So what is inflation?
Inflation is simply a measure of the change in price levels. For example, if the inflation rate is said to be 2% then average price levels have increased by 2%. Price levels are measured using something called the Consumer Price Index (CPI). Sound familiar? You have probably come across a few headlines in the news over the years regarding the CPI. The CPI compares the cost of a fixed basket of goods in one year, say 2015, to the cost of that same basket of goods at “base year” prices. The current CPI base year in Canada is 2002. Thus, the Bank of Canada is comparing today’s cost for a fixed basket of goods to the cost of that basket in 2002, so you can measure the percentage change in prices over the years. If the CPI increases it means that the price level has increased. In other words, each dollar you spend is buying you fewer goods.
How does inflation affect savings?
Inflation eats away at the purchasing power of your dollar. So if you have been putting money away in a savings account that earns a lower interest rate than the inflation rate you have been effectively losing your hard earned money!
Has someone been taking money out of your account? Of course not. However, the money you put into that savings account 10 years ago, 20 years ago and so on is not worth the same amount today. Sure a $100 bill in past is still a $100 bill today, but that same $100 will buy less today than it did in the past. In other words, the “real” value of your money, being what you can actually purchase with your dollar, is decreasing when inflation increases. This is shown when you hear someone say “gas used to be 25 cents a litre back in the day”.
The Bank of Canada has a target inflation of roughly 2%. Let’s compare this to the top savings accounts offered by Canada’s Big 5 Banks:
|Bank of Canada Target Inflation Rate||2.00%|
|<$5,000||$5, 000 -$24,999||$25, 000 or more|
|TD High Interest Savings Account||0.55%|
|High Interest TFSA Savings Account||0.50%|
|Bank of Nova Scotia|
|Momentum Savings Account||0.50%||1.50%||1.50%|
|Savings Accelerator Account – TFSA||0.90%||0.90%||1.00%|
|Bank of Montreal|
|Premium Rate Savings Account||0.45%||0.45%||0.45%|
|TFSA Savings Account||0.50%||0.50%||0.50%|
|Royal Bank of Canada|
|RBC High Interest eSavings Account||0.55%||0.55%||0.55%|
|Canadian Imperial Bank of Commerce|
|CIBC eAdvantage Savings Account||0.00%||0.60%||0.60%|
|CIBC TFSA Tax Advantage Savings Account||0.55%||0.55%||0.55%|
As shown above, the target inflation rate is higher than all of the interest rates offered by the savings accounts of Canada’s top 5 banks. If you plan to save your money long-term in one of these accounts you will be slowly losing money to the impact of inflation over time. Not ideal for retirement plans!
How to combat inflation…
There are several different types of investments that could potentially fight back against the effects of inflation. We will discuss a few of these investments briefly here.
Bonds, although being seen as a lower-risk investment, bonds are in danger of losing “real” value to inflation. In a bond, such as a Canada Savings Bond (CSB), you are essentially lending money to the borrower for a set period of time in hopes of receiving the principal amount plus the interest rate at a later date (date of maturity). Some bonds offer regular payments called coupons as well. Seems like a pretty safe bet right? Well, this depends…
Bonds have two main risks. The first being that the borrower defaults on the bond commitment and is unable to pay back the principal amount plus interest. This is unlikely for a Canada Savings Bond since the Bank of Canada has the power to literally print money. The second risk has to do with inflation.
If you purchase a CSB that has an annual interest rate of 1%, then you will be have a 1% increase in your investment in that year (see The Miracle of Compound Interest). However, if the annual inflation rate is 2% then the purchasing power (or the amount of stuff you can buy) of your investment has decreased by 1%. Basically, that 1% gain is not worth 1%.
One method of fighting inflation with bonds is by using Treasury Inflation-Protected Securities (TIPS). TIPS pay a fixed rate of interest, however, the principal (or the amount owed to the holder of the bond) moves with inflation. The principal amount rises and falls with the CPI. Thus, in a period of inflation the principal amount will increase, and in a period of deflation the principal amount will decrease. The fixed interest rate is then applied to the changing principal amount. This can be beneficial to the investor because they will receive a higher interest payment if inflation increases.
Stocks can be a great way to beat inflation. The key word here is can, not are. The stock market tends to increase over time at a rate that is generally higher than the inflation rate. However, there are periods of time where the stock market does very poorly. In the long-run however, there is an increasing trend. Be wary though, individually selecting winning stocks can be a fool’s game, even for those who have decades of market experience. The way to mitigate this risk is to diversify.
Diversify. Great, thanks for the buzz word. Yes, diversification is one of the basic strategies regarding investments. However, there are many different ways to go about diversifying one’s investment portfolio. We will follow up with more of an in-depth look into different investment strategies, but when it comes to diversifying your savings in order to combat inflation one of the easiest and low-risk methods is called indexing or investing in index funds.
An index fund is essentially a mutual fund with a lower fee. The reason that it has a lower fee is because it does not try to outperform the market. Yes, that’s right, it does not try to outperform the market. An index fund simply allocates its capital by buying parts of every stock in a sector or benchmark (or index). For example, you can invest in an index fund that purchases all of the stocks in the S&P 500. This is an effective way of combating inflation because of the increasing trend that the market shows over time. The fact that index funds also offer an affordable way to diversify your portfolio means they are a great way for your retirement savings to combat inflation in the long-run. Beware, it is possible for index funds to experience significant price corrections that result in large losses in the short-run. This may be immanent given the current record high price levels of North American markets. However, if you’re saving for the long-run, a balanced portfolio of index funds may provide a suitable option for you to diversify your investments in an effort to combat inflation.
Long live purchasing power!
Breaking The Trend