Inflation is eroding the value of our savings

We saved a lot of money in Ireland during the pandemic.

By the end of February, Irish households had collectively increased deposits by €30bn in the same month of 2020, just before the pandemic struck, to stand at over €142bn.

That provides a big buffer for the economy as things look increasingly precarious against the backdrop of uncertainty brought on by the war in Ukraine.

However, in an environment where savings already pay little to nothing with interest rates rock-bottom, the value of that money is effectively being eroded by inflation.

So should we just spend our savings or are there better ways to use the money?

an unexpected visitor

After the financial crisis, there were years when we had little or no inflation in the euro zone.

In fact, there were periods of deflation, all of which led the European Central Bank to reduce interest rates on loans to a minimum.

The deposit rate was brought below zero. Those steps were taken in an attempt to get people to spend more and start borrowing to get some inflation back into the system.

When the pandemic hit, the initial expectation was that economies would experience a contraction of at least the magnitude of the financial crisis.

That turned out not to be the case, and when economies reopened, demand rebounded strongly, but supply chains weren’t ready.

Therefore, delays arose, and the price of materials inevitably began to rise.

Inflation is back and the Russian invasion of Ukraine, coupled with ongoing Covid lockdowns in China, have seen it rise to levels not seen in decades.

All of which have an effect on our immediate spending practices, but also on our future plans.

“There are the short-term issues on the forecourt and at the till, but the bigger issue is the time value of money,” says Frank Conway, founder of Moneywhizz and the Irish Financial Review.

“High inflation has a detrimental impact on the value of money,” he added.

He did some calculations to demonstrate the effect.

Taking a lump sum of €50,000, a 7% inflation rate would erode its value by more than €3,000 in just one year, bringing the actual value of the cash to €46,728, he calculated.

A 7% inflation for a decade would halve the value of the lump sum compared to its value before inflation started to kick in.

A quiet recovery

It was hoped that the extra billions that had been set aside, simply because people did not have a normal spending pattern during the pandemic, could be released into the economy and fuel recovery in areas that had suffered the most from Covid lockdowns.

However, these so-called “excess savings” are now expected to have a more moderate effect as purchasing power is effectively reduced.

“As the value of savings is eroded by inflation, households become more cautious and more of the savings are used to cushion rising costs, rather than being used for discretionary spending,” Gerard said. Brady, Ibec’s chief economist in the group’s recent report. economic prospects.

Savings, he said, tend to be concentrated at the top of the income distribution, which is why there have been calls to focus any fiscal support against inflation on lower-income households where ‘excess’ savings are likely to be minor.

But even for households with lower savings levels, the same problem exists.

These are the households that are most likely to rely on a fixed income and may be trying to save money for education or simply building an emergency fund for unexpected expenses.

Not only is it harder to secure that money to set aside now, but the value of those savings is also being eroded.

Spend it or save it wisely?

So what’s the best way to avoid, or at least mitigate, the impact of inflation on our savings?

According to Frank Conway, there are two main methods.

The first is through the pension structure and the other is passive investment.

“That’s a little bit weirder for people. It’s where you buy a diversified fund that will grow over time. An S&P 500-type fund,” he explained, with the S&P being the main index of major US stocks.

“If you look at the performance of the S&P since 1926, it’s grown on average 10% a year. It could take a beating for 3 years, and that’s the problem, but in the long run, well-managed funds do their job,” he said. saying.

One drawback is that the returns on such funds are taxable, but he advised that savers should maximize the tax benefit available in pension plans before moving on to other investment methods.

However, he warned those who contribute to pension plans to keep a close eye on the performance of their funds and make sure they are not overcharged in fees.

While pension plans can work well in times of inflation, if stock and bond market earnings generally exceed the general level of price increases, inflation can be detrimental in the post-retirement period.

“It’s more damaging to the idea of ​​retirement because it will erode the value of anything you have, just like the state pension,” Conway said.

When it comes to spending money, it’s a good idea to use leftover cash in an inflationary environment to pay off some more expensive forms of debt, like credit cards and personal loans, especially if interest rates are about to go up .

What about active investment?

In general, we don’t tend to have a culture of investing in stocks and shares in Ireland, which partly explains why our savings levels are so high.

However, there seems to be a growing acceptance among consumers that the value of their savings is eroding anyway and that now is a good time to invest money.

According to the Bank of Ireland in its latest savings index, attitudes towards investing have risen since the beginning of the year, despite a high degree of volatility in the stock markets.

There was also a higher incidence of people actually investing, as well as a jump in the number of people who thought the coming year would present good investment opportunities.

“I suspect there is a growing recognition among some consumers that saving is no longer enough given near-zero interest rates. Many are looking elsewhere for their long-term plans, especially in the face of inflation concerns,” Kevin Quinn , investment director. He explained the Bank of Ireland strategist.

Could deposits be back in fashion?

Given that the European Central Bank has been charging banks for parking excess deposits in its overnight facilities for about eight years, we’re lucky we haven’t been hit by negative interest rates on our savings.

Beyond the large deposits of companies or very high net worth savers with balances of more than one million euros, banks have not deviated from charging for our deposits.

But the interest rate environment could be about to change.

The US Federal Reserve and the Bank of England have started to raise interest rates and the European Central Bank is likely to do the same in the coming months.

Having resisted the idea for a long time, clinging to the argument that inflation was ‘temporary’ and would pass, it now appears that the sands are moving on the idea of ​​a European level rate hike.

ECB Chief Economist Philip Lane, a former Governor of the Central Bank of Ireland, appeared to confirm expectations of an imminent ECB deposit rate hike, which investors are now expecting in July.

However, he was cautious on the idea of ​​further hikes, citing the war in Ukraine as a risk to the outlook.

“The story is not the question of ‘let’s get away from -0.5% for the deposit rate,'” Professor Lane told Bloomberg TV.

“The big issue that we have to continue to rely on the data for is the scale and timing of interest rate normalization,” he said.

The ECB has never said what it means by normalization, but politicians expect a rate of between 1% and 1.25%, well below the current rate of inflation.

“It’s all relative,” Frank Conway explained.

“If inflation is 3% and you receive 2% on your deposit, you are losing money.”

He said we could possibly go back to a scenario where money could become very valuable again (with high interest rates attached to deposits), but there was no sign of that at the moment.

So the best bet for anyone lucky enough to have a lump sum right now is to consider paying off expensive debt or investing it in a pension or diversified fund.

Once enough money has been set aside in an account that can be easily accessed in the event of an unexpected event — typically around three to six months of living expenses, Mr. Conway recommends — the rest should be put to work.

With inflation likely to hit 8% in the coming months, our cash is rapidly losing value.