During most of 2020 and 2021, global news headlines were dominated by coverage of the COVID-19 pandemic. In 2022, the pandemic is still being mentioned in the news, but we are seeing more coverage related to rising inflation, which appears to be an inescapable development around the world. In the United States, a country that takes pride in being able to keep inflation under control, more than half of American families are one missed paycheck away from plunging into financial tragedy, and this is a greater problem than it was more than a year ago when labor and economic activities were constrained by the pandemic.
For those who are living paycheck to paycheck, the thought of trying to build wealth or plan for retirement might feel strongly out of reach. It is certainly difficult to think about long-term financial goals when you are barely making ends meet, but the current high cost of living should not completely preclude you from investing in your future. Compound interest is a financial strategy worth exploring during inflationary times because it can actually provide an intelligent hedge against future periods of high inflation.
The Basics of Inflation
In macroeconomic terms, inflation is what happens when regional economies go through periods of lower purchasing power. The basic mechanism of inflation involves consumer prices going up while salaries stagnate or prove to be insufficient. There are various ways to measure inflation, but the one method that truly applies to everyday Americans is the consumer price Index (CPI), which in the U.S. is measured and published by the Bureau of Labor Statistics. The CPI has increased by nearly 9% since May 2021, which means that your paycheck feels at least 10% lighter compared to last year.
Microeconomics researchers at the University of Michigan believe that the real impact of inflation on American families is closer to 15%, particularly when we take into account fuel prices, mortgage interest rates, and the higher cost of rents. Americans are hardly the only ones dealing with inflation in 2022; in Argentina, for example, the CPI has increased by more than 60% on an annual basis.
The current economic trend of global inflation is tied to various geopolitical factors, such as the Russian invasion of Ukraine, the lower production output in China, and the slow pace of recovery from the pandemic. We feel these reverberations because we live in a globalized economy. With the very few exceptions of tiny nations that happen to enjoy considerable wealth, inflation has become a global issue that cannot be escaped, but this does not mean it cannot be mitigated.
In all economies driven by capitalism and free markets, the rate of inflation will always outpace the yield of compound interest; this is the result of financial competition, and it allows regulators to avoid the kind of severe inefficiencies that can spiral down into an economic depression.
If we take the 15% real CPI estimated by the University of Michigan, we see that it is much higher than the 5.5% rate of interest set by the U.S. Federal Reserve Board in August 2022. It is also much higher than the most enticing compound interest high-yield savings account, which offers a 2.25% annual percentage yield (APY). Even the most lucrative five-year certificate of deposit was only paying about 3.5% in August 2022.
In order for an American investor to defeat inflation in 2022, the annual return on an asset portfolio would have to be greater than 15%. We have already established that compound interest alone will not catch up to inflation. You might be able to accomplish this through stock investing or real estate, but those are investing activities that convey a certain amount of risk, and which are not guaranteed to produce returns.
Compound Interest and Inflation
We know that inflation reduces our purchasing power along with the value of our savings. Obviously, this is not an ideal situation for building wealth, which is why compounding is one of the best financial strategies to hedge against inflation. To see how compound interest can help you deal with inflation, let’s use one of our calculators to figure out the following scenario:
- In the year 2012, a nurse in Idaho deposited $1,000 into a money market account, paying 1% APY compounded on a daily basis. She also made a firm commitment to contribute $500 each month to the account.
- In 2022, the nurse will have $64,206 in her money market account. She has effectively grown her account balance into a safety net that can help her alleviate some of the negative effects of inflation. While her income may have lost 15% of purchasing power over the last 12 months or so, she could very well tap into her account in order to cover monetary shortfalls.
Time will always be the most important factor in the calculation of compound interest. If the nurse in the example above had not applied a compounding strategy ten years ago, her financial ability to deal with inflation today would be sharply diminished. Since we can’t really make up for the lost time, we must keep in mind that failing to build wealth now will affect us in the future. Now is the time to get started with compounding because the inflation we consider to be extraordinary now may become the new normal down the line. Any funds that you are able to deposit for compounding today might be the funds that save you from catastrophic financial ruin tomorrow.
All in all, if you decide to wait until inflation levels off to start compounding, you would be missing out on daily interest being paid and reinvested into your portfolio. We don’t know if things will ever get back to normal; arguably, wages would need to be raised at some point, but this may take longer than expected. Time is one of those things that we can’t get back once it is gone. The time to take advantage of compound interest will always be now. Waiting for things to get better does not make sense; you don’t want to lose out on the exponential nature of compound interest. The longer you wait, the less you will be able to earn.