Advanced Personal Finance

Now is not a great time to be a saver.  In fact, it’s a down-right lousy time.  Rates on everything from high-yield savings accounts to CDs are way down.  In the meantime inflation is up (though still moderate by historical standards), by even the federal government’s dubious accounting.  Mix that together and what you get is negative real interest rates.  I’m going to explain exactly what that means to you and your finances.

My use of the term ‘negative real interest rates’ refers to the phenomenon when the return from completely safe investments is lower than the Consumer Price Index (CPI) - commonly known as ‘inflation.’ 

So you know exactly where I’m coming from, let me specify a couple of the elements.  I consider ‘completely safe’ to be FDIC insured or US government backed.  For our simplified purposes, let’s take that to mean a high-yield savings account.

While the term ‘inflation’ isn’t technically correct in this context, it’s close enough.  Inflation for our purposes is the increase in year-over-year consumer prices.

Here’s where the numbers are for these elements right now:

• CPI 2007: 4.1%
• Typical high-yield savings account represented by ING Direct: 3.4% APY

If you keep your money in this savings account, after inflation, your real return is a negative 0.7%.

Strategies

A couple of thoughts on how to deal with the situation:

1. Consider saving using TIPS.  Treasury Inflation Protected Securities are essentially savings bonds that guarantee a real rate of return after inflation.  There are all kinds of things to consider when thinking about TIPS (like the tax implications), but for some situations they work.
2. Pay down debt.  I know this may seem counterintuitive but consider paying off high interest debt (think credit cards) at an accelerated rate instead of saving more money.  Sure you need an emergency fund, but if it just gets smaller in real terms, you’re losing.
3. Shift savings/investments into retirement accounts.  If you save and invest outside a retirement account, now might be a good time to bump up the amount you put into that tax-advantaged retirement account if possible.  Your investments inside those accounts will likely be slanted toward a more aggressive allocation.
4. Don’t try to ‘make up the difference’ by seeking out unnecessary risk.  So your super-safe savings are returning a negative real rate.  Don’t lose sight of what those funds are for and why they’re in a safe place to begin with.

That’s just what I could come up with.  Anybody want to chime in with other suggestions?  I’m interested to know how other people deal with negative real interest rates in practice.

Share This

If you enjoyed this post, you may want to subscribe to my RSS feed.

This entry was posted on Wednesday, February 13th, 2008 at 7:59 am and is filed under Inflation, Banking, TIPS, Investments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.