Since March when the pandemic began in the U.S. I’ve learned a couple of things.
1. The government was definitely not prepared to handle this situation.
2. Most of us weren’t either.
When the effects of the pandemic first started being noticed in early 2020, we focused all of our attention on the mistakes the government made that got us into this situation. We constantly heard about the inadequate supply of PPE for doctors or the inability for the Department of Labor to process the number of unemployment claims being made. What was left out of the conversation was the fact that while the government was improperly prepared for a global recession, few of us had prepared by saving an emergency fund that would help us through this either. While it is almost unanimously agreed upon that we should all have an emergency savings that covers 6 months of expenses, only 23% of Americans do. That means that when the staggering job losses started in March, ¾ of those people had little to no savings they could rely on to pay their bills until they found a new job. AKA, we weren’t prepared.
The pandemic has exposed the incredible importance of having an emergency savings, but an unfortunate fact about your savings is that you’re losing money with it every year. Don’t go running off to check your account balance; it’s staying the same. The loss you’re experiencing is due to a decrease in purchasing power caused by inflation.
Purchasing power is what you can actually buy with your money. If you have $100 today, and you want to buy a pair of shoes that costs $100, you can buy that pair of shoes. Next year if you want to buy the same pair of shoes they will cost around $102. The $2 increase in price for the same pair of shoes is due to inflation. The inflation rate of around 2% each year is what erodes your purchasing power, so unless you earn another $2 by next year you won’t be able to purchase the shoes.
The erosion of purchasing power caused by inflation is also why you’re losing money by saving. Every year prices are getting higher while your balance remains the same, so every year you can buy less and less with the money you have saved.
If you’re thinking that somebody must have found a way around this by now, you’d be right. Introducing the high-interest savings account! This type of savings account pays you a much higher return for keeping your money in it than a traditional savings account. Right now, high-interest accounts are paying around 1% as opposed to a traditional savings account that pays around .01%. That means if you’re saving in a high-interest account you’re only losing 1% purchasing power due to inflation instead of the total amount of inflation at 2%.
“But that means I’m still losing money!”
True, but once interest rates go up again the rate of return you’re receiving on your account will also increase. The return on high-interest savings is so low right now because the Federal Open Markets Committee (FOMC) dropped its target federal funds rate to 0% earlier this year at the start of the pandemic. The federal funds rate is the rate at which banks can borrow money from each other to meet their reserve requirements each night. A bank’s reserve requirement is the amount of cash they need to have in their vault at the nearest Federal Reserve Bank. If they are below their requirement near the end of the day, they’ll ask another bank to lend them the money overnight. The rate at which they borrow this money is the federal funds rate.
If one bank can’t find another bank to lend them the money they need to meet their reserve requirement, they can borrow the money directly from the Fed at a different rate. This is called the discount window. The Fed sets the rate for the discount window slightly higher than its target federal funds rate. That incentivizes banks to set the federal funds rate below the discount window rate. That’s because a bank wants to make whatever money it can by lending to other banks. To make borrowing from their bank more attractive than borrowing from the Fed, they offer a slightly lower interest rate than is offered at the discount window.
Banks use this same methodology to determine the interest rates they charge to consumers. When the federal funds rate is lowered, a bank will lower the interest rate it’s charging to the public to become a more attractive lender to consumers. These rate drops mean that it costs you less to take out a loan. This is why you’re probably hearing that you should buy a house right now since mortgage rates are so low. (Don’t do that unless you’ve saved 20% for a down payment and have prepared to buy a house.) While you should only take out a mortgage if you’re adequately prepared, this increase in borrowing is what the Fed wants to happen. Stimulating borrowing also stimulates spending and keeps money flowing through the economy, which is the Fed’s goal when the economy is struggling.
In times of hardship, people tend to stop spending and start saving a lot more money. This is good if you don’t have an adequate emergency fund, but a large decrease in spending will exacerbate the poor economic situation. When you stop spending, businesses’ revenues decline, which means they need to reduce their expenses, which often leads to layoffs. The people who are laid off now have less money to spend because they no longer have an income (or a far smaller one), so they reduce spending, which reduces companies’ revenues, which leads to more layoffs, and the cycle continues.
To avoid this downward spiral, the Fed lowers rates to incentivize spending. While this is good for borrowers, it also means that the rate you’re receiving on your high-interest savings account goes down. Since the bank you have your savings with is now earning less money from lending, they aren’t able to pay you as much to save with them.
Unfortunately with COVID, the interest rate drop did little to increase spending. That was because the lockdown caused entire sectors of the economy, like restaurants and airlines, to be completely shut down. Even if you had the money to travel or go out to dinner, you weren’t able to. Since it was impossible to spend in these sectors, they suffered huge losses of revenue even though interest rates were as low as possible.
As these sectors begin to open back up, spending will increase gradually and more people will go back to work. Then the people who go back to work will start spending more again, and the cycle will continue. As more people increase their spending, demand for goods will increase which means companies will in turn increase their prices. An overall increase in prices is what causes inflation.
Once the actual inflation rate is exceeding the Fed’s target inflation rate, they will start to raise interest rates. This will cause a decrease in borrowing because borrowing will become more expensive. A decrease in borrowing causes a decrease in spending which then stabilizes prices. While borrowing becomes more expensive when interest rates increase, the rate of return you’ll receive from your high-interest savings account will also increase. In the future when interest rates rise and the return you’re receiving exceeds the inflation rate, you’ll be able to preserve all of your purchasing power and earn money on your savings.
Future Rate Expectations
Next week on September 15-16 the FOMC will meet to discuss whether it should raise interest rates. Unfortunately for your savings, it’s expected to leave the target federal funds rate at 0% until it sees significant economic improvement. That level of improvement is likely several quarters or years away, so for now, you can expect to continue to lose money through your savings.
Raising and lowering interest rates is one of the best tools the Fed has to stimulate economic recovery. With the federal funds rate at 0%, the Fed can’t cut rates any further to stimulate spending. To find another means to do that, they recently revised which of their goals they will be focusing on. The Fed’s goals are to maximize employment while controlling inflation. To help speed up economic recovery, they have decided to focus heavily on maximizing employment and allow inflation to increase slightly in order to do that.
With these new goals in mind, they will now be targeting an inflation rate slightly above 2% since inflation has been running slightly below 2% recently. This will create an “average” rate of inflation around 2%. To bump up inflation, the Fed has decided to increase the money supply. The stimulus check you may have received is one way they are doing this. Increasing the amount of money in circulation is called quantitative easing, and is a strategy that is used to stimulate spending and economic activity the same way that lowering interest rates does. The Fed is hoping that an increase in economic activity will then lead to an increase in employment, which will allow them to achieve their goal of maximizing employment.
While an increase in inflation may be good for employment rates and the overall health of the economy, it will only further erode the purchasing power of your savings. If you’ve been lucky enough to keep your job in 2020, have an adequate emergency fund, and still have extra money to spend, you can help out the entire economy by continuing to spend your money. Once our economy is back in full swing, the Fed will increase interest rates and you can start earning some money by saving, but until then your savings is going to cost you.