BOSTON — Investing with the expectation of losing money is stupid. Locking your money into an investment that can't keep pace with inflation is the same thing. With the cost of living on the rise and interest rates on the decline, that makes bank certificates of deposit that are more than a 1.5 percentage points behind inflation a dumb idea.
For certificates of deposit, savers who locked their money in before the Fed's recent cuts are much more likely to be ahead of inflation, and clearly should ride out the length of their term deposit. For investors with new CDs, penalties for early withdrawal could make a pullout even more costly than simply lagging the rate of inflation.
Clearly, certificates of deposit are not money losers. No matter how low the payout, they are better than stuffing money in a mattress, and they provide a safe haven — with coverage from the Federal Deposit Insurance Corp. — for investors who are skittish about the market.
But anyone turning away from market risk could be giving a big wet kiss to purchasing-power risk — the chance that their money grows more slowly than the rate of inflation — and there is little doubt that the majority of people investing in CDs now fall into that category.
For proof, look no further than the numbers.
For 2007, inflation was 4.1 percent, as measured by the Consumer Price Index. While that is a backward-looking measure and not necessarily indicative of the future, the reality is that inflation tends to move gradually. That would be enough to forecast inflation staying in its current neighborhood, but anyone watching the Federal Reserve Board cut interest rates knows that the big concern most experts have had with these moves is that they might encourage future inflation.
"Aggressive cuts in short-term interest rates could well open the door to inflation," says Greg McBride, senior financial analyst for Bankrate.com, "so while the Fed is preoccupied at the front door with the economic slowdown, it may be letting inflation sneak in the back door. Certainly, you won't find many people who expect the inflation rate to drop much in the near future."
Inflation doesn't even seem to be a back-door concern for many investors, who continue to plow cash into CDs and money-market investments, even as the Fed's rate cuts have been driving savings yields down.
Currently, according to Bankrate.com, the average two-year CD nationwide yields 2.5 percent; the top two-year certificate of deposit available nationally is from InterVest National Bank and has an annual percentage rate of roughly 4.1 percent, or equal to the pace of inflation.
Stretching out further, the average five-year CD carries a 3.3 percent rate, with the best yields topping out at 4.25 percent. On the short-term side, the average one-year CD is also at 3.3 percent, according to Bankrate.com, with the top rates checking in at 4 percent.
In other words, average CDs are alarmingly below the rate of inflation.
Moreover, savings yields are almost certain to fall further. For starters, the market is still digesting the Fed's big cuts; many observers believe that CD yields typically settle in at roughly 0.6 to 0.7 percentage points below the Fed funds rate. That formula would suggest that average CD rates are headed to 2.4 percent or less.
But that's before the Fed makes its next cut, which many pundits already are calling for and predicting will occur at the Fed's scheduled March 18 meeting. If that cut or any subsequent moves spur inflation, the gap between the average CD and the rate the money must earn to maintain purchasing power will grow wider.
None of this is a suggestion that savers leave their safe harbors to seek dramatically better returns. People who are putting their money into cash investments, like CDs, are doing it first and foremost to preserve their principal, and even the worst CDs achieve that financial goal.
The saver's secondary goal is to maximize returns without losing the safety and security they sought in the first place.
"You need to be willing to shop around, and to send that money someplace where you can get the best return, even if that means not working with the bricks-and-mortar bank you can walk into in your hometown," says McBride. "Cast a wide net in your comparison shopping and send your money to the bank that gives you the best return."
That doesn't mean being reckless. Stay with institutions whose deposits are covered by the Federal Deposit Insurance Corp., which provides protection in the event of a banking catastrophe.
"Don't go too far and get to where your money is at risk, but don't be afraid to go outside your normal comfort zone and look a little further away if that's what it takes to get a better yield," says Connie Bugbee, managing editor at iMoneyNet. "There are still banks out there that need the money and that are willing to pay better for it, and people should take advantage of that, so that they do the best they can against inflation."
Chuck Jaffe is a senior MarketWatch columnist. His work appears in dozens of U.S. newspapers.