“The rains are finally here,” she said, as soon as she got into my room with a view, overlooking the bus depot.
“So is the petrichor,” I said. “And it smells like grease.”
“Ah V. One can trust you to take the romance out of any situation.”
“Sorry about that,” I said.
“You remember, my father had given me some money.”
“Yes.”
“I wanted to put that into a fixed deposit.”
“Yes.”
“This morning someone told me that the rate of interest on a fixed deposit is very high.”
“Really?”
“Yes,” she said. “The logic offered was that the rate of inflation as measured by the consumer price index in May 2019 was at 3.1%.”
“And?”
“The interest rate on a fixed deposit of one year is around 7%.”
“That's right,” I replied.
“Given this, the real rate of interest on the fixed deposit comes out to 3.9%. This is obtained by subtracting the inflation (7%) from the interest (3.1%),” she explained.
“Yes,” I said with a smile.
“Why are you smiling?”
“I love it when you explain things logically.”
“Role reversal?”
“Whatever.”
“So, where were we?” she asked.
“We were talking about the real rate of interest of 3.9%.”
“Oh, yes.”
“Why is the real rate of interest important?” I asked.
“For the simple reason that inflation needs to be taken into account. I may be earning a return on investment, but it is also important to figure out whether the return is higher than the prevailing inflation.”
“Yes.”
“Basically, the purchasing power of my wealth should not decline because of inflation. Hence, it is important that the return on investment is higher than inflation.”
“Is that happening in this case?” I asked.
“Yes.”
“Are you sure?”
“Yes. We just did the math. The real rate of interest works out to 3.9%.”
“Does it?”
“V, why are you confusing me?”
“I am not. You know that the interest earned on fixed deposits is taxable.”
“Oh, yes.”
“And that you come in the 30% tax bracket.”
“Yes.”
“So, after tax return on your fixed deposit works out to 4.9% (7% interest on the fixed deposit minus 30% of 7% to be paid as tax.”
“Oh, I hadn't thought of that.”
“So, your actual return on the FD comes out to 4.9%. Now compare this to inflation of 3.1%, your real rate of return works out to 1.8%.”
“That's a big fall from 3.9%,” she said. “
“Also, the rate of inflation is calculated by following the prices of certain goods and services. Or what economists like to call a basket of goods and services. And food products form a little over 39% of this basket.”
“Oh.”
“This reflects the average Indian. He or she spends 39% of his spending on food. Now that is not the case with you. As people rise up the income hierarchy…”
“Income hierarchy?” she butted in.
“Basically, what I wanted to say is that as people make more money, they spend a lesser proportion of their income on food.”
“Makes sense.”
“In your case, we need to take a look at core inflation, which excludes food, fuel and light products.”
“And how high is that?”
“Core inflation in May 2019 was at 4%. And it has been falling. In February 2019, it was at 5.1%.”
“How does the math look now?” she asked.
“Your after-tax return on the fixed deposit is 4.9%. If we subtract an inflation of 4% from it, your real return is now down to 0.9%. So, you just about making enough money on your fixed deposit to beat the rate of inflation.”
“And I was thinking that putting money in a fixed deposit would mean that I would actually earn a good return.”
“Of course, you are.”
“You are confusing me again V.”
“The bank will definitely return your money at the end of one year.”
“Joking?” she asked.
The example is hypothetical.
Vivek Kaul is the author of the Easy Money trilogy.
