Oran A Hall | Inflation winners and losers

Inflation is more than higher prices. It is that creepy force that changes the real value of assets, savings, income and debt. It makes some people better off and others worse off financially, as some are better able to protect themselves and experience real gains as opposed to others who experience real losses, even if not immediately obvious, in nominal terms.

There are several clear winners from inflation, including people who borrow at a fixed-rate of interest and owners of real assets. But there are also losers, including savers, lenders and earners of fixed incomes.

Borrowers of fixed-rate debt include property owners with fixed-rate mortgages, students with fixed-rate loans, borrowers of fixed-rate consumer loans, and even businesses that issue fixed-rate bonds and debentures. Governments also issue fixed-rate debt instruments. Borrowers benefit in the sense that, although their principal repayments remain unchanged, inflation makes the real value of each dollar repaid less in real terms. Similarly, the real value of the interest payments is also less.

On the other hand, the lenders lose in real terms as the principal repayments and the interest they receive lose real value, as they are able to buy less with the same nominal sum.

The real rate on a loan or investment is the difference between the nominal interest rate and the inflation rate. If, for example, a person borrows at 9 per cent when the inflation rate is 5 per cent, the real rate is 4 per cent. If the inflation rate increases to 7 per cent, the real rate becomes 2 per cent.

The owners of real assets – property, equities and commodities, for example – are also winners. Inflation tends to cause property values to appreciate, and the value of equities tends to increase as the nominal value of company profits tends to increase. The appreciation in the values of these asset classes tends to cancel out losses from other classes, like bonds, thus making them quite popular as long-term hedges against inflation.

Investment portfolios which are weighted in favour of assets which have the ability to appreciate in value are best positioned to counter inflation and reap real returns. Investors who are not able to invest directly in property and equities have the option of investing in unit trusts or mutual funds that have portfolios which have capital gains as their primary investment objective.

Another class of winners is the owners of life insurance policies with an investment component based on investment vehicles which focus strongly on capital appreciation more than on income. Real estate and equities are the most common instruments in such portfolios in Jamaica.

But there are losers.

People on fixed incomes, pensioners whose pensions are fixed, and investors who favour income over capital gains tend to be the losers. Inflation eats into the real value of their principal and the interest on fixed-rate bonds and debentures, as well as on savings accounts.

Unit trust and mutual fund portfolios which lean towards interest-bearing securities, while earning more on new investments, tend to see the capital values of such instruments fall in response to higher interest rates and may cause unit values to decline.

This is also true for the owners of life insurance policies that have an investment component that is geared to the build-up of income from fixed-rate, interest-bearing instruments rather than capital appreciation.

Whereas fixed-rate debt instruments do not give much protection against inflation, variable-rate instruments generally provide some protection. Because the rate paid on them is generally tied to the return on an instrument with a market-determined rate, and often with a premium thereon, the returns on such investment instruments is closer to the rate of inflation.

On the other hand, there is a negative side to loans with a variable rate of interest – lending institutions generally increase their lending rate in response to the authorities raising interest rates in an effort to bring inflation under control. This applies to both old and new loans.

The higher inflation gets and the longer it continues, the greater the loss for people who are not protected well against it. The real value and purchasing power of their financial assets and income get increasingly eroded with time, so the gap tends to widen. On the other hand, assets with the capacity to appreciate in value are generally able to move in step with inflation, sometimes surpassing it, thus making them good long-term hedges against inflation.

The Bank of Jamaica has raised the policy rate from 5.5 per cent to 6.0 per cent in response to inflation exceeding its targeted rate of 4 per cent to 6 per cent for the year. This will trigger a round of interest rate increases. Consumers who have fixed-rate Jamaican dollar debt, holders of variable-rate investment instruments, investors in new debt instruments issued at higher rates, and holders of assets having the capacity to appreciate in value, are the winners. Th losers are holders of savings and investment instruments that generate fixed income directly, or indirectly, through pooled investment funds, consumers who have variable-rate debt obligations, and consumers taking on new debt obligations. The big loser is the consumer, whose ability to buy goods and services shrinks.

Oran A Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: finviser.jm@gmail.com