Importance of Beating Inflation
Do you know your inflation adjusted interest rate?
Most of us don’t consider the effect of inflation on our cash, savings or investments. The Federal Reserve (“the Fed”), which is responsible for adjusting the money supply in an attempt to control inflation, has set a target rate of 2%. Since the mid-’90s, the rate of inflation has remained rather stable, hovering around 2.0%. However, this has not always been the case.
Throughout much of the 1970s and 80s, the rate of inflation was much higher, causing prices to rise faster than many investors expected. Even at these high rates, the savings rate was still well above the inflation rate, meaning investors could preserve their wealth by assuming little to no risk. Contrast this with today, after the Fed cut interest rates to 0% for the second time in a decade and expects rates to remain at this level for at least the next few years. These economic factors almost guarantee that depositing with a bank will cause your savings to lose value over the next decade.
What is inflation?
Inflation is a term used to describe the change in prices of everyday goods and services. If inflation increases, this means that the things you buy are getting more expensive, and at a faster rate. A little inflation is good; it means the economy is growing. When the inflation rate is around 2%, prices rise gradually over time. Because prices rise gradually, people and businesses are able to plan for the future.
When prices increase, every dollar buys fewer things. You may have received an inflation-adjusted wage increase at your job. Since you are doing the same work — but can buy fewer things a year later — this adjustment is meant to allow you to maintain your standard of living with the change in inflation. Because the change happens over time, you probably don’t notice it day to day, or even from month to month.
Hyperinflation is when prices rise too quickly. Consider a scenario where you were expecting to buy groceries and prices doubled from one week to the next. Because you earn the same wage, you can now only afford half the food you used to purchase. It’s not too difficult to imagine how this quickly leads to economic instability, as consumers rush to make purchases, further driving prices up. This may sound like fiction, but occurred in Germany in the 1920s and as recently as 2016 in Venezuela.
A decrease in prices, otherwise known as deflation, may sound like a good thing, but is actually very dangerous. In this scenario, people hold back from making purchases because they expect the price to drop. Since fewer people are buying goods and services, the economy shrinks. This creates a negative feedback loop where the problem spirals out of control. This is why most central banks, like the Federal Reserve, want a small amount of price inflation to maintain a healthy economy.
Why does inflation matter?
Even a predictable level of inflation is worth considering when evaluating the performance of your saving or investment vehicles. Remember that inflation is the measure of the change in prices of everyday goods and services. If the interest rate on your savings account equals the rate of inflation, then you are earning a return as fast as prices are rising. For example, if your savings account earns 2% per year and inflation is 2%, then you’ve preserved your purchasing power, or the amount you can buy with your dollars.
If you’re earning less than the inflation rate (or holding cash), then you are losing wealth. This is similar to the example above, where prices increased faster than you were able to receive a raise. Anyone who has kept their money in a traditional savings account over the past decade has experienced a decrease in their purchasing power. With savings rates at historic lows, the value of these deposits have been eroded by inflation.
This is why it is important to know your Real Interest Rate (RIR). Your RIR is the amount you earn after accounting for inflation. This will tell you whether or not you are earning more than inflation. Tools like APRtoAPY.com can help you calculate your RIR. If your RIR is positive, congratulations on growing your purchasing power! If it is negative, you may want to consider switching to a deposit account with a higher interest rate.
Why is inflation a concern now?
In traditionally healthy economies, interest rates are significantly higher than the inflation rate; the exception would be during brief periods of economic correction, like the Dot-Com Bubble or Great Recession. The past decade has presented a unique situation for savers, as this is the first sustained period where inflation remained higher than the benchmark rate set by the Federal Reserve. This resulted in all traditional savings accounts yielding a negative RIR. Savers and investors have been forced to take on the risk of stocks and bonds to earn a return that preserves wealth.
The Federal Reserve recently dropped interest rates to 0% to encourage economic growth, making it even harder to earn a decent yield. During this same period, the U.S. government has injected trillions into financial markets, raising speculation that inflation could increase well above 2% for the first time in a decade. The savvy investor will ask themselves, how much risk is appropriate before you’re no longer able to preserve your wealth?
To learn more about how Linus can help you beat inflation with a positive RIR, visit www.getlinus.io.
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