Inflation Proof Certificates of Deposit

There is a widespread assumption that " certificates of deposit " expose their owners to the ravages of Inflation. Behind that assumption is the inherent characteristic of all fixed income products, "since the income is fixed and level, year after year, inflation will gradually eat away at the purchasing power of that unchanging dollar amount". So, for example a $100,000 C.D. at 5% will produce $5,000 of yearly income. If inflation increases 3% a year, after one year your principal is worth only $4,850. Every year it falls an additional 3%. It certainly sounds like a depreciating asset. But is it always? The answer is no, not always.

There are two strategies that can make your CDs inflation proof.

1 )

Generally speaking and over the long haul, there is rough correlation between inflation and interest rates. That is to say, when inflation goes up, so do interest rates. Medium term CDs because of their frequent renewals allow you to lock in the newest interest rate which, in an inflationary period, is likely to be higher than your previous rate. In this way you can, with a minor lag, track rates and thereby track inflation.

What if interest rates go down? That would nullify this strategy, however given the long period of credit contraction, resulting from the excesses in the housing and other market, that lies before us, the highest probability is that rates on one two and three year CDs will continue to rise well into the future, or at worst hold steady. The Fed is limited in it's ability to lower interest rates to only the shortest term federal funds and to do even that, risks a major devaluation of the US dollar, which is inflationary in it's consequences and therefore to be avoided.

2 )

For those in the fortunate position of having money they can put away without having to draw down the interest, the CD choice is even more desirable. In the example given above that $5,000 of interest income is by the second year added to the principal which now totals $105,000. During that second year the same 5% interest earned grows to $5,250. This builds automatic yearly growth into this FDIC insured investment vehicle.

There is an additional cautionary note to be considered. You want to be careful of the institution from which the CD is purchased. Some banks and credit unions are more exposed to the subprime mortgage market than others. Despite having FDIC insurance, banks and credit unions experiencing difficulties may have no recourse but to impose inconvenient delays in granting access to your money.