How Inflation Policy Affects You

By Greg McFarlane | February 20, 2012 AAA

How low can you go? If you're Ben Bernanke, the answer will remain zero for at least the next two years. The Federal Reserve Board Chairman (by some measures, the most powerful man in the world) recently announced that he plans to keep interest rates negligible through 2014. Bernanke thus estimates a long-term goal of 2% inflation for the near future. How will that impact you?

SEE: What Investors Should Know About Interest Rates

Low Rates
For starters, it means money will continue to be artificially cheap. It's been artificially cheap for three years now, the rationalization behind the low rates being that they make it easier for people to borrow money, invest it in expensive things of lasting value that require long-term financing (e.g. homes), and thus watch the economy rebound that much more quickly.

However, it hasn't quite worked that way, largely because unemployment remains at generational highs, and it's hard to take advantage of low rates when you don't have much income.

If you're trying to save, well, there isn't much incentive to put your money in a standard interest-bearing certificate of deposit (CD) or money market account when the payouts are so low. There are ultimately only two things you can do with a dollar - spend it now or defer spending it (the latter also known as saving and/or investing). Low interest rates, and by extension, low inflation, encourage people to spend those dollars faster.

"Inflation" is a word with a negative connotation, which makes some sense. When your money's purchasing power decreases, that's always going to be bad, isn't it? If $1 today becomes worth 90-something cents next year, then taken to the extreme that could ultimately mean carrying wheelbarrows of bills around just so you can buy everyday grocery items. (That's not a metaphor, by the way. It happened in post-World War I Germany and in Zimbabwe as recently as three years ago.)

A little inflation isn't necessarily negative (accent on "little"). If that sounds counterintuitive - that your money gradually losing value can't possibly be beneficial - give it a few more paragraphs.

Contrast inflation with a zero change in price levels (or with inflation's rarely seen antimatter counterpart, deflation.) Yes, under the latter scenario your dollar buys as much as or more than it did before; but without at least a little inflation, lenders and borrowers would have to change their behavior so much that it could mean the end of banking.

No Inflation?
Over the last 20 years or so, three-year CD rates have averaged a little above 5%. Will your bank offer you a 5% CD if inflation is at zero? Keep in mind that inflation has averaged about 3.3% annually over the last century, and that a posted interest rate is essentially the inflation rate added to the real, constant-dollar interest rate. That nominal 5% then becomes a real interest rate of 5% without inflation; no inflation means the nominal rate and the de facto rate are identical.

If prices stayed the same from year to year, no bank would offer you a rate anywhere near as generous as 5% on a CD. (As proof of this, three-year CDs are currently going for around 1.4%.) If lenders started offering 5% three-year CDs today, they'd have to lend money out at even higher rates in order to stay in business. Few people are going to borrow money from a bank if they have to pay it back at a real interest rate of 6 or 7%, especially today. The higher the (real) interest rate gets, the less chance the borrower has of being able to pay the loan back, which means that no one borrows money at all. Businesses can't grow and the economy stagnates, ultimately lowering GDP.

So why wouldn't a lender just lower the nominal interest rat, and charge the same real interest rate it always did? Because nominal interest rates can't get much lower than they already are. One-year CD rates are barely 1% right now. If they fell 100 basis points, there'd be no appreciable difference between putting your money in a bank and hiding it in an empty tomato can in the pantry.

The Bottom Line
There's no formally defined level of "normal" inflation, but it makes sense for us to let that 3.3% number serve as one. With a normal level of inflation, it's more likely that borrowers and lenders can find that happy equilibrium. At a federally mandated 2%, we're still uncomfortably close to stagnation. Many experts think that raising inflation by a point or two could help people who are looking to maintain a constant income from their investments.

Regardless of whatever money professionals and a sense of justice would dictate the Fed should do, the Chairman has spoken. At the very least, if we can be somewhat certain that we'll have 2% inflation for the next couple of years, then we should be able to make investment and saving decisions accordingly.

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