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How higher inflation might benefit savings accounts -- eventually

April 17, 2014

| MoneyRates.com Senior Financial Analyst, CFA

The Bureau of Labor Statistics (BLS) announced Tuesday that inflation perked up a little bit in March -- and the stock market promptly rallied after the announcement.

To anyone who lived through the inflation-plagued 1970s, the idea of investors welcoming inflation may seem like a through-the-looking-glass type of experience. Welcome to the 21st century.

The upside of rising prices

The BLS reported that the Consumer Price Index rose to 0.2 percent in March. That would project to an annual inflation rate of 2.4 percent -- higher than the 1.5 percent rate of inflation over the past year, and only the second time in the last eight months that inflation exceeded 0.1 percent.

Significantly, the BLS report showed solid price gains across most sectors, rather than inflation being narrowly driven by a spike in one or two sectors. That seems to suggest these price increases are not due to temporary disruptions, but that they are taking hold throughout the economy in general.

Here's the tricky part: Inflation is not normally welcomed like a long-lost friend. So why the positive market reaction to an uptick in inflation?

The answer is that while moderate inflation is good, if it slips toward deflation (i.e., falling prices), it is a symptom of severe economic weakness. In fact, deflation can become part of a vicious cycle: Low demand leads to falling prices, and once consumers observe that prices are falling, they feel no urgency to buy now, so demand falls further.

From Wall Street to the Federal Reserve, there has been some concern that inflation, which has been at 1.5 percent over the past 24 months, has been a little too quiet. After all, if the economy were actually picking up steam, one would expect inflation to be rising a bit.

Thus, signs of life from inflation can be interpreted as signs of life for the economy as a whole.

Careful what you wish for

However, the experience of the 1970s can be seen as a cautionary tale. That was the decade when the expression "stagflation" came into the vocabulary -- a combination of economic stagnation and high inflation. The 1970s proved that rising inflation does not necessary signal strengthening economic demand.

Still, two things warrant the positive reaction to a rise in inflation this time around. First of all, increasing from a 1.5 percent to a 2.4 percent annual rate is hardly a sign of runaway inflation. Second, this comes in the context of the most recent employment report, which showed 192,000 new jobs being created in March. This suggests that there just might be an actual increase in economic activity accompanying the rise in inflation.

That might seem like cold comfort to depositors in savings accounts, who have already seen their interest rates fall behind the inflation rate. What savers should hope to see is a sustained strengthening of economic growth accompanied by only a moderate rise in inflation, as those are the conditions under which savings account rates might finally get ahead of rising prices.

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