Why save during an inflation?

By Philip Brewer on 13 August 2008 2 comments

You can always tell when inflation has become ingrained in an economy--you start hearing people say, "Buy now before the price goes up!"  I remember hearing that a lot in the late 1970s, but I haven't heard that much so far in the current inflation. (This fact probably gives the Federal Reserve a certain amount of comfort.)  I have, though, started to hear its close cousin, "Why save when the interest rate is below the inflation rate?"

It's easy to see the logic there.  When the best return you can get on your cash barely tops 3%, but inflation is running over 5%, it's easy to figure that it's stupid to hold cash and watch its purchasing power shrink by more than 2% a year.  The fact is, it's not stupid to save, even during inflation.  Here are a few good reasons to hold cash.

For liquidity

You need a certain amount of cash just to cover your routine expenses.  In fact, especially when interest rates are low, there's not much cost for holding a bit of extra cash.    

Suppose, for example, you keep an extra $1000 or $2000 in cash.  Interest rates are about 2 percentage points under the inflation rate, so that means your loss in purchasing power amounts to $20 to $40 a year.  If the extra cash prevents just one overdraft fee or late-payment charge, you've already broken even.  If it gives you an opportunity to take advantage of a good deal, you could save even more.  In fact, if it just saves you an occasional anxious day worrying if a transfer is going to go through in time for you to fulfill some obligation or another, I'd say it's worth the money.  (I admit to putting a high value on avoiding anxious days of worrying.)

For major purchases

It's possible to invest your money in search of a higher return, and then sell those investments when you need to make a purchase, but that's usually not the best choice.  First, you incur transaction costs.  Second, you take on the risk that your investment will go down (very possibly by more than the few percent that inflation would have taken from you).  This risk is especially acute when we're talking about short time horizons, such as the time it takes to accumulate enough money to buy something of moderate costs, such as a new refrigerator or camera.

Even for larger purchases, such as sending your kids to college or buying a house, accumulating cash should be part of your strategy.  If your time horizon is long (college savings for a small child), investing more aggressively can make sense.  But once you're expecting to spend the money within less than five years, you should definitely be moving part of the investment into cash.

For investing

Making an investment is rather like making a major purchase:  Unless you're going to borrow money, you need enough cash on hand to pay for it.  It's possible to invest small amounts of money, but there are often transaction costs involved.  Sometimes you can sell some other investment to raise funds, but unless you have another investment that you've already decided you want to sell, that's probably the wrong choice.  

Just like with major purchases, it's usually better to accumulate enough cash to make a significant investment in a single transaction.

For security

Sure it's bad to see your wealth shrinking by a couple percent a year, but that is by no means the worst that can happen.  Just in the last month, for example, gold (the classic inflation hedge) is down from $986 to $809.  That's an 18% loss in less than 30 days!  The point is not that gold is a bad investment--the point is that it is an investment.

The value of cash may decline.  In fact, it almost certainly will.  But, short of hyperinflation, its decline will be slow and broadly predictable.  If your rent or mortgage payment comes to $1000, you can be quite confident that $1000 will cover the bill.  If you took to holding your savings in gold, you simply couldn't know.  (Since the middle of last month, your $1000 bill would have jumped from 1.01 troy ounces to 1.24 troy ounces.)

For preparedness

Inflations always end.  Sometimes they end with hyperinflation making the money worthless, but more often they end with high interest rates leading to a horrible, grinding recession.  In that situation, cash is king and physical assets like gold do very poorly indeed.

If you think hyperinflation is a real risk, you should definitely hold some physical assets like gold or silver or real estate.  But you should hold them as an investment, not as a cash substitute.  

On the other hand, If (like me) you expect this bout of inflation to end like other periods of US dollar inflation, you'll want to keep some cash on hand, to be ready to take advantage of those high interest rates when they come.

How to hold cash

It's easy to feel dumb holding cash when interest rates don't match the inflation rate, but don't let that tempt you to invest it in ways that expose you to excessive risks in an effort to pick up a little extra yield.  The whole point of cash is that it isn't an investment.

It's still pretty easy to get 3% in an internet savings account.  Money market funds are paying a bit less, and Treasury bills are paying a bit less yet--but either one pays enough that they're perfectly reasonable ways to hold some cash.

In fact, with rates as low as they are, you're not really out of pocket very much if you hold some cash in the form of actual cash!  (When rates go up again, this will change.  Back in the early 1980s, interest rates were so high that it was very tempting to keep your money earning interest until the last possible moment.  With rates where they are now, you really don't need to worry about that.)

During a period of high inflation, it may well make sense to adjust your portfolio mix to hold less cash than you'd hold when inflation was low, but don't let the situation tempt you to hold less cash than you need, or to invest your cash in ways that make it insecure.  There are all kinds of problems, but there's a large class of problem for which cash in hand is the best solution.  Don't let a little inflation keep you from having that cash when you need it.

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Guest's picture

WAMU has an online savings acct that is paying 3.5%, and an 8 month CD for 4.24%. No, it won't make you rich, but it's not a bad place to park your stash. I've staggered some CDs and have 4 months of cash in the online savings.

I agree, there's NEVER a good time not to save, it just doesn't make sense to me. I always sleep better knowing that if I were suddenly laid off, injured, or my car died, I have the funds to deal with it!

Guest's picture

You can also save in a foreign currency that's holding value better if you're willing to pay the exchange rate to change it into Euros or something else. I've often done this with British pounds when I'm saving to go visit my aunt there.