Wasting Away
Remember around 1980 when money market funds earned as much at 17% per year? Compared to the paltry rates we see today, the interest rates of the late 70s and 80s seem fantastic. We yearn for the chance to get higher rates on bank CDs and cash accounts. But high interest rates alone do not give a complete picture. The real return on investments can only be measured after inflation and after income taxes.
Investment interest rates and inflation rates tend to move in tandem. So when I hear people talk about high interest rates they were paid on investments in the past, I automatically question what the rate of inflation was at the time. In 1980, the rate of inflation was 13.6%. If a certificate of deposit paid 17% that year, the after-inflation return was actually 3.42%. But wait. Investors had to pay taxes on the 17% earned. Tax brackets in 1980 ranged from 17.4% to 70% depending on the amount of taxable income, of course. Therefore the real return on a 17% certificate of deposit averaged -4.24%, depending on the tax bracket. Yes, that is a minus before the rate, meaning that investors created negative wealth for 1980 by investing in bank CDs and cash accounts that paid 17%, and it was worse for high income earners.
Are we better off today? Well, cash accounts are paying about .5%, inflation is about 2.9% and the maximum tax bracket is 35% providing a real return of about -2.6. Right now, high income investors are actually creating more wealth than they did with 17% interest rates!
It is not really that we are creating more wealth; we are just losing less wealth to taxes and inflation. Investors can tolerate a year of these losses, from time to time. But today we are entering our fourth year of negative wealth accumulation by playing it safe with investment dollars. Inflation trumps safety almost all of the time. As I mentioned before, interest rates and inflation tend to move in tandem. Therefore higher interest rates either reflect or predict higher inflation rates. It’s like you can’t get ahead.
When I interviewed new clients during the 1980s, their biggest concern was inflation. High inflation was all over the news. The President passed out WIN buttons – Whip Inflation Now. It was like somehow we could go out into the street and wrestle inflation down on the ground. Inflation isn’t like that, though. It is an invisible economic force that accumulates in little ways that impact us in a big way. Today most investors don’t think about inflation. Even the most recent policy statement from the Federal Reserve indicates that inflation is subdued. But inflation continues to be a part of the constant erosion of long-term accumulation of wealth.
If history is our guide, interest rates will rise along with inflation; and maybe income taxes. Then CDs and cash accounts will be wasting away wealth – just at a quicker rate than today.