Since the beginning of Covid-19, Australia has become a nation of savers. But what kind of financial cushion do cash savings offer if inflation takes hold?
Unable to travel, socialise or do many of the other things that usually deplete their bank accounts, Australia has become a nation of savers. However, this welcome financial cushion may not be as protective as hoped if inflation takes hold.
Cash has its role. If people have a short-term savings goal, such as a house deposit or a new car, cash is almost certainly the right place for their savings. Equally, it is always sensible to have a few months’ worth of expenses in a readily accessible cash account as a buffer against life’s various hiccups – redundancy, sickness, a leaky roof. But too much in cash for too long can be corrosive for long-term wealth, particularly today.
How will inflation impact you?
The rising prices of goods and services will erode the real value of your savings pot. While cash may feel inherently safe, the way inflation works is that $10,000 goes in and years later – it only buys half as much, that is a real problem. This isn’t as unlikely as it sounds, a savings pot of $10,000 would be worth just $6,100 in real terms after 25 years with inflation at 2%, the lower end of the current Reserve Bank of Australia target which is between 2% and 3%. If inflation rises to 3%, that drops to $4,780. At 4%, that savings pot is worth just $3,750.
This wouldn’t be a problem if savers were getting higher interest on their savings accounts to compensate. But the majority of savings accounts now pay less than 1%. Another thing to note is that banks charge their customers to save with them. Low interest rates have, unfortunately, changed the landscape. Cash savers are often losing money in real terms and the longer they remain in cash, the more the problem compounds.
Inflation has been hovering around the RBA’s target rate of 2-3%. However we may be headed towards a higher inflation environment. There are short-term reasons as the world emerges from lockdown, there is built up spending. After over a year confined to their home, people are keen to travel, socialise, shop. There will likely be supply problems for certain goods. This creates shortages and pushes up consumer prices.
There are also longer-term reasons for structurally higher inflation. Governments are spending large sums to build back the economy. This is also creating significant demand in key areas and driving prices higher.
Equally, some of the deflationary forces that have curbed inflation over the past two decades are reversing. Globalisation, for example, brought cheap goods from China and lowered prices for everyone. The pandemic has proved difficulties with long supply chains that cross multiple borders. Global governments are now working to ‘reshore’ critical industries. This may raise the price of goods and services.
In normal circumstances, central bankers would simply put up interest rates in response to any inflationary pressure. However, the recovery is fragile and banks, led by the RBA, have made it clear that they will look through short-term inflationary pressures until economic growth is firmly established. It is also increasingly difficult for central banks to raise rates: debt levels are higher, particularly for Governments. High rates also risk real disruption to equity and bond markets, which have grown dependent on central bank liquidity. This means inflation will be allowed to ‘run hot’ for longer.
Cash is not the only problem area, bonds, for example, are also risky because their income is fixed and therefore doesn’t keep up with higher prices.
For savers who have managed to build up some spare cash over lock down, it is worth considering the risks of holding it in cash at a time of potentially rising inflation. The stock market can be a volatile place, but it does have some advantages in today’s climate. A carefully blended and diversified portfolio can help protect the real value of a savings pot. Remember, investments carry risk and you can get back less than invested.
Can Wealthy & Wise help you manage your money?
Wealthy & Wise offers a range of investment and financial planning services. If you’d like to find out more about how we can help you, we offer a free, initial consultation with one of our experts. There is no obligation to take any of our services. You can book online or call us on 02 7229 6578.