Last week Fed Chairman Ben Bernanke gave a press conference. In the conference he was asked about a number of things, including the Fed’s target inflation rate eroding away the savings of people. You likely know your bank account it paying practically nothing in terms of interest, say 1% (for argument). But inflation is much higher than that, say 3%. This means that every year you have less and less buying power. What did Bernanke say?
Over time savings rates do cover inflation.
Now if you actually watched the press conference you’ll know Bernanke fumbled with his words a little bit and some people could interpret his statements as implying savings rates always cover inflation. But he’s not so stupid.
Nevertheless, people pounced on the idea to prove they are capable of basic subtraction. Yes, if you look at the current rates offered on CDs or savings accounts and compared that to the current level of inflation, you will find that as of this moment in time you will not get enough returns to cover the inflation.
But Bernanke said that over time savings rates do cover inflation. We certainly know we are not in normal times, but charts always do a much better job of illustrating the point.
What you’re seeing here is the inflation rate (in red) and the rate on a 6 month CD graphed over time. Not only is it clear these two items are closely correlated, but it’s also obvious that for most of the last 40 years even a 6 month CD pays better than inflation. 12 month CDs are usually higher than 6, but that data was unavailable. The difference would have been even wider.
Now why is this? In finance interest rates are made up of a few components. The most basic are the cost of funds, the expected inflation rate, a premium for time, and a premium for risk. In simple terms, if a bank offers you a 5% mortgage, that rate accounts for all of these things. The blue line in the chart represents a cost of funds, and the red line represent inflation. By combing these rates with others banks are able to calculate how much interest to charge (at a minimum) in order to make it worth their time to lend money.
It stands to reason that the cost of funds (the blue line) would be more than the rate of inflation most of the time. This is because when you deposit money at a bank you are essentially lending it to them much like they will lend it out in a mortgage. You aren’t worried about risk due to FDIC insurance, and your cost of funds is zero since it’s yours. So you are compensated for time and inflation.
Even if that doesn’t make sense to you, the chart should. The Fed Chair understands that the interest rates on deposits are practically nothing these days. But, when the economy recovers the rates will go up again and you will again be compensated for inflation.
 By The Weakonomist |
The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics. Also keep in mind that nothing I say can be construed as financial advice. |
