Big PictureEconomicsFixed Interest & Bonds

How inflation erodes returns

27 Apr 2022 1 month(s) ago

If interest rates rise, how will that be affected by inflation?

There are growing signs that interest rates may be on the rise in Australia. The ABC is reporting that economists expect a big rise saying the next inflation figure could be “the biggest annual consumer price increase since CPI jumped 5 per cent in the year to September 2008, which immediately preceded the peak of the global financial crisis.”

The ABC says some economists are forecasting even bigger price rises still:

“Westpac is tipping a 2 per cent jump in consumer prices over the past quarter and a 4.9 per cent surge over the year.

"The biggest contributor is the cost of building a house, which of course includes building construction materials, construction wages, and the margins that developers are able to get,' the bank's chief economist Bill Evans told the ABC's RN Breakfast program.”

With inflation probably going to surge, it is important to have a clear understanding of the real interest rate: that is, the reported interest rate (nominal) minus inflation. If interest rates are 1% and inflation 2% then the real interest rate is actually negative; investors are losing money in effect.

Like all financial issues, however, things get complex when you look closely. Citigroup has tried to tease out some of the issues:

“The most straight-forward conceptual definition of the real interest rate is that it’s the nominal rate adjusted for inflation. That seems simple enough. Certainly we understand nominal interest rates—we interact with them every day. We also understand the concept of inflation. And if in recent years there has been a lack of familiarity with inflation, the current episode is rapidly curing the problem.

The basic idea is that what matters for investors, households, and firms is not the number of dollars that their investment earns but, rather, what they can actually buy with those dollars. Thus, returns should be adjusted for inflation or alternatively framed entirely in real terms—if I forego a unit of consumption today, how many units of consumption will I be able to enjoy tomorrow?

“But where things gets trickier is the question of exactly how such adjustments for inflation should be done. Critically, what affects economic decisions is not where inflation has been over the past period but where I expect inflation to go during the period ahead. Hence, the appropriate definition of the real rate is not the nominal rate minus the recently observed inflation rate but, rather, the nominal rate minus the expected rate of inflation over the relevant holding period.”

US real interest rates: have been in a long term decline, it is the same trend in Australia

Inflation is really about expectations. What people think will happen in the future. There is no doubt those expectations are getting more gloomy, not just because of the Ukraine war but also because of the supply chain collapses in the wake of COVID.

What is happening in China also looks suspiciously like that country starting to shut off, which it will eventually have to do to deal with its catastrophic ponzi scheme otherwise known as its banking system.

We may be looking at a new world order that is bifurcated: Russia and China versus the West with India and Brazil somewhere in the middle.

But back to real interest rates. Investors may find fixed interest products more attractive but they should take inflation into account:

“There is no single, fundamentally “correct” empirical measure of inflation expectations. And for this reason, there is unlikely to be a single unique empirical measure of the expected real interest rate.

“But another observation should also be borne in mind. In some deep sense, even the definition of “correct” is hard to pin down in this context. What really matters for economic activity today is not so much where inflation actually lands in ten years but, rather, where people think it will land.

“The behavior of households, firms, investors, and even the public sector will hinge on these views. We see no reason why rational agents will hold expectations about inflation that differ systematically from actual outcomes. But to the extent that they do, the fact that their views are off.”

Solving these complexities is not the business of investors, but this does point to the need to analyse how higher inflation affects you, as an individual. Higher overall inflation will almost certainly lead to higher interest rates, but in calculating how that is discounted by inflation it makes sense to look at your own household budget to see the effect.

Citi is bearish on real (after inflation) GDP, or economic growth:

“While the trajectory of inflation remains to be seen, the outlook for real GDP strikes us as skewed toward lackluster outcomes. The headwinds that characterized the post- GFC period—including aging demographics, high levels of debt and deleveraging, and corporate hesitance to invest in physical capital—seem likely to remain in place. We would certainly welcome higher economic growth, but it’s hard to place a high probability on such scenarios. “


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