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Inflation exits the year with a whimper

January 17, 2013

| MoneyRates.com Senior Financial Analyst, CFA

Inflation took a breather in the fourth quarter. If it continues to relax, it might actually create some breathing room for savings accounts and other deposits.

The Bureau of Labor Statistics announced yesterday that the seasonally adjusted Consumer Price Index was unchanged for the month of December. That meant that consumer prices actually declined overall during the fourth quarter, and were up only 1.7 percent in 2012.

A crucial relationship with savings accounts

That 1.7 percent is considered low by historical standards of inflation, but it still exceeds current interest rates on savings accounts and other deposits. This highlights the crucial relationship between inflation and interest rates. In terms of whether a depositor is really gaining or losing purchasing power, interest rates cannot be viewed in isolation. They have to be viewed relative to the level of inflation.

This relationship is complicated by the fact that rising inflation can push interest rates higher. On the surface, that might seem to be good for interest rates, but it actually represents no progress at all. Indeed, if interest rates lag behind the rise of inflation, those rates could go up and still be worse off.

The flip side of this is that low inflation can lead to falling interest rates, especially when the lack of inflation is a symptom of economic weakness. However, interest rates are currently so low they don't have much further to fall. Therefore, having prices decline in the fourth quarter was good for depositors, because it gave them a rare chance to come out ahead of inflation -- even with most interest rates below 1 percent.

The outlook for inflation

Getting ahead of inflation for just a few months doesn't really help depositors that much, so the key question is, what's next for inflation? Here are three reasons to be concerned that inflation could make a comeback in 2013:

  1. The fiscal cliff deal was more stimulative than budget-friendly. The resulting boost in the economy could lead to higher prices.
  2. Oil prices are always just a crisis away from the next spike. Inflation has a way of following the lead of oil and gas prices. These have been declining in recent months, but how long can that last?
  3. Unusual weather conditions are creating challenges for farmers. The climate seemed to deal in extremes last year -- either floods or droughts. If this continues, it could disrupt the food supply, leading to higher prices.

For now, the easing of inflation in recent months has left a little room for CD, savings and money market rates to get ahead of rising prices -- especially for those bank customers who actively pursue higher interest rates. Even so, depositors will have to keep a wary eye on inflation, because today's extremely low interest rates still leave deposit accounts vulnerable to any uptick in prices.

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