Inflation and fixed deposit

Subject: Economy

Context:

In a situation of high inflation and declining interest rates, fixed deposits (FDs) with banks will have to take the backseat in an investor’s asset allocation, especially for those in the highest marginal tax bracket.

Concept:

• A fixed deposit (FD) is a financial instrument provided by banks or NBFCs which provides investors a higher rate of interest than a regular savings account, until the given maturity date.
• Any financial instrument must serve the purpose of growing your money — so, the first thing one must see before putting money in an FD is whether it provides real growth to the investment (net of inflation). If adjusted for inflation, fixed deposits actually generate negative returns. Consider this example:
• For an investor falling in the highest tax bracket, a 10-year investment of Rs 10 lakh in a bank FD offering 5.4 per cent, will generate a post-tax return of close to Rs 4.4 lakh. This means the investment of Rs 10 lakh would grow to Rs 14.4 lakh after 10 years. However, if inflation is 5% in the same period — which will be actually around 7% taking into account lifestyle and education inflation — the investor will actually lose money. This is because the investor’s Rs 10 lakh needed to have grown to Rs 16.28 lakh in 10 years just to cover for the 5% inflation. Since the FD grows to only Rs 14.4 lakh, in real terms the investor would be poorer by close to Rs 1.9 lakh.