How Your Savings Account Can Lose Value in an Inflationary Environment

If “comparison is the thief of joy” then inflation is the thief of purchasing power. Though it seems like your savings account is a great place for excess cash, the truth is, in an inflationary environment, it's like having a tiny leak in your boat that slowly sinks it. How can you be losing money if you aren’t withdrawing it from your account?

In simple terms, inflation is the rate at which the general level of prices for goods and services rises, resulting in a decrease in purchasing power over time. While moderate inflation is considered healthy for economic growth, it poses a significant threat to savings.

Although inflation has been steadily decreasing over the past year, interest rates remain elevated. This has not been much of a conversation for the last 15 years as it was an unprecedented period of low rates. According to the CEIC data, the average money market rate reached a record low of .089% in 2014.  In June of 2022, the cash conversation changed as the federal funds rate (which money market funds are based on) went above 1%. By May of 2023, rates were up to their highest levels since May 2006.  

(source: macrotrends.net)

One of the primary reasons your savings account “loses value” due to inflation is that the interest rate on savings often fails to keep pace with inflation. Traditional savings accounts typically offer low-interest rates, which may not even match the inflation rate, let alone surpass it. As a result, the real value of your savings diminishes over time.

Consider this scenario: suppose you have $1,000 in a savings account with an annual interest rate of 1%. If the inflation rate is 2%, your savings effectively lose 1% of their purchasing power annually. In a decade, your $1,000 will buy significantly less than it does today. While it may not seem like that big of a deal for $1,000, it is a much larger return on $20,000, $50,000, or even $100,000. 

As we’ve witnessed in the post-COVID environment, inflation can lead to higher costs of living meaning you need more money just to maintain your standard of living, further diminishing the value of your savings.

So, what can you do to mitigate the impact of inflation on your savings? Ideally, the cash in a savings account should be an amount you are comfortable with for month to month bill coverage, and perhaps a bit more in case of an emergency where you need your cash that same day. Anything over that amount might be better served in a different vehicle taking advantage of rates and earning yield.

Another option to explore is a money market fund, which is considered a cash alternative. In 2021 when rates dropped drastically during the pandemic, the US Money Market Treasury Yield (I:USMMAR) yielded something similar to a bank account, less than 1%. As of April 2024, the same money market yielded 5.33%. 

In conclusion, while your savings account may appear safe and secure, it's not immune to the erosive effects of inflation. By diversifying your investments and exploring alternative savings vehicles, you can mitigate the loss of value caused by inflation.

 

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