Banks Inflation & Interest Rates

RMathew has posted a nice article on his blog, mentioning that the Interest earned on the savings bank account should be exempted from tax, as the interest rate earned in the savings bank account is way below the rate of inflation.
To understand the concept, here is a simple example.
You have a savings bank account with XYZ bank. The bank pays you an interest of 3.5% per annum, as per the RBI or Reserve Bank of India policies.

Imagine you have 100 Rs. as spare for a year. You have 2 options:
1) Put the money in your savings bank account and let it earn 3.5% rate for 1 year. So at the end of the year, you will get 103.5 Rs. as returns

2) Use that money to buy something you need, say half a kilo of tea leaves. You may not use the tea leaves immediately, but after 6 months to 1 year, you may use it.

Now, the interesting case is with the inflation. Inflation measures the dearness or Mehengaai (Hindi). So, if the rate of inflation is 7%, then what costs 100 Rs. today, may cost 107 Rs. a year later, OR to be more precise, the present price as compared to last years price has increased by 7%, as inflation is measured on historical values.

Coming back to the example above, suppose you put your money in the bank and take out 103.5 Rs. a year later. You will find that the tealeaves that you could have bought for just 100 Rs. a year before are no more affordable, even with the 103.5 Rs. because due to inflation, the price has increased to 107 Rs.

Hence, this brings us to the concept of Real v/s nominal interest rates:
Real Interest Rate = Nominal Interest Rate – Inflation

What the bank is providing is only Nominal Interest rate (3.5%). What you actually get, in terms of purchasing power, is the Real Interest rate. In the above example, the Real interest rate will be negative, as Nominal – inflation = 3.5% - 7% = -3.5%

Hence, in essence the money you deposit is loosing value for purchasing power, due to inflation.
Moreover, even though you are earning nominal interest, you have to pay tax on it. So 30% of 3.5% is 1.05%. Therefore, after tax, all you get is just 2.45% which is well below the inflation figure of 7%!
Mathew is expecting the government to stop charging interest rate on this nominal value earning, as it is not a real profit. He also suggests that the money should not be kept in the savings bank accounts, but should be invested.

However, the question is about certainty. Today, everyone is talking about inflation, because it is high at 7%. While it was down at 3.5% to 4%, no one noticed that. Government cannot make a period based ruling, that if inflation is higher than the interest rate, then tax will not be charged. It all depends upon the market timing and that works randomly.

What can the investors do to fight such indirect losses?

Unfortunately, there is no sure shot way to fight inflation. Countries like Zimbabwe, which are witnessing a crisis have seen inflation at the rate of 20000% in one single year, if you want to talk about the extreme cases. However, the best bet is to keep money in Fixed Deposits, or get into tax saving infrastructure bonds, as explained in this article: Are we using the banks account effectively?

Unfortunately, there is no such thing like sure to get money – even with the bank rates. The Fixed deposit bank rates change ever now and then.

Though they are less volatile, but changes are expected. Don’t expect the government to do anything – you know who are sitting to make laws for citizens.

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