Prices of goods, services and assets must be corrected for the effects of inflation in order to make meaningful economic comparisons over time. To correct for the effects of inflation, economists distinguish between what they call nominal prices, or prices in terms of some currency, and real prices, or prices in terms of purchasing power over goods and services.
We also distinguish between nominal and real interest rates. The nominal interest rate on a savings or investment instrument is the promised amount of money you receive per unit you deposit. The real rate of return is defined as the nominal interest rate you earn corrected for the change in the purchasing power of money.
An investment is defined as the current commitment of money or resources in the expectation of reaping future benefits. One of the key lessons in investment, or even simple savings for that matter, is that the rational investor or saver will always aim to earn a real return for the money or resource commitment. The first order of the investment objective is thus to maintain the purchasing power of one’s resources and that means beating inflation.
The simple and dirty formula for real interest rate is nominal interest rate minus the rate of inflation. MBA students know the more exact computation but for our purpose this will suffice. To beat inflation, one’s investment must thus at least be above the inflation rate.
BSP Governor Ben Diokno made the following statements about Philippine inflation. He said it averaged 2.6% in 2020 and will remain within the 2% to 4% range in 2021 and 2022. The question remains though whether this can be sustained. Inflation rates here and abroad are starting to rise. No less than the Department of Finance flagged inflation risks from higher prices of food particularly meat and vegetables. Domestic demand will expand if the pandemic is managed and growth perks up.
Following significant drops in early 2020 followed by a period of stability, crude oil costs have risen from approximately $49 per barrel in mid-December 2020 to average rate of $56 per barrel. The US Energy Information Administration estimates that while global consumption was down by 9.0 million barrels per day (mbd) in 2020 (around 10%), it will grow by 5.6 mbd in 2021. There are also output cuts led by Saudi allies in OPEC.
Even without the surge in inflation, millions of Filipino depositors whose main outlet for their excess funds are bank savings accounts now literally suffer from negative real returns in their savings. Banks today continue to cut their savings deposit rates amidst the low interest rate regime. Online research reveals that savings deposit rates are around .125% to .25% for the major banks.
Do the arithmetic. If inflation is 2.6% (per BSP), already our ordinary savings have a .125% less 2.6% or -2.475% real rate of return. For emphasis, this is a negative return which means that every year the purchasing power of whatever funds we leave in our savings accounts plummets by more than 2%. Frankly, there is no incentive to save in banks except for liquidity, safety and convenience. But today we all pay a price for those qualitative benefits.
The problem of a looming inflation can have more negative effects on our savings. During periods of high unemployment which flattens wages and spending, policy makers typically cut interest rates which tempers inflation. Already, the BSP delivered five interest rate cuts totaling 200 basis points last year, with the benchmark overnight repurchase facility rate at a record low of 2%, one of the world’s most aggressive in policy easing. Bank’s reserve ratio’s have also been cut by 200 basis points, providing liquidity support.
But with the hope for bounce back in GDP growth of 6.5% to 7.5% in 2021, there will be additional inflation pressure. The private sector beneficiary of stimulus programs will find itself with fresh cash as vaccinated economies reopen. Households and firms may remain cautious. But amid the joy of reopening they may instead go on a spending spree. That might result to a lot of money chasing goods and services that might not be in simple supply, resulting in a period of inflation. The typical policy response is increasing interest rates for it to tail off.
The Economist has written about warnings of a group of prophets of doom called “inflationistas.” Some predict a possibly high but transitory spike in prices as consumer spending bounce back from the pandemic. Another group warns of a more persistent inflationary pressure showing a fundamental shift in inflation dynamics. The more pessimistic group warns that complacent or distracted central bankers will allow such pressure to go unchecked, leading to a decade of stubbornly high inflation. The same article concludes, after discussing the arguments of the “inflationistas” and their dove counterparts, that a recovery from the pandemic that is untroubled by excessive inflation looks likely. However, it is not guaranteed.
There is palpable cause for concern. This piece is in behalf of the millions of Filipino savers who are not getting their fair share of economic benefits because of size and lack of access to better financial instruments. Hopefully, inflation will not make us all worse off.
The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.
Benel D. Lagua is former Executive Vice President and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and a long-time advocate of risk-based lending for SMEs.