Inflation & FD Interest Rates

Recently a reader has asked me the following query and that’s why I thought to answer this query.

Dear Sir,
Kindly inform us Why nowadays bank FD interest rates are decreasing? What is the reason? Some time FD interest rates are 8 to 9% and now 6% per year
Reader

Well, See. The FD Interest rate depends on the rate of Inflation. Usually Interest rate is adjusted 2% higher than the Inflations. Previously Inflation was around 6% and thus the interest was 8% that was fairly good. But in the year 2008, in India the Inflation was 12%. Now at that time the interest rate was only 9-10% that was 2% below the Inflation. That was a bad thing.

But now, in India the Inflation is just 1.5% when I am writing this article. Since last 3 months the Inflation was negative (Deflation). So to keep adjust with Inflation government and banks are reducing Interest rates on FDs to 6%.

NOTE: Today’s 6% Interest rate is much better than yesterday’s (Few month before) 8-9% Interest rate. Because Today’s Interest rate is +4.5% higher than the Inflation while previously The Inflation was was 10% and the Interest rate was 8-9% which was just 1-2% higher than the Inflation which is not a good thing for the Investors.

In Layman’s Explanation – Why Inflation rate is so important?

Well, see. The above was somewhat heavy explanation. Now, let me tell you this in layman’s (My Favourite) Language.

See. Inflation is the Silent money killer. Inflation will erode the purchasing power of your money over the time. The problem with inflation is that you and me can’t see it with our eyes. But we have to see it with our minds.

Say for Example, You have Rs.100 in your pocket today and the inflation rate is 10% per annum than after 1 year, you will have the same Rs.100 in your pocket. So with your eyes, you will see the same 100 rupees in your pocket. But because of the Inflation, the purchasing power of your Rs.100 after 1 year become today’s Rs.90 only.

So if inflation is 10% than it means that after a year you will be able to buy only 90 rupees of products and services in the economy as that of today.

Thus, the real return from any asset = Return – Inflation.

Suppose if the stocks give you 15% per annum return in the long run and the average inflation in the long run is 5% than your real return from the stocks is just 10%.

The same is true for FDs. If your FD is giving you 10% return and the inflation is 8% than your real return is just 2%. Today your real return on FDs is + 4.5% because inflation is just 1.5% and FDs are offering 6%.

One year back (2008), the scenario was more worst. FDs were giving you 10% return and inflation was 12% so your real return was –2%. Yes, You were actually loosing money from your FDs.

Anyway…I hope this much information is useful to you.

Well, I am right now working on to prepare a story for your daughter who is in first standard and still reading my blog. The story will help her to change her mindset about Money since childhood. I will publish it soon as soon as I will prepare it. (Probably 1 week or a two). Kindly send me your e-mail address to my e-mail ID. I will inform u as soon as I will publish the story….!!!!