Sunday, February 21, 2016

In today's economy, with today's interest rates, should non-profit organizations use the time value of money?

Interest rates tend to reflect rates of inflation. The two are closely connected. Interest rates, which are set by the Federal Open Market Committee, which is comprised of the Federal Reserve Board of Governors a five of the regional Federal Reserve Bank chairmen, are manipulated to adjust to inflationary trends. If the costs of goods and services is rising, an obvious indication of inflation, then the Federal Reserve may choose to raise interest rates, which makes it more expensive to borrow money and, consequently, slows spending and economic activity. Conversely, lowering interest rates spurs economic activity by making it cheaper to borrow money to finance plant expansions or recapitalizations, new business start-ups, and so on.


The "time value of money" is a concept that suggests that investing money today makes more sense than holding that money static, like in a savings account when, as is the situation today, interest paid on savings is very low. Normal inflationary pressure degrades the constant value of money. That is why the dollar today buys far less than the dollar of, say, 1970. Inflation means that you get less for your money than you did yesterday. For the past decade, however, interest rates have remained historically very low, which means that it is relatively inexpensive to borrow money, but also that savings does not accrue much in the way of additional value. Your money may not be buying significantly less than it did ten years ago, because inflation has been low, but it also is not earning much because interest rates are also low.


When considering the path that a non-profit organization should take, then, one needs to estimate, to the extent possible, the direction in which inflationary trends will go, and the direction that interest rates will go. The non-profit organization that holds its money in a simple saving account will not accrue much in the way of added value. Interest rates are too low. Because inflation is also low, however, that money is not necessarily losing value, although it actually is because, while inflation has been very low, it exists nonetheless. (inflation today, March 18, 2016, is one percent) By definition, a non-profit organization is not in business to earn a profit. It is also, however, not in business to lose money. It has to do something with its reserves, or they will lose value over time. The organization, then, needs to consider safe, which means low-risk, which means low-reward, ways to invest its money, such as in money markets, that will earn more than banks are paying for basic savings accounts. Whether that organization wants to pursue a higher-risk, higher-reward investment strategy is the question for the organization's board to consider. As to the basic question, however, of whether a non-profit organization should view its financial status through the "time value of money" prism, the answer is yes, it should. Failure to pay attention will inevitably lead to diminished worth. Inflation can occur at any time. A natural or manmade disaster could adversely affect supplies of oil or natural gas, leading to increases in prices for those commodities as well as for products, like everything made with plastic, that are derived from petroleum products. Even a non-profit organization has to be concerned about the potential decrease in the value of its financial holdings should such a development occur.


What we know from history is that economies function in cycles. The United States has been experiencing a highly unusual period of seriously low inflation and interest rates, while much of the rest of the developed world, like across Europe, is undergoing serious difficulties in terms of debt ratios and expenses linked to financial problems in countries with which they are linked by treaty and/or custom. Nobody knows what the future will bring, either near- or long-term. The non-profit, therefore, should consider the time value of money, but it may want to err on the side of conservatism with respect to risk.

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