Inflation erodes 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 their deposits by €30bn from the same month in 2020 – just before the pandemic hit – to over €142bn.

This provides a major buffer to the economy as things look increasingly precarious amid the uncertainty brought on by the war in Ukraine.

However, in an environment where savings are already paying little or nothing with interest rates at rock bottom, the value of that money is effectively eroded by inflation.

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

An unexpected visitor

In the aftermath of the financial crash, there were years when we had little or no inflation in the Eurozone.

In fact, there have been periods of deflation, all of which prompted the European Central Bank to cut borrowing rates to rock bottom.

The deposit rate has been reduced to below zero. These measures were taken in order to induce people to spend more and to borrow to put some inflation back into the system.

When the pandemic hit, economies were initially expected to experience a contraction of at least the magnitude of the financial crisis.

This turned out not to be the case and when economies reopened, demand rebounded strongly, but supply chains were not ready.

Therefore, delays appeared and the price of materials inevitably began to increase.

Inflation was back and the Russian invasion of Ukraine, along with the continued Covid lockdowns in China, saw it reach levels not seen in decades.

All of this has an effect on our immediate spending practices, but also on our future plans.

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

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

He did some calculations to demonstrate the effect.

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

Inflation at 7% over a decade would effectively halve the value of the lump sum compared to its value before inflation started to bite.

A half-hearted recovery

It was hoped that the extra billions that had been set aside, simply because people weren’t in a normal spending pattern during the pandemic, could be released into the economy and spur recovery in regions that had the most suffered 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 savings are used to protect against rising costs, rather than being used for expenses. discretionary,” said Gerard Brady, chief economist at Ibec in the group’s recent report. economic perspective.

Savings, he said, tend to be concentrated at the higher levels of the income distribution, which is why there have been calls to target any anti-inflation tax support to low-income households. income where “excess” savings are likely to be lower.

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 they may try to put money aside for education or simply build up a rainy day fund for unexpected expenses.

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

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 second is passive investing.

“It’s a little more alien to people. That’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 the best stocks in the United States.

“If you look at the performance of the S&P since 1926, it’s grown an average of 10% a year. It could take three years, and that’s the problem, but over the long term, well-managed funds do their job” , he added. mentioned.

A downside is that the returns from these funds are subject to tax, but he advised savers to maximize the tax advantage available on pension plans before switching to other methods of investing.

However, he warned those contributing to pension schemes to monitor the performance of their funds closely and ensure they are not being burdened with fees.

While pension plans can work well in times of inflation – if stock and bond market gains generally outpace the general level of price increases – inflation can be detrimental after retirement.

“It’s more detrimental to the idea of ​​retirement because it will erode the value of everything you have in advance, much the same as the state pension,” Mr Conway pointed out.

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

What about active investing?

Overall, we don’t tend to have a culture of equity investing in Ireland, which is part of the reason why our savings levels are so high.

However, consumers increasingly seem to accept that the value of their savings is eroding anyway and that now is a good time to invest money.

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

There was also a greater incidence of people actually investing, as well as an increase in the number of people who believed the coming year would present good investment opportunities.

“I suspect some consumers are increasingly recognizing that saving is no longer enough given near-zero interest rates. Many are looking elsewhere for their longer-term plans, especially in the face of inflation concerns. “, Kevin Quinn, Chief Investment Officer Strategist at Bank of Ireland explained.

Could deposits become fashionable again?

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

Apart from the deposits of large companies or very wealthy savers whose balances exceed 1 million euros, the banks have not strayed into charging our deposits.

But the interest rate environment could be about to change.

Both the US Federal Reserve and the Bank of England have started raising interest rates and the European Central Bank is expected to follow in the coming months.

After long resisting the idea – sticking to the argument that inflation was “transient” and would pass – the sands now seem to be leaning on the idea of ​​a European rate hike.

ECB Chief Economist Philip Lane, 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 about the idea of ​​further upside, citing the war in Ukraine as a risk to the outlook.

“The story is not about ‘are we going to move away from -0.5% for the deposit rate,'” Professor Lane told Bloomberg TV.

“The big issue where we still have to rely on data is the extent and timing of interest rate normalization,” he said.

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

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

“If inflation is 3% and you get 2% on your deposit, you lose money.”

He said we could eventually revert to a scenario where silver could become very valuable again (with high interest rates attached to deposits), but there was no sign of that yet.

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’s easily accessible in case something unexpected happens — typically around three to six months of living expenses, Conway recommends — the rest needs to be put to work.

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

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