A Drop In Consumer Prices -- With A Catch

Inflation took a step back in March, which is news that should come as a relief to bank depositors in savings accounts and other interest-bearing instruments. However, there is a catch involved that prevents this from being completely good news for depositors.

Prices decline in March

Last week the Bureau of Labor Statistics announced that the Consumer Price Index (CPI) declined by 0.2 percent in March. This put to rest fears of a flare-up of inflation that had been stoked by the previous inflation report, which showed a 0.7 percent rise in the CPI during February. The decline in consumer prices during March left inflation at a moderate 1.5 percent over the past year, and running at an even milder pace over the past six months.

Once again, petroleum products were the key driver of inflation. In February, a 9.1 percent spike in gasoline prices had contributed heavily to the rise in the CPI. In March, a 4.4 percent drop in gasoline prices was the leading factor the CPI's decline.

Declining prices are a welcome break for bank depositors. With CD, savings, and money market rates generally running below 1 percent, virtually any inflation represents a loss of purchasing power for bank accounts. The catch is that the March decline in CPI was accompanied by signs of a slowing economy, and that is not good news for depositors.

Four scenarios and their impact on savings accounts

To better understand the trade off between falling prices and slowing growth, imagine a four-way grid that depicts the possible outcomes for both inflation and economic growth, with each ranging from high to low. The result would be four possible combinations, as described below:
  1. Low inflation, slow growth. If this sounds familiar, it's because it has been the dominant environment of the past few years. In this scenario, inflation doesn't do too much damage, but savings accounts are not able to get ahead because slow growth keeps interest rates low.
  2. High inflation, slow growth. This would be even worse for depositors, because while rising inflation might eventually push interest rates higher, a slow growth environment would likely mean that interest rates would rise more slowly than inflation, causing savings accounts to lose purchasing power more quickly.
  3. High inflation, high growth. Under this scenario, both interest rates and prices could rise rapidly. Savings, money market and certificate of deposit rates would look healthier, but that would largely be an illusion because much of those higher rates would be eaten up by inflation.
  4. Low inflation, high growth. This was the best-of-both-worlds environment that the U.S. enjoyed during the late 1990s. It would give interest rates a chance to get solidly ahead of inflation again.

The March CPI number suggests the U.S. is still in the first scenario. Depositors can count their blessings that it isn't the second one, but the ideal of the fourth one still seems a long way away.