Challenge of increasing savings amidst soaring inflation

In the midst of the tangible hardships felt by the Sri Lankan populace, a less severe, more sinister phenomenon has reared its ugly head – inflation which has now firmly entered the double-digit territory and is growing rapidly.

Indicated by the Colombo Consumer Price Index and National Consumer Price Index, inflation stood at 14.2% and 16.8% respectively YoY for the month of January alone. Inflation in the month of February 2022 further edged up to 15.1% YoY. While a natural level of inflation can be expected and managed for a healthy economy, in the aftermath of the COVID-19 pandemic many economies struggle with unprecedented price increases. For example, neighbouring India reports 6.01% YoY, while the USA reported 7.5% YoY inflation as at Jan 2022 – the highest in 40 years.

The cause of this current price level rise has been attributed to a mixture of excessive money printing, soaring oil and raw material costs and the breakdown of value chains world over.

Local think tank Advocata published a composite measure of the increase in prices for a select number of key ingredients known as the Bath Curry Indicator. This reports a 15.85% YoY change, in line with national indicators and is more pertinent to the average Sri Lankan consumer. These price increase effects are exacerbated considering the value of the Rupee eroding over time. As a Sri Lankan rupee earner, the purchasing power necessary to obtain certain goods and its equivalent value in a foreign currency should theoretically be similar and be reflected by the exchange rate. However, due to currency value fluctuations this is not always at parity, meaning a Sri Lankan rice packet will temporarily be more expensive than the same rice packet in India or USA, even after considering ingredient and transportation cost differences. This increase of the price level leaves most Central Banks at odds with its usual role of facilitating economic growth. The Central Bank of Sri Lanka has a general mandate towards managing inflation vis-a-vis the toolbox of policy instruments at its disposal. In order to stimulate economic recovery in the backdrop of COVID-19, CBSL reduced interest rates to historic lows in an effort to facilitate borrowing and spur growth. In order to return to normalcy, policy rates have increased by approximately 1.5% since August 2021 indicating a policy ‘tightening’ cycle.

While this appears to have just begun and is arguably likely to continue from the CBSL the potential future increase in interest rates can be seen in the general market by deposit taking institutions. These policy rates are eventually expected to cascade down to other market rates, and are to be enjoyed by Fixed Deposit holders to savings account holders alike.

Furthermore, the past year saw an unprecedented amount of Rs. 1.2 trillion worth of Government money printing in response to the expected production shock, in order to cushion the fall out in economic production.

Economic participants now with more access to money, at least have the means to maintain their previous level of spending. While this could be argued to have caused inflation, the newly printed money would find its way to investments and other ventures, resulting in asset price bubbles. Therefore, the need for the previously loose monetary conditions to now be tightened needs to be heeded.

Ultimately the direction CBSL will take depends on the Monetary Policy Review meeting scheduled for tomorrow to determine the stance on interest rates and whether market rates will follow, offering some form of protection against high inflation, albeit delayed.

The act of insuring oneself against inflation losses referred to as inflation hedging, is usually done either by protecting income through inflation linked with returns that readjust to the effects of inflation or by investing in products that are believed to outperform inflation i.e., earn more than annual inflation. The former can be seen in rental income linked products such as Real Estate Investment Trusts which earn returns from rental income that adjusts with inflation, while the latter can be done through investing in precious commodities such as gold. Gold is generally regarded as a safe store of its intrinsic value.