The impact of low interest rates has received a lot of attention over the last few years. For home owners with a mortgage, low rates have been helpful. But for savers, each rate cut has led to an immediate reduction in their income.
But another issue that can have just as much impact on your money is the rate of inflation. It has the ability to erode any gains that you might make on an investment.
We know that inflation refers to the rate of increase in the price of goods and services over a period of time. Inflation isn’t always bad news. It can sometimes act as a signal of increasing demand in the economy.
The opposite of inflation — deflation — can have a crippling effect on the economy. To keep this at bay, the Reserve Bank sets an inflation target. Currently, the target is between 2% and 3% ‘over the cycle’. Meaning they want the inflation rate to average within this band over the medium term. This level — they believe — allows the economy to grow without prices rising so quickly that people stop spending.
Currently, the Reserve Bank puts the rate of inflation in Australia at 1.7%. However, it hasn’t always been this low. Look at the Reserve Bank’s inflation chart below:
You won’t understand the real impact of inflation until you look at your investments and see the effect that it has. Let’s look at some of the main asset classes to see how much you really earn after taking inflation into account.
Look at the table below. The first columns refer to the bank and the products they offer. The next columns look at how much you’ll actually earn, and then adjusted for inflation.
I don’t know about you, but it looks like a pretty raw deal to me. On the positive, you know that you will get your money back after a year. But lending $10,000 out for a year to receive $90 back after inflation? It would barely cover the cost of a tank of fuel for a medium sized car.
How about investment properties?
Investing in property can have tax benefits for some investors, and capital appreciation may overcome the costs involved. But there is still the risk that property prices could reverse, or that governments might be tempted to change taxation policy.
Currently the Australian market is trading on a yield of 4.3%. That’s the average across the market. CBA pays out 4.6% at the current price. Telstra is at 4.9%.
Taking into account inflation, Telstra pays out 3.2% yield. In comparison, the $10,000 term deposit with CBA earns 0.9% after inflation.
Look at the following chart from the RBA:
Source: RBA, ABS
Click to enlarge
The red line shows the historical cash rate. The blue line shows the real cash rate after taking out inflation. This is the dilemma facing investors: trying to find income when the real rate is so low.
By the industry’s own numbers, electricity prices alone have gone up over 50% in the last five years. And that’s probably being conservative.
That’s why we need to include inflation in our calculations. Even more so, the real cost of inflation and how it erodes your income.
However, that doesn’t mean chasing after any old dividend paying stock. The next challenge is to avoid the yield trap.
Tomorrow, part three: the dangers of focusing purely on yield.
Income Specialist, Markets and Money Australia