How inflation affects your term deposit and savings account returns
- Term deposits are generally considered a safe and low-risk investment vehicle as they offer guaranteed returns and are backed by the Australian Government's Financial Claims Scheme.
- Inflation reduces the real value (purchasing power) of term deposits by eroding the value of money over time.
- Despite the nominal amount of money in a term deposit increasing due to interest, it buys fewer goods and services at maturity.
Term deposits and savings accounts are generally considered to be among the safest places to park and grow your money, as the Australian Government guarantee backs both. There is virtually no chance of you losing money – or so you might think.
While you might not actively lose money with them in the same manner you might with other investment products, the effects of inflation can reduce the real value and purchasing power of your cash.
Here’s how inflation can affect your savings.
What is inflation?
Inflation is broadly defined as the general increase in the prices of goods and services across an economy over a period of time, which, in turn, reduces the purchasing power of money.
It’s a natural thing that occurs in growing economies, as more and more people buy things, the prices of goods and services rise. Your parents or grandparents might have been able to buy a loaf of bread for a few cents years ago, whereas today one loaf easily costs $2 or more. That’s inflation in action.
See the latest prices of essential goods in Australia in our Grocery Price Index
Inflation is dependent on several key economic factors, such as wage growth and supply chain issues (cost-push factors), consumer confidence (demand-pull factors), and inflationary expectations.
Central banks such as the RBA (Reserve Bank of Australia) and the US Federal Reserve have inflation targets that they believe are conducive to a healthy economy.
The RBA’s target is for an annual inflation rate in Australia of between 2% and 3%.
“The Reserve Bank uses a flexible inflation target to help achieve its objectives of price stability and full employment, and its overarching goal of promoting the prosperity and welfare of the Australian people,” the RBA says.
If inflation is too high:
- Purchasing power is reduced; people will be able to afford fewer goods and services over time.
- Workers may seek wage increases, which in turn raises firms’ costs, which may lead firms to raise prices further and/or reduce workers.
- Returns on investment may be lower.
If inflation is too low:
- Consumers may delay purchases if they expect prices to fall.
- Businesses may resort to laying off workers.
To help keep inflation within its targets, the RBA can adjust the official cash rate.
Raising the cash rate increases borrowing costs for households and businesses, cooling demand to lower inflation.
Conversely, lowering the rate stimulates spending and boosts inflation.
How does inflation affect term deposits?
Inflation reduces the real value (purchasing power) of term deposits by eroding the value of money over time. While term deposits provide a fixed, secure interest rate, rising inflation means the cost of living increases faster than the value of savings.
In fact, term deposits’ locked-in rates make them particularly vulnerable to inflation, as they prevent investors from capitalising on higher rates that may arise later to combat inflation.
Key impacts of inflation on term deposits:
- Reduced purchasing power – Despite the nominal amount of money increasing due to interest, it buys fewer goods and services at maturity.
- Negative real returns – If the inflation rate exceeds the interest rate, the “real” rate of return is negative.
What is the real rate of return?
Let’s say you had a one-year term deposit paying 4.50% p.a. (nominal rate)
By investing $10,000 with interest paid at maturity, you’d earn $450 in interest. Not bad. However, when you factor in inflation, you’ll probably be disappointed.
After adjusting for annual inflation of, for example, 3%, that 4.50% p.a. nominal rate is worth just 1.50% p.a. This is known as your real return – the nominal rate minus the inflation rate. After 3% inflation, you need $10,300 to maintain your original purchasing power. Your total ending balance is $10,450.
Your "real" gain, therefore, is just $150. And that’s before we even take tax into account.
- Take note: You must declare income earned from investments and assets on your tax return, which includes interest earned on savings accounts and term deposits.
How to counteract inflation?
- Laddering – Instead of locking away a huge sum in one term deposit, break funds into smaller deposits with different maturity dates.
- Compare rates – Choose banks offering higher, competitive rates to better offset the effects of inflation.
Want to earn a fixed interest rate on your cash? Compare your options in the table below that features term deposits with some of the highest interest rates on the market for a six-month term.
| Bank | Term Deposit | Interest Rate | Interest Frequency | Term | Automatic Rollover | Maturity Alert | Early Withdrawal Available | Minimum Deposit | Maximum Deposit | Notice Period to Withdraw | Account Keeping Fee | Online Application | Joint Application | Tags | Features | Link | Compare | Promoted Product | Disclosure |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
5.35% p.a. | At Maturity | 6 months | $5,000 | $19,999 | – | – | |||||||||||||
5.20% p.a. | At Maturity | 6 months | $10,000 | $5,000,000 | – | – | |||||||||||||
5.15% p.a. | At Maturity | 6 months | $1,000 | $1,000,000 | – | – |
- Asset allocation – Investing in a diversified portfolio is critical to hedge against inflation. Consider shares, properties, bonds, ETFs, and managed funds. Before making any investment decisions, make sure to consult a professional.
Savings.com.au’s two cents
Term deposits are considered safe, low-risk investment options to store and grow your money. They feature fixed interest rates and are protected under the Australian Government’s Financial Claims Scheme. They offer guaranteed returns.
However, term deposits are not entirely safe against the impact of inflation. If the fixed interest rate you locked in is lower than the inflation rate, the purchasing power of your money may decrease. Additionally, term deposits typically have penalties for early withdrawal. So make sure you understand how term deposits work and how economic factors affect your savings before making any decisions.