Is there such a thing as a guaranteed rate of return? There seems to be a trend for people to “flock to safety” by buying certificates of deposit (CDs) or their Canadian equivalent, guaranteed investment certificates (GICs). There is no risk if a capital loss, at least in nominal terms.
However, money is just a scorecard. What matters is what we can acquire with that money in terms of real resources. What happens if you earn a rate of return of 2% on your CD, but prices increased by 3% over the same period of time?
CDs and GICs can make sense when compared to leaving your cash in a chequing or savings bank account. If you’re using it for that purposes then that’s one thing. However, what about as a long-term investment? Can CDs and GICs preserve your capital over the long term?
What is the real rate of inflation?
Inflation is a hard and pernicious thing to measure. The traditional measure of inflation, and the one I agree with, is that it is a monetary phenomenon and not a price phenomenon. What this means is that if you buy a computer in year 1 and it costs $1,000, you buy another computer in year 2 and it also costs $1,000, and both the money supply and production doubled in the mean-time, you just got screwed out of half of your money, even though prices didn’t rise. Inflation is not just about rising prices. Had there been no inflation, the computer would have dropped in price to $500, since workers are now producing twice as much.
However, it is very hard to measure how increasing money actually affects the economy, and the individuals within that economy. To a certain extent, credit creation based off of demand is legitimate and some of both inflation and deflation is to be expected in a healthy, functioning economy. Problems set in when bad debts are papered over rather than being allowed to fail, and when the government spends money into existence and spends this money on favoured parties. These favoured parties get to spend the new money first before prices have risen, thereby transferring over real resources to themselves and screwing over those who get the new money last, if they even get it at all.
On top of it, you have various ways that the official rates get fudged. If I no longer have enough to buy steak, and I buy hamburger meat instead for the same price, then my consumer basket has changed. In a sense, since I’m not paying more, I didn’t experience any inflation at all, right?
Getting screwed out of our hard-earned cash
Let’s say the official government inflation rate is 2.5% (in line with official numbers), and that skeptics are claiming that the real rate of inflation is actually 6%. Let’s say that the truth lies somewhere in between and use 4% as our inflation rate. We’ll take a look at how our time deposit fares in this scenario, using a 5-year time deposit rate of 2.10%, compounded daily.
|Less: Taxes at 20%||$2,214.15|
After five years, we receive interest of $11,070.73 on our investment, pay taxes of $2,214.15 on our gains, and lock in a gain of $8,856.58. Not so bad? Not so fast.
The purchasing power of our money has changed over this period of time. We can no longer buy the same amount of real goods, per dollar. It would be short-sighted of us to consider our nominal gains in a vacuum, without considering the impacts on our purchasing power. Let’s discount this net payment at varying rates of inflation, depending on your favourite statistic:
|Real returns after taxes||Loss|
|Discounted @ 2.5%||$96,065.18||-$3,934.82|
|Discounted @ 4%||$89,123.25||-$10,876.75|
|Discounted @ 6%||$80,640.95||-$19,359.05|
There is nothing flattering about this picture. Not only did we lose money in real terms, but to add insult to injury, the government taxed us on our loss! Even going by the official government statistics, we still lost 4% on our investment, and going by the skeptics’ estimated inflation, we lost a full 20% on our investment. Ouch!
My personal rate of inflation
Home prices in Canada have been increasing at a nominal rate of something like 7% per year throughout the last decade. Gas prices… at 8% per year. I don’t remember how much food cost 10 years ago, but I do remember I used to get a lot more for $50 than I do, today. Inflation here is probably at least 3% to 4% per year.
Add it all together and I think that I have been personally experiencing an inflation rate far greater than 2% to 3% over the past few years. Some of you might say “well, you’ll recover on the housing inflation when you sell”, but I don’t think so; another decade of 7% per annum in a country with plenty of land doesn’t make too much sense to me. Rents have been increasing more or less at the same pace; at some point these rises have to temper out.
Dear reader, what is your personal rate of inflation? What are your thoughts on investing in GICs and CDs in an environment where rates of return are very low, but rates of inflation are high?