Sunday, January 1, 2012

How The Federal Reserve Screws You

I went to the bank yesterday to make a deposit and out of curiosity I asked what the interest rate was on a basic savings account.  The teller told me that it was 0.2%.  Pretty pathetic right.  Of course savers who have money parked in savings/money market accounts aren't too happy about the puny returns but the situation is actually much worse than many people understand.  To illustrate what I mean, lets look at a simple example.  Say we have an emergency fund of $10,000 in a savings account which earns 0.2% annually (we'll compound annually for the sake of simplicity).  At the end of the year we end up with a scrawny return of $20.  But hey, its better than nothing.  At least we are now ahead by $20, right?  Unfortunately no, that isn't the case.  We forgot that the income is taxable interest (at ordinary interest rates).  So lets say were in the 25% bracket.  With this in mind we have to subtract $5 from our $20 leaving us with a return of $15.  Now that is a pathetic return on investment.  But hey, at least we got something and are ahead by $15, right?  Well, no, because we still need to calculate the effect of inflation on our investment.  As of the end of November, the average inflation rate for 2011 was about 3.2%.  So if we take our original investment of $10,000 plus our return of $15 and multiply that by 3.2% we see that we have actually lost purchasing power of about $320.  Yep, our money is now worth about $9695 in real dollar terms.

Of course part of the reason interest rates are so low is because of the federal reserves attempts to get the economy moving again.  The hope is that with such low rates, people will start borrowing and spending money again.  But the flip side of this sort of policy is that it punishes savers.

So to sum it up, the government promotes a policy that punishes the responsible savers through inflation and taxes in hopes that it will get the irresponsible spenders to start borrowing and spending again.  Hmm, does this sound like a solid plan to you?

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