Low interest rates in a low inflation period might not be as bad as pensioners consider those, and this could be proved using dosa economics, according to RBI governor Raghuram Rajan.
The governor pointed out that industrialists grumble about high rates while retirees complain about low rates they get on deposits. “Both overstate their case, though as I have said repeatedly, the way to resolve their differences is to bring CPI inflation steadily down,” Rajan said.
Rajan spoke of a letter from a retiree that rued the lesser rate of interest on a one-year fixed deposit, making it harder to make ends meet. He, however, observed the retiree is getting more today but are not realising it as they do not take into account the fall in the underlying inflation.
To prove his point, the governor introduced something known as ‘Dosa Economics.’
Rajan took an example where he considered a pensioner who could buy 2,000 dosas with a savings of Rs 1 lakh at the cost of Rs 50 but wants to invest and buy more. “At 10% interest, he gets R10,000 after one year plus his principal. With prices of dosas having gone up by 10% to R55, he can buy 182 dosas approximately with R10,000 interest,” Rajan said.
He then considered a case where at 8% interest, the pensioner gets Rs 8,000 as interest while the inflation stands at 5.5%. “(Now,) each dosa costs Rs 52.75, so he can now buy only 152 dosas approximately. So the pensioner seems vindicated: with lower interest payments, he can now buy less,” Rajan indicated.
The governor then pointed out that the pensioner gets his principal back as well and it has to be adjusted for inflation. “In the high inflation period, it was worth 1,818 dosas, in the low inflation period, it is worth 1,896 dosas,” he said.
In the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas, Rajan pointed out adding that the retiree is about 2.5% better off in the low inflation period in terms of dosas.
“Indeed, with 10% return and 10% inflation, the deposit is not giving you any real return net of inflation, which is why you can buy only 2,000 dosas after a year of investing, the same as you could buy before you invested,” Rajan said.
In contrast, when inflation is 5.5% but the interest rate you are getting is 8%, you are earning a real rate of 2.5%, which means 2.5% more dosas, he added. “So while I sympathise with pensioners, they certainly are better off today than in the past,” Rajan said.