The Federal Reserve (the Fed), the central bank that everyone loves to hate, has lowered its target interest rate to 2.25%, down from 3%. The Fed is reducing rates in an attempt to stimulate the economy and prop up weak financial markets. What does this mean to you?
Well it’s either good or bad depending on your financial situation. If you are a borrower, than its good because it will now cost you less to borrow money. However if you are a saver (or lender) than it’s not so good because you are making less money on your savings.
In my case I have on online savings account with HSBC. In response to the Fed’s rate cut, HSBC has lowered their APY (Annual Percentage Yield) from 3.55% to 3.05%. How much is that going to cost me? Well if I use my handy savings calculator to compare two rates then I can estimate my loss.
I’ll use $15000 as my current balance, and leave the monthly contributions at zero. My first interest rate is 3.55%, the APY I was receiving and the second interest rate is 3.05%, the new rate. Let’s estimate this over one year only.
So my results show that this cut is going to cost me about $77 over the next year. Not a huge sum by any means. However, my concern is that even high APY accounts like HSBC are approaching the point where they barely cover inflation every year.
If we assume a rate of inflation around 3% then we are already dangerously close to the inflation rate. What does that mean?
It means that if are APY dips below 3%, we are actually losing money on our savings. How can that be, how can we lose money on a savings account? The answer is that our money is worth less (not worthless) each year.
You see the government keeps printing more money each year. As that money enters the economy it drives down the price of current money. Think of it like any other simple supply and demand equation. Right now oil is expensive. That’s because there is a limited supply of oil on the market. If all of a sudden, oil were plentiful, say we discovered a huge supply of oil under the US that was both easy get at and cheap to refine, oil prices would fall because their was more supply.
The same is thought to be true about money. More supply, money is worth less, less supply, money is worth more. Of course there are many other factors and this is a vast over simplification as even economists don’t totally agree on this matter.
However, we can take the basic theory and apply it. The Consumer Price Index (CPI) is a tool used by the US government to measure the average price of goods and services purchased by households. You may have heard of the CPI in the news as it’s a very important indicator of economic health. For instance the February 2008 CPI was 4% higher than in February 2007 CPI. That’s not good as average prices were up four percent over last year. So my 3.05% savings account is not even keeping up with inflation. Plus that 3.05% is taxed at my regular marginal tax rate so now I’m really in trouble.
At this point, I probably need to find some other savings options. The value of my money is decreasing faster than interest can make it grow. Plus I have taxes to consider on top of it. This is why the stock market seems to be the best long term investment. Earning higher rates is the only way to keep ahead of inflation. Of course, we put our money at risk in the stock market but it’s a trade off you have to make if you don’t want to lose money in the long run.
So what do you think? Do the lower rates concern you? Are you changing your savings strategy because of this? Leave a comment and let me know.
Article Links
Consumer Price Index Government Site
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