Kitchen Table Economics & Investing by Damian Lillicrap

Author:Damian Lillicrap [Lillicrap, Damian]
Language: eng
Format: epub
Tags: BUS050040, BUS050030, BUS050020
Publisher: University of Queensland Press
Published: 2013-07-01T00:00:00+00:00

13

Cash and inflation

Investing 101 says that the long-term return to cash should be above the rate of inflation (consumer price index) because if you don’t at least get this return there is little incentive for you to invest your money. If the cash rate is above inflation and you don’t invest (or at least put your money in the bank to earn interest) you are losing spending power. Over the last decade in the United States, though, we have had two extended periods where the cash rate has been less than inflation. So these rules don’t always hold! But let’s stick to the story.

The return to cash can be broken into two components, the inflation rate and the ‘real’ cash rate, where real refers to the return above inflation. For example, if the cash rate is 3.5 per cent and the rate of inflation is 2 per cent, then the real cash rate is 1.5 per cent. Similarly, if the rate of inflation is 2 per cent and the cash rate is 0.5 per cent, the real cash rate is negative – 1.5 per cent. A negative real cash rate is sometimes referred to as financial repression, because savers are ‘repressed’ – they can’t make enough return to keep up with inflation.

There are a number of reasons why the authorities (such as central banks) may set the real cash rate to be negative. Cyclically the authorities may want to encourage investment. If people’s money can’t keep up with inflation by being invested in cash, this encourages them to take on market risk to get the return they are after. Negative real cash rates can also be good for banks; they can borrow from people at very low rates and lend out at higher rates. Sometimes authorities will tilt the playing field in banks’ favour in this way to help them rebuild capital after a crisis. Part of the reason that people get upset when interest rates are negative is that it is sometimes seen as a form of taxation with savings being penalised to help out banks.

The risk-free asset

Cash is often referred to as the risk-free asset class because there is less volatility, and there isn’t the risk of losing your capital because of market price moves. This is a vulnerability of other asset classes such as equities and bonds. Contingent on government guarantees and the like, you can of course lose your cash if the bank you deposit it in goes broke – but this is referred to as credit risk not market risk.

What is often not appreciated is that what is low risk for someone may be higher risk for someone else because of the other risks that are being managed. For some investment schemes that have a known payout in a number of years this payout defines their risk. The least risky thing for these schemes, if they currently have sufficient funds to meet that obligation, might be to invest in a high-quality government bond that has the same maturity as their liability.

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