Don and Erik outside of Scotia Tower in Toronto, before inspection of the Scotia Global Banking and Wholesale precious metals vault.
Inflation is on the rise. Why should you care? It’s safe to assume most people want their savings to maintain its purchasing power over time. If you invest a $100 into a 5 year GIC at 2.75% interest, you gain $2.75 of interest each year, but lose purchasing power to inflation every year you have your money invested. If inflation is 2% per year, you are effectively $0.75 ahead of the game.
But don’t forget tax! Interest income is taxable income in the year received.
If you make $50,000/yr salary and have a non-registered GIC paying you 2.75% per year, your effective tax rate on the interest income added to the top of your salary income will be taxed at roughly 33%. After tax, you are left with 1.84% return. If we assume the above 2% inflation, your savings are compounding at a -0.16% rate of return!
A huge factor affecting future purchasing power is government debt and ongoing deficits. Governments love to spend money. It is also difficult for government to convince citizens to pay more tax for these expenditures, therefore they go into debt. Governments have been further encouraged by very low borrowing rates which makes it look much more “affordable” to borrow for their budgetary needs.
This debt will need to be paid back eventually, along with the interest on the accumulating debt. This reality only gives governments a couple of options:
- Increase tax rates and run budget surpluses to pay interest and repay principle.
- Massively reduce services in order to run budget surpluses (not a likely option do to public push-back).
- Refuse to pay back their debt or interest owing (very unlikely: could cause seriously political and financial upheaval).
- Engage in policies that will increase inflation.
Increasing inflation is the most likely outcome because it doesn’t tarnish government’s reputation as drastically as the other options. Government’s like higher inflation rates because it means their fixed term bonds (money borrowed from citizens, ultimately) become smaller and smaller and less intensive to pay back over time as our currency is inflated.
Inflation often becomes a government best practice because it goes mostly unnoticed in the eyes of the public. The problem, however, is the lagging impact it has on the average citizen, saver, and tax payer. It is often not realized until it is too late.
Gold is an interesting investment asset because it acts as a safety net or insurance against high government spending, stock market instability, and poor central-bank policy (the printing of money to increase money supply and inflate prices of goods and services). Theoretically, an ounce of gold today should purchase the same amount of goods and services as it did 100 years ago, regardless for how we account for that value in paper dollar terms.
Gold tends to be the most appealing when returns on cash and bonds are at low or even negative rates, higher than normal government spending is forecast, and other investment assets are overpriced.
If you take into consideration the points made previously in this post it is easy to conclude that the supply and demand for gold should be on the rise. This is fascinating to many because the exact opposite is found in the market currently. Gold is bouncing around a 10 year low.
A rise in inflation is likely to increase the price of gold over time (through supply and demand principles), however, it will be interesting to see if the prevalence of new digital currencies such as Bitcoin affects the supply and demand of Gold.
More on that in another post!