Savings Rates Below Inflation? Save Anyway

When savings rates are below the inflation rate, it's easy to think, "Why should I save? Even after the interest, I'm losing money!" But there are two good reasons to save, even in the face of a negative return. (See also: While Waiting for Rates, I-Bonds)

Both your short-term and long-term goals depend on an appropriate level of savings.

When You Need Cash, Only Cash Will Do

Your short-term goals depend on savings because only cash is cash. That is, your debts and other obligations are owed in dollars (or whatever your local currency is). Cash in the bank is what will enable you to pay your debts. Any other investment — gold, stocks, foreign currency, whatever — may (or may not) do well as an investment, but is of no use in paying your bills. The utility company will not take your tenth-ounce kruggerrand or your 50-euro banknote. They want cash.

The fact is, liquidity balances (the money you keep on hand to bridge the gap between one paycheck and the next) and your emergency fund (the money you keep on hand to cover unexpected expenses or an unexpected drop in income) both need to be in cash.

Your Long-Term Goals Need Funds Too

Your long-term goals depend on savings, because savings is what will fund your investments. But interest rates on savings below the inflation rate create the potential to start thinking that you're losing money every month, and once you do that, it's easy to delude yourself into figuring that it makes sense to spend the money "before it loses its value."

That particular delusion takes two forms.

The first is the investment delusion, where you add what you figure you're losing to inflation to your estimate of investment return. So, if you think you're a stock market genius who can earn 8% in the stock market, and the inflation rate is running along at 2%, you imagine that your stock market return would be like getting 10% better than cash.

The second is the buy now delusion, where you figure you might as well pull the trigger on any planned purchases now, since if you wait the price will just go up. (There is a particularly pernicious version of this, where you figure it makes sense to borrow money to make the purchase, since you'll be paying the debt back with cheaper inflated dollars.)

The fact is, investment decisions and spending decisions need to be judged on their own merits. The inflation rate is one factor to include (although when the inflation rate is as low as it is now, it's a pretty small factor). The return you can get on cash is also a factor to consider — but very low rates on cash actually support keeping higher cash balances. (Back when you could earn 14% on your money fund, it was worth going to some effort to minimize the cash in your wallet and pay your bills at the last possible moment, so you could keep that money working for as long as possible. When you can't even get 1% on your money, the convenience of having cash on hand tends to outweigh the tiny lost income.)

All that should have very little impact on how much of your money goes for investments or on the mix of investments you select. Your investment portfolio should be structured to support all your long-term goals — retirement, college for the kids, etc.

That's because those goals — your long-term goals — are the ones that are threatened when you imagine that savings rates below the inflation rate are a reason to spend rather than save.

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Guest's picture

You raised another excellent point, Philip. Thank you.

I will add another reason as to why we should always save money – it will help us to develop the savings habit, which is critical to build wealth. As what will make or break us financially is our money habits, it is critical for us to develop and then maintain the habit of saving money. And this must be done regardless of what happens in the outside world: low interest rate, recession, deflation or even wars.

Guest's picture

I don't plan on ever doing it, but I read some interesting articles about Roth IRAs and being able to take your initial investment money out very liquidly - as long as you don't take out any of the return.

I considered using a Roth for my Emergency fund but anything that will get you any return will also put your funds at risk. So most of my savings will continue to sit in a 0.72% money market shrinking away. I'm surprised no bank can compete and find a way to offer me more than that. Then again I just refi'd a house for 30 years at 4% (thats a deal I'd never make even my best friend)

Philip Brewer's picture

You want the main chunk of your emergency fund money to be extremely accessible. But there's a lot of room in between the complete liquidity that you want for your emergency fund and any sort of very long-term investment. Sometimes it makes sense to have some only moderately liquid money for a very bad or very long-lasting emergency, and a Roth IRA can be a good choice for those funds.

I wrote a post a while ago that touched on a particular—rather extreme—version of that idea:

It drew an excellent comment thread. Well worth reading the whole thing.