Tuesday, May 02, 2006

Inflation - part 3

In the previous two posts I summarised the significant effect that even a relatively low rate of inflation can have on the real value of savings over time and pointed out that the true rate of inflation may currently be higher than the 2-3% currently indicated by CPI data in many developed countries (about 1.8% in Hong Kong). A figure of 6+% has been suggested as the true rate of inflation in the US.

If the true rate of inflation is higher than the reported rate, and the rate which is widely believed to represent the rate of inflation, this has implications for portfolio management.

The first (and obvious) conclusion is that the nominal return which investments must generate needs to be higher to compensate for the higher rate of inflation. It makes it harder to justify investing in deposits and bonds and more essential than ever that investments which can grow over time be selected.

The second (less obvious) conclusion is that the real cost of debt is less than the CPI data would suggest. In fact, if the true rate of inflation were 6+%, it would follow that real interest rates on mortgage finance in Hong Kong are currently negative (mortgage rates are typically 5.25-5.75% at present). In this situation, it makes sense to borrow as much as can be comfortably serviced and to delay repaying that debt as long as possible. Put differently, does this mean that debt is underpriced? If so then full advantage should be taken of that mispricing - with the caveat that the possibility of interest rates rising has to be taken into consideration when borrowing.

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