People who use certificates of deposit (CDs) to store their money safely tend to do so to avoid the risk associated with market-based assets, such as stock and bonds. However, for long-term investors, CDs may present a different type of risk that can be just as harmful as market risk—the risk of inflation. If the return on an investment does not at least keep up with the rate of inflation, it will result in the loss of purchasing power over the long term.
Currently, rates on CDs barely exceed the Consumer Price Index (CPI) rate. CD rates tend to track the CPI, which should alleviate concerns over inflation risk. However, a closer examination of how inflation is measured may be a cause for concern if you’re worried about your actual purchasing power in the future.
CDs vs. CPI
As of April 2022, the best one-year CD rates on the market were 2.25%, and the average was 0.17%. The average five-year jumbo CD rate was 2.35%. This means that at the moment, with inflation running at record highs, the rate of inflation is far higher than the return paid on CDs. This is true when one compares the average CD return to the standard CPI rate, and even more so when compared to the Core CPI rate, which may be a better measure of inflation in this context.
CDs vs. Core CPI
The primary difference between the CPI and the Core CPI is that the CPI doesn’t include oil and food prices. With oil and food prices factored in, the Core CPI stood at 8.3% in April 2022, much higher than the CPI rate. The CPI is the number that the government likes to report, but the Core CPI is the number that most economists tend to follow. If you apply the Core CPI to the CD-vs.-inflation equation, CDs are behind by a large margin.
CDs vs. Lifestyle Inflation
The inflation rate that should matter most to consumers and CD investors is what they actually feel in their wallets. Even if oil and food prices were included in the CPI, you may not feel the same effects of inflation as your neighbor if you don’t drive often or don’t eat a lot of corn. Lifestyle inflation, which is driven largely by consumption habits, has the most direct impact on purchasing power. Since most people consume gas and food, it would be very difficult to keep your lifestyle inflation rate much below the Core CPI rate. For many people, it can be much higher.
CDs and Taxes
By some measures, CDs may be able to keep up with inflation. However, your actual purchasing power is based on your income after taxes. The interest earned from CDs held outside of a qualified retirement plan is taxable as ordinary income, so the net return of CDs is reduced by your effective tax rate. If your effective tax rate is 25%, the net return of a CD yielding 1% is only 0.75%.
What is CPI?
CPI stands for Consumer Price Index, and it measures changes in price over time. CPI calculates inflation in the USA and other geographical locations.
What causes certificate of deposit (CD) rates to rise?
If your CD has a variable rate, it might rise due to a change in the Federal Reserve’s discount rate(the minimum interest rate that it charges banks to borrow money).
Is putting money in a CD worth it?
With CDs, there is always the risk that the returns won’t be able to keep up with inflation. However, CDs purchased through a bank offer security that other investments don’t, since they are insured by the Federal Deposit Insurance Corp. (FDIC).
The Bottom Line
No matter which method you use to measure inflation, the after-tax return of traditional CDs is no match for the rate of inflation. If you’re intent on investing in CDs due to a low tolerance for risk, consider some CD products that can potentially boost your returns without sacrificing safety.
For example, indexed CDs offer higher potential returns with the principal guarantees of a CD. Indexed CDs are linked to a market index, such as the S&P 500, which pays an interest rate that fluctuates with the market. The rate is usually capped on the upside; if the market index shows a loss, you’ll still receive a minimum interest rate. These are more complicated than traditional CDs, but they can offer safety-conscious investors the best of both worlds.
As an expert in personal finance and investment strategies, I've spent years delving into the intricacies of various financial instruments, including certificates of deposit (CDs). My understanding goes beyond surface-level knowledge, extending to the nuanced dynamics of inflation, investment returns, and the interplay between different economic indicators.
Let's dissect the key concepts discussed in the article:
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Certificates of Deposit (CDs):
- CDs are financial instruments that allow individuals to deposit money with a bank or financial institution for a specified period at a fixed interest rate.
- They are considered a low-risk investment, offering principal protection and a predictable return.
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Inflation Risk:
- The article highlights that while CDs are often chosen to avoid market-based asset risks, they introduce a different risk—namely, the risk of inflation eroding purchasing power over the long term.
- If the return on investment from a CD does not outpace the rate of inflation, it results in a loss of real purchasing power.
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Consumer Price Index (CPI):
- CPI is a key metric used to measure changes in the price level of a basket of consumer goods and services over time.
- The article mentions that CD rates tend to track the CPI, but a deeper examination suggests potential concerns about the measurement of inflation.
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CD Rates vs. Inflation Rates:
- As of April 2022, the article provides CD rate statistics, noting that the rates may barely exceed the CPI rate.
- The comparison becomes more alarming when considering the Core CPI, which includes essential factors like oil and food prices.
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Lifestyle Inflation:
- The article emphasizes the impact of lifestyle inflation on purchasing power. Even if certain items are excluded from the CPI, individual consumption habits can significantly affect one's experience of inflation.
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CDs and Taxes:
- The article underscores the importance of considering taxes in evaluating the real returns on CDs. Interest earned on CDs is taxable as ordinary income, reducing the net return based on the individual's effective tax rate.
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Alternative CD Products:
- To address the challenge of traditional CDs potentially not keeping up with inflation, the article suggests exploring alternative products.
- Indexed CDs, linked to market indices like the S&P 500, are presented as a more complex but potentially higher-yielding option with principal guarantees.
In conclusion, my expertise in personal finance confirms the validity of the concerns raised in the article. The after-tax return of traditional CDs may indeed struggle to match the rate of inflation. Investors, especially those averse to risk, should consider innovative CD products like indexed CDs to strike a balance between safety and returns.
