Now is a tough time to earn a decent return on cash. That’s no surprise to anyone. Even though interest rates have perked up from historic lows, we are still in a period of abnormally poor returns on cash.
But are you ready for a surprise? It has been worse. Want an even bigger surprise? It was worse in 1980. That’s right, it was harder to earn a decent return on cash in 1980 when interest rates were almost five times higher than they are now.
I suspect many of you are questioning that statement – and for good reason. To provide a bit of context, let’s take a trip down memory lane.
The early 1980s were difficult. The economy had fallen into a deep recession. Consumer spending and business borrowing were plummeting. The ag sector in particular was reeling. Exports and crop prices were in a vicious tailspin. The green lawns of courthouses across the farm belt were pierced by little white crosses representing farmsteads lost in the crisis. Borrowers with variable rate loans were being suffocated by payments that grew bigger and bigger. It was brutal.
At the end of 1980, the average 30-year fixed rate mortgage was 18.5%. The one-year Treasury bill yielded nearly 11% in the fall of 1980.
That last point is particularly important. It’s also the reason I suspect many of you are questioning my statement that it was hard to earn a good return on cash in 1980. How can 11% be bad?
Because gross returns don’t tell the whole story.
An analogy might help. Be warned: If you are squeamish – or perhaps vegetarian – you may not appreciate what comes next.
Let’s say you fatten a steer to 1,200 pounds and deliver it to a butcher for processing. After the butcher completes his handiwork, you are left with a pile of meat. Does the weight of that meat equal 1,200 pounds, the live weight of the steer? Of course not. You lose a significant portion of mass to unsavory extras.
The butcher removes the head, hide, horns, and guts. What’s left is a cold carcass. Even then, the butcher’s job isn’t done. There is still fat and bone to be trimmed. The actual amount of boneless, trimmed beef that you receive is usually 40% of the animal’s live weight.
And so it is with investment returns.
One-year Treasuries yielding 11% in 1980 is the equivalent to the live weight of a 1,200-pound steer. It is simply the starting point. What must be removed in the case of interest rates is not hide and horns but inflation, the general increase in the prices of goods and services.
Why does inflation matter when evaluating interest rates? Because any investment must first outpace inflation. If you earn a 5% return on an investment and inflation also increases by 5% in that timeframe, your money doesn’t allow you to buy any more goods or services than it did before you made the investment. You merely maintained your buying power.
Evaluating interest rates without factoring in the inflation rate is no different than failing to recognize that you do not end up with a bundle of meat equal to the live weight of a butchered steer.
Let’s go back to 1980. While Treasuries were yielding 11%, inflation was running rampant. In fact, in 1980, inflation was raging at more than 12% per year. As a result, anyone purchasing an 11% Treasury was losing ground. They generated an 11% return, but the cost of everything around them was increasing at more than 12%.
Compare that to our recent experience. In 2018, one-year Treasuries yielded an average of 2.3%, almost five times less than in 1980. But inflation was equally muted. It averaged about 2.1% last year. Investors who bought Treasuries in 2018 didn’t make much, but after inflation they still ended up slightly better off. That’s important to remember.
Higher interest rates may make us feel better, but they don’t always allow us to live better. Inflation can be a thief in the night, silently robbing us of our hard-earned returns.
But there’s still one additional variable that is vitally important to investment returns that hasn’t been discussed. Tax rates.
In 1980, the average American household faced a total federal tax rate of 19%. While the numbers for 2018 won’t be released for some time, it appears the average American household’s total federal tax burden will be closer to 12%. The less we pay in taxes, the more of our returns we get to keep.
If inflation is a thief in the night, taxes are a thief in broad daylight. Both chip away at our returns over time.
No one will look back at 2018 as a particularly great time to earn money on cash. But considering inflation and tax rates, it could be worse. It could be 1980.
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