Inflation: Savings Accounts Are Not "Safety Accounts"

Jan 15, 2007 by Adam C. Powell, Ph.D.

Recently, one reader wrote:
Honestly I know very little about ETF’s and so therefore, I would take my money – all $2,000 worth (which I don’t actually have accumulated yet) and “invest” in a savings account. Sure you don’t really earn much that way, but you don’t lose any money, either! With the current unstable situation in Iraq and natural disasters such as tsunamis occurring regularly and being broadcast all over the news, I think that what will be going on with emerging markets and foreign economies is extremely unpredictable at this time. While I can count on a certain predictable amount of money in my savings account, I can not count on any money that I put into an investment of that type.

I have met many people who share a similar perspective. Unfortunately, I feel that they do not realize that there is some risk involved in storing money in a savings account instead of investing it. In the mid-nineties, it was possible to purchase a 20 oz. soft drink from a vending machine for $1.00. Now, it would be hard to do so for less than $1.25. Simply put, a 20 oz. soft drink costs 25% more now than it did in 1997.

Imagine you received two $100 bills in 1997. You took one of the bills to the bank, got it changed into a hundred $1 bills, and then fed the machines into a vending machine to buy soda. At the time, you would have been able to receive 100 bottles of soda. Now, imagine you had taken the other $100 bill and placed it under your mattress (or in a non-interest bearing bank account). In 2007, you could go to the bank and get it changed into a hundred $100 bills, just as you had done in 1997. You could then take the money to the vending machine and use it to buy bottles of soda, just as you had done the time before. However, this time, you could only afford 80 bottles of soda ($100 / $1.25 per bottle = 80 bottles). Who stole the twenty extra bottles of soda that you would have received in 1997? Inflation. It is not safe to store money in a manner that has an expected rate of return less than the rate of inflation. If you do so, you will be able to buy less and less with your savings over time.

In order to calculate the rate of inflation, the Bureau of Labor Statistics calculates the Consumer Price Index (CPI).

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Definitions:

Consumer Price Index (CPI): The Consumer Price Index is a measure of the average cost of purchasing a bundle of goods typically purchased by American consumers. The bundle includes expenses such as food, petroleum, clothing, and medical care. When used to calculate the inflation rate, the average Consumer Price Index for the nation is used.

Inflation Rate: The Inflation Rate is a measure of the rate of change in the Consumer Price Index. The formula for inflation is (Today’s CPI – Last Year’s CPI) / Last Year’s CPI. Thus, the larger the increase in the price of goods overall, the higher the inflation rate.

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What is the Current Rate of Inflation?
Every month, the Bureau of Labor Statistics calculates the current inflation rate. A list of monthly inflation rates is available on InflationData.com. As you can see, the inflation rate in 2006 jiggled between 1.31% and 4.32%, with the overall inflation from 2005 to 2006 being 3.17%. What does this mean to the average investor? If you made less than a 3.17% return on your money over the last year, you have lost purchasing power (your ability to buy stuff with your wealth). While your money might have been “safe” in a bank account, you are essentially the person who had inflation steal twenty of your bottles of soda. If you made more than 3.17% return on your assets, you increased your purchasing power. Many bricks-and-mortar savings accounts pay far less than 3.17% interest. If you are using one, it is costing you money.

What should you do?
If you wish to maintain your purchasing power, make sure that you are investing your money in something with an expected return that is greater than the inflation rate. There are many options that have little to no risk attached to them that yield a return equal to or better than the inflation rate. Low-risk options include Internet-based high-yield savings accounts and CDs. For those seeking higher returns (and higher risk), equities and other vehicles should also be considered. If you do not take action, you face the certainty that you will lose purchasing power over time as a result of inflation.