How Inflation Can Deflate Your Savings (And How to Protect Yourself)

Andrew Hepburn
by Andrew Hepburn March 11, 2016 / No Comments

When you invest in equities, the biggest risk is that you might suffer a capital loss. In other words, the stocks you own could fall below your purchase price. With savings products, however, there’s something else to consider.

The good news is that in Canada most savings products are guaranteed, both by the bank that issued them and by a government insurance program in the event that the bank fails (though you want to stay within the prescribed amounts that are insured.) So your initial investment, plus interest, will be paid back to you. On that score you can rest easy.

The primary risk with savings products is that inflation eats away at your purchasing power. If the interest you’re receiving doesn’t keep up with the rate of inflation, you’re technically losing money. This may not be a huge issue if you’re only parking your money in a shorter-term vehicle (like a high-interest rate savings account) until you decide what to do. But if you’re stuck in a longer-term product (like a GIC) that’s not keeping pace with inflation, you could end up losing a decent chunk of your starting purchasing power.

Let’s use an example to quantify how this phenomenon plays out. Assume that you decide to purchase a $10,000, five-year non-redeemable GIC paying 2.50% interest. Interest compounds annually. At the time of purchase, inflation is 2%.

Year Ending value $10,000 in real terms at 2% inflation
1 $10,250 $10,200
2 $10,506.25 $10,404
3 $10,768.90 $10,612.08
4 $11,038.12 $10,824.32
5 $11,314.08 $11,040.80

As you can see, because the GIC is earning more than the rate of inflation (2.5% vs. 2%), your purchasing power is not just being maintained but actually rising.

But what would happen if you purchase the same GIC and the rate of inflation immediately rose to 4% per year for the duration of your term?

Year Ending value $10,000 in real terms at 4% inflation
1 $10,250 $10,400
2 $10,506.25 $10,816
3 $10,768.90 $11,248.64
4 $11,038.12 $11,698.58
5 $11,314.08 $12,166.52

With inflation at 4%, you still end up with $11,314.08, but your purchasing power at the end of the term will not match your initial investment. The magic of compounding works in reverse because the high rate of inflation leaves you further and further behind as the years go on.

Is this to say you shouldn’t buy longer-term savings products? No. If you think inflation will remain low, or even fall, longer-term vehicles such as three- and five-year GICs can provide pretty good returns, especially compared to much shorter-term alternatives. But if you’re worried about the potential for rising inflation, then you’ll either want to keep your savings in shorter-term products or only buy longer-term ones that are redeemable. That way, if inflation goes up, you can take advantage of higher interest rates.

There’s a term in economics called the money illusion. What it means is that while we often think in nominal terms when talking about money, this is a mistake. We should actually be thinking in real, or inflation-adjusted terms. The money illusion says that someone who makes $50,000 this year and $50,000 next year is making the same amount of money. In fact, with inflation, that person will need a higher salary just to have the same amount of purchasing power.

The same principle holds true with investing. You want to make sure your current investments are keeping track with inflation. And always be aware that if we get hit with unexpectedly high inflation, it will affect longer-term savings products the most.

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Flickr: KMR Photography


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