Effects, expectations of inflation

Individuals in the field of finance review massive amounts of information. One of the most fundamental is expectation for inflation. As an investor, one will try to determine or calculate what their real rate of return will be for a particular investment. For example, during 2007 a five year government bond was averaging 4.4 per cent yield while inflation expectations over the following five years were around 2.3 per cent. As long as these variables remained constant, this would have generated a real rate of return of around 2.1 per cent to an investor. 


What this means to you 

This is important because as the US dollar or your functional currency depreciates over time you know that your savings will be able to generate a return of 2.1 per cent over inflation per year. This calculation works as long as these assumptions remain constant. This is incredibly important for all investors, but in particular pensioners that are living off their savings. Based on the scenario presented above, without considering tax or other factors, an extremely conservative pensioner with investible assets of $2 million dollars could invest that money into a government bond and could obtain an income of approximately $42,000 a year without eroding any of the purchasing power of the principal.  


The game changer 

The problem with finance is that expectations, thus in turn variables, constantly change. In 2008, with the subprime mortgage crisis and the Eurozone debt crisis, many countries including the US, UK and Eurozone cut interest rates to historic lows. The main reason was to help spur growth by making borrowing money more affordable to governments, corporations and individuals. One of the best places to see this unprecedented all time low was the US 30-year fixed mortgage whose rates were 3.87 per cent for the week ending 17 February, 2012.  

The problem facing most pensioners is that they are on the loan side of the equation and not on the borrow side. Most pensioners have cash they want to loan for a reasonable amount of interest and, at a minimum, would like the interest rate to be higher than the inflation rate. In the current environment, it is extremely difficult to beat the inflation rate without taking on some risk.  

Below is a summary of the US government interest rates on bills notes and bonds for the week ending 17 February, 2012: 1 Month .03 per cent, 6 Month .09 per cent, 1 Year .18 per cent, 3 Year .42 per cent, 5 Year .88 per cent, 10 Year 2.01 per cent. 

With a change in the economy, the calculation looks entirely different when you include inflation expectations running around 1.9 per cent for the next five years. What one would gather is that the real rate of return for investors in five year treasuries is around -1 per cent per year for the next five years. 


Why would the government allow or encourage this? 

The US, UK and Eurozone governments want to create a disincentive for people to put money into risk-free assets fixed income and instead to put money into riskier asset classes such as stocks, private equity and lower rated bonds. The thought is that investments in stock, private equity and lower borrowing costs will ultimately create new jobs and help spur the economy. The assumption is correct in that jobs have been created and money has piled into the US and UK stock market as seen with the approximate 19 per cent return in the S&P 500 in USD terms and in the approximate 12 per cent return in the FTSE 100 in GBP terms for the period of 2009-2011.  


Looking Ahead 

The future of interest rates has sparked much debate amongst economists. There are many questions about what the expected level of inflation will be in a few years. There are two different views on inflation in the United States. One camp agrees with the Federal Reserve which says it is difficult to have inflation when there is high unemployment in the labour market. The other camp thinks there is so much money being pumped into the system that it will lead to a spike in inflation.  

After reviewing the data, the Federal Reserve’s view that there will be low inflation for the next few years seems more compelling. There will most likely be a significant decrease in the unemployment rate and the economy will continue to make additional progress. However, there are still too many headwinds such as the Eurozone debt crisis for there to be a spike in inflation rates above historical averages within the next two to three years in the United States.  


Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.