Rising interest rate may not be a bad thing for the economy

The market has been talking and speculating about a rise in the interest rate since last year. There is a lot of fear about this and a lot of people are predicting doomsdays scenario on this. Personally, I think there is a lot of misunderstanding on the impact of rising interest rates on the economy. My blog for today is to show you why rising interest rate is not necessary a bad thing for the economy and you. There are a lot of reasons for this but I will just focus on two of them. Firstly, interest rate is a tool to keep inflation manageable. Secondly, rising interest rate that is well managed, will not affect business or consumer sentiment. Ok, let’s move on to the first point.

Interest Rate is a tool to keep inflation manageable

In an inflationary environment where the economy is booming, there is simply too much money chasing after too few goods. Things will get more and more expensive every day and the value of your dollar will drop dramatically. It hurts savers and lenders. For example, in an inflationary environment, a loaf of bread that costs you $1 today may go up in price to $3 tomorrow. Everything in your savings accounts and CPF will be devalued. To prevent this from happening, the central bank will raise interest rate to cool the economy. Higher interest rate will increase the borrowing cost and this will reduce the demand for goods and services. It will eventually stabilize the economy and make growth more sustainable. Hence, rising interest rates is necessary to keep inflation at bay.

Well managed interest rate policy will not affect business or consumer sentiment

Before today’s close to zero interest rate environment, most of us will remember that we could get about 2%-3% p.a. for a normal fixed deposit. It is only from 2008/09 onwards that interest rate has dropped close to zero. This is neither the norm nor a new norm. The interest rate has dropped to zero because Federal Reserve in US has to do it to rescue the economy from the Great Recession then. If we look at the 12 month FD interest rate for the past 20 years in Singapore (all the way back to 1994), it has always ranged from 1% to 4%. And, we still have some of the best growth in GDP during those years. For example, in year 2000, GDP grew close to 9% and 12m FD rate was close to 2.5-3% p.a. To say that an increase in interest rate will crash the economy is seriously over exaggerated. In fact, a well managed increase in interest rate will not necessarily affect the business or the consumer sentiment.

All said, I hope this blog will alleviate the fear regarding the impact of rising interest rate on the economy. In months to come, when the interest rates goes up, do remember that it is not a bad thing after all.

 

CPF Review Wish List - Inflation Indexed bonds

There is an ongoing debate on CPF and its minimum sum scheme in supporting the retirement needs of our local residents. Today, the return on our CPF OA is pegged to a weightage of 80% of the average of 12-month fixed deposit rate and 20% of the average savings rate published by major local banks. As you know, fixed deposit rates and savings rates are very low now, and the computed pegged rate will probably give you a return of less than 0.5% per annum on CPF OA. This is really worrying because the latest CPI rate is close to 2% and we will get -1.5% (yes, negative 1.5%) for our CPF OA on real return basis if not for the legislated minimum of 2.5% per annum return on our CPF account. Nevertheless, CPI is expected to hit between 2% and 3% this year, and this will leave us with close to 0% real return on our CPF OA even with 2.5% per annum. I believe it is time to look at something that Monetary Authority of Singapore has mooted a couple of years back – inflation indexed bonds.

Imagine you buy an inflation indexed bond with real return of 3%. If there is no inflation, the return will stay at 3%. If inflation rate goes up to 2%, then the actual return will be adjusted accordingly to 5% to account for the 2% inflation rate. In a way, your investment is protected from inflation risk and you will get 3% for your investment. And, if CPF OA can be invested in inflation indexed bonds, this will help, in a great way, to alleviate the worries that we have today regarding whether our CPF is enough for our retirement. We are assured of a positive real return on our CPF saving over the years.

I really like this idea although I believe the implementation of such scheme will not be easy. There will be concerns like the credit ratings of these investments, risk-free or not risk free and others. However, at the end of the day, inflation will eat away our savings if we do not do anything about it. We definitely need more innovative ideas to protect our CPF savings.