invested as
efficiently as possible. Savings Accounts come with a set of predefined features. Across
the board, Savings Accounts tend to offer similar interest rates and offer little in the way
of variations. Fixed Deposits, on the other hand can be customised to suit financial
needs of all kinds, whether short-term or long-term.
There is a variety in tenure for Fixed Deposits (FDs), ranging from 7 days to 10 years,
and the interest rates only get better the longer you choose you keep your money
invested in them.
Fixed deposits vs savings accounts

Savings Accounts provide more freedom in terms of withdrawing large sums of money
from your deposited savings.

Withdrawing your savings from a Fixed Deposit is likely to attract penalties.
Deposit products come with greater liquidity. One never knows when a financial
emergency may strike. So, if you suddenly find yourself in need of immediate funds,
which of these two options should you opt for? Between Fixed Deposits and Savings
Accounts, the latter provides more freedom in terms of withdrawing large sums of
money from your deposited savings. You can freely make withdrawals from a Savings
Account, while withdrawing your savings from a Fixed Deposit is likely to attract
penalties.
How to mitigate inflationary impact on portfolios
When it comes to mitigating impact of inflation and market risks, nothing can beat
diversification of portfolios. For small savers, bank deposits and such other fixed return
products comes with greater amount of security and simplicity. However, the returns on
these products barely match the prevailing inflation, exposing the investor to losses in
real terms over a period of time.
Thus it is advisable for these investors to diversify their investment portfolios into shares
and equity-linked mutual funds. Investing in shares can potentially provide better
protection against inflation than deposit accounts or bonds which aren’t index-linked.
That’s because the companies that you invest in via shares or funds can often raise
prices to cover higher costs – this should, in theory, enable them to grow at the same
rate or higher than inflation over time. That said, equity investments come with their
share of risk while offering the potential for higher returns.
While investing in equities and equity linked products, investors should keep in mind
that not all companies will be able deliver consistent returns beating inflation. Some may
see their profits fall or end up with losses that could even see them go out of business,
presenting the investor with a greater danger of losing his capital.
Also, bear in mind that investing in the stock market carries a high risk of losses, so you
must be prepared to accept that you could get back less than you put in, and that the
value of your investment and any income from them may not keep up with inflation.
One of the options for fixed income investors seeking inflation-beating returns is indexlinked bonds, which are government bonds whose interest payments and value at
redemption are adjusted for inflation. However, if they are sold before their maturity,
known as the ‘redemption date’, their value could have fallen as well as risen – bond
prices can change, as bonds are bought and sold on the open market.