What Inflation Does To $20,000 Sitting Still

I left about $20,000 sitting in a checking account for most of a year because I did not want to think about it.

The balance never went down. I looked at it maybe twice and it said the same thing both times, and that steadiness felt like the safe choice.

It was a slow subtraction I could not see, because the number on the screen never moved.

Nominal and real

A nominal amount is the number printed on the statement. A real amount is what that number can actually buy.

Inflation is the rate at which prices rise, which makes it the rate at which a fixed pile of money buys less. If prices go up 3 per cent over a year, a $100 grocery run becomes $103, and the $100 sitting in your account now covers about $97 worth of what it covered last year.

Both measurements are true at once. Only one of them is shown to you.

Ten years on one balance

Take $20,000 in a savings account paying 0.5 per cent, with inflation running at 3 per cent a year, held for ten years with no deposits and no withdrawals. Those rates are picked to make the arithmetic visible, not as any kind of forecast.

The nominal side: $20,000 growing at 0.5 per cent a year for ten years comes to $21,023. Your statement reports that you made $1,023.

The real side: prices rising 3 per cent a year for ten years multiply by a factor of 1.344. Divide $21,023 by 1.344 and you get $15,642 measured in today's money.

The line going up is what the bank tells you. The line going down is what the money does at the shop.

The same balance at a better rate

Change one input. Same $20,000, same 3 per cent inflation, but the money sits in an account paying 4 per cent.

$20,000 at 4 per cent for ten years is $29,605. Divided by the same 1.344 price factor, that is $22,029 in today's money.

A real gain of $2,029 instead of a real loss of $4,358. The two outcomes are $6,387 apart and the only thing that changed was which account held the money.

The rate that matters is the gap

Your real return is roughly the rate you are paid minus the rate prices are rising. A 4 per cent account against 3 per cent inflation is about 1 per cent of real return. A 0.5 per cent account against the same inflation is about minus 2.5 per cent.

So a bank advertising 4 per cent has told you half a sentence. Four against three is a gain. Four against six is a loss you are taking inside an account that looks like it is paying you.

Where the erosion actually shows up

The reason this is so hard to feel is that it never arrives as an event. Nobody sends a notice. No line appears on the statement.

It shows up as the lunch that used to be $12 and is now $16. The rent renewal that came back $250 higher. The same model of car, three years later, $9,000 more than you remember paying. Each one reads as a separate annoyance rather than as one force acting on the same balance.

A $20,000 balance losing 2.5 per cent of real value a year loses $500 in year one. That is not an event either. It is $500 that simply is not there, and it works against you on exactly the same compounding curve that works for you in a retirement account.

The safe choice is safe against one thing

There is a real kind of safety in a savings account and I do not want to talk anyone out of it. The balance cannot fall. There is no year where it drops 18 per cent and no morning where you open the app and wince.

That is protection against short-term price movement, and for money you need next March it is precisely the right thing to buy. Nobody should have next year's tuition payment in something that can halve.

The risk it does not cover is the one that never produces a bad day. Nothing in that account will ever tell you that the $20,000 you put aside for a down payment eight years ago now covers about two thirds of what it would have covered then.

What this does not mean

It does not mean holding cash is a mistake. An emergency fund is not an investment and grading it like one is how people end up with their car repair money in something that dropped 20 per cent the month they needed it.

The $12,000 sitting in savings for the transmission, the vet, the three months between jobs, is doing a job that has nothing to do with beating inflation. The right amount of real return to expect from it is roughly zero, and that is fine.

What it does mean is that you should know which money is doing which job. Money you might need in the next twelve months belongs in cash. Money you will not touch for a decade, parked at half a per cent, is being converted into less money on a schedule.

Two words on the rate itself

The number to compare across banks is the APY, the annual percentage yield, which is the rate after compounding has been accounted for. A headline rate quoted without compounding can differ slightly from what lands in the account over a full year, and the APY is the version that lets you put two banks next to each other honestly.

Savings rates also move. They are not locked the way a mortgage rate is locked, so an account paying 4 per cent this year can pay 1.5 per cent in two years without asking you, and the only warning will be a line in an email you did not open.

Do this

Look up the actual rate on the account holding your savings. It is on the statement or one click into the account details, and a fair number of people discover it is 0.01 per cent, which on $20,000 is $2 a year.

Then look up the latest twelve-month change in the consumer price index, the government's main measure of how fast prices are rising, published every month by the Bureau of Labor Statistics at bls.gov.

Subtract the second number from the first. Whatever comes out is what your savings are really doing, and if it has a minus sign in front of it you now know something the statement was never going to tell you.