INSIGHTS

Interest rates might not be quite as low as you think, and inflation is also running a little hotter than many headlines would suggest. Let me explain.

The current interest rate on a six-month term deposit is 2.8 per cent. However, you’re not really going to make a return of that level though, because inflation is going to erode your spending power slightly between now and next year when this investment matures.

As measured by the consumer price index (CPI), the annual inflation rate is 1.5 per cent at the moment. As a result, the “real” interest rate you’re looking at is only 1.3 per cent.

To add insult to injury, if we reduce the original 2.8 per cent to account for tax (and let’s assume a 30 per cent personal tax rate), it falls to 2.0 per cent. When we then remove inflation, the real (and after tax) interest rate is a paltry half a per cent.

The concept of real interest rates is important, because there have been periods in history when interest rates might have looked attractive (for savers, that is), but inflation was also very high at those times. Consequently, investors weren’t getting nearly the returns they thought they were.

The 1980s is a good example. Interest rates in New Zealand averaged 13.6 per cent during that decade, rising to around 18.0 per cent on a couple of occasions. However, we must remember that annual CPI inflation averaged 11.1 per cent during the 1980s, and peaked at 18.9 per cent in 1987!

For long periods during the 1980s, inflation was running higher than interest rates were, sometimes by as much as 5-6 per cent. While interest rates were very high on the face of it, real interest rates were actually negative for about four years of that decade (as well as all of the 1970s).

Are savers today better or worse off than those in September 1985, when the six-month term deposit rate was 17.80 per cent?

Neither. They’re in virtually the same position, because annual inflation at that time was 16.3 per cent and the real interest rate (before tax) was similar to where it is today, at around 1.5 per cent.

It should be noted that while consumer inflation has been very low, we have seen rampant asset price inflation in many parts of the world. Fuelled by low interest rates and quantitative easing, house prices and sharemarkets have moved dramatically higher.

Another pertinent point is that for many within our society, it probably doesn’t feel as if consumer inflation has been as low as the official statistics suggest.

Here in New Zealand, many of the products that have driven inflation lower are of a discretionary nature. Examples include air travel, electronic goods and imported clothing.

In contrast, many of life’s essentials – such as rent, local body rates, insurance and electricity – have seen steady increases. This was highlighted in last week's CPI report for the September quarter.

While the headline suggested a very modest inflation rate of 1.5 per cent, this was entirely driven by very low tradables inflation (which is influenced by the currency as well as global factors), which declined 0.7 per cent form a year earlier.

Meanwhile, non-tradables inflation (which better reflects domestic inflationary pressures) was much higher. This measure is running at 3.2 per cent annually, which is the strongest we've seen in eight years.