subscribe: Posts | Comments

Where to put your savings in today’s low interest rate economy

1 comment

I’ve been waiting to finish this article until the UK’s inflation figures were released. They show the CPI figure for November to be 4.1%, higher than predicted by the majority of economists. This figure is more than double the 2% target that the Bank of England’s Monetary Policy Committee is supposed to aim for, yet the UK’s interest rates are falling rather than rising.

(Incidentally, a fall in the rate of inflation doesn’t necessarily mean that prices are falling. That is one possible interpretation, but alternatively it could mean that prices are continuing to rise, just not as quickly as before. Newspaper articles rarely make this distinction, unfortunately.)

Of course, the MPC would say that it is targeting inflation two years hence, which it always says. The trouble is, it’s nearly always wrong in its predictions. There’s no reason to believe that the central projection of the MPC this time around – that the UK will suffer deflation unless rates are slashed right now – is any more accurate than other economists’ predictions of higher inflation.

Given the fall of sterling on the currency exchange markets, and the rise of food costs last month (the two facts not being entirely unconnected, of course), you may be inclined to think that the latter is more likely than the former, at least in the medium term. But there’s no way of knowing for sure because the outcome largely depends on the actions of those in power.

If you have savings in the UK, as a great many people still do, this debate really matters. For example, if deflation is on the cards then it doesn’t really matter what your savings are earning in interest; as long as the amount is positive, you’re gaining. In fact, if the economy suffers deflation at 2% while you get zero interest on your savings, you’re gaining even more than you would be by having, say, 6% interest on your savings in a 4% inflationary environment; or at least you are as a taxpayer, because in the former scenario there’s no tax to be paid.

So, if you think deflation is the most likely outcome now, and you trust your bank to keep it safe without going bust, leave your money in the bank and don’t worry about the interest rate. Better still, fix your rate now with a one-year bank bond in the expectation of base rates continuing to fall and deflation taking stronger hold in future.

However, if you think we are heading for a bout of inflation in the near to medium term future, the last thing you want is for your money to be stuck in a low interest rate bank account while prices of everyday goods shoot upwards.

Unfortunately, it’s not so easy to recommend options for saving in an inflationary scenario. It would make sense to keep those savings fairly liquid (i.e. not tie them up in a one-year bond) because banks would be likely to increase their rates to savers to attract new funds, and you may benefit by being able to switch to a new bank at short notice.

There are other possibilities, though. You may want to put some money in the government-backed NS&I index-linked savings certificates scheme, although this is linked to RPI rather than CPI, and the latter is more likely to fall since it contains some housing-associated expenses (it has already moved below CPI and could stay that way for a while). However, the interest you make on the money saved in these certificates is tax-free.

If you’re feeling a bit braver, you may decide to put some money in physical gold, a traditional hedge against inflation, though not a guaranteed one.

And you may decide to take out a loan at the current relatively low interest rate to leverage an asset investment, rather as mortgage-holders have done over the last decade.

You may even decide to move your money out of sterling entirely before it drops even further against other currencies.

But in this, as with any other investment, beware. It’s possible that sterling has fallen as far as it’s going to, and that other currencies may now drop against it. You may make money by shifting into Yen, Euros, Australian dollars, etc., but equally you may lose. So-called ‘momentum investing’, where people invest at the end of a price curve rather than the start, has been the bane of many an investor, amateur and professional. There’s no way of knowing whether or not sterling is at that point.

There are many economists predicting deflation, but also quite a few predicting inflation in the medium term, so there’s no consensus on which to base your investment decisions. Arguably your thoughts on the inflation versus deflation argument will depend on your faith in the ability of governments to manage money effectively and neutrally. Having seen what they’ve done over the last few years, it’s hard to see them suddenly developing the knowledge, reason and abilities that they are supposedly paid for, but stranger things have happened.

If, after reading this article and doing your own research, you still haven’t made up your mind whether deflation or inflation is the most likely outcome, your best option is to make sure your savings are diversified in a variety of investments. This is unlikely to make you fantastically rich, but it might at least prevent you losing all your wealth in these uncertain times.

  1. JKA on Economics UK says:

    Hi Alex,
    The rate of inflation fell to 4.1% CPI basis but food inflation (over 10%) and household utility bills (over 38%) are still extremely high exacerbated by the fall in Sterling.

    Headline inflation rates will be flattered by VAT and interest rate cuts and RPI may be negative into 2009. But service sector CPI inflation is steady at 3.5%.

    In the medium term, inflation is set to return as most economists would agree. In the short term, deflation is the policy challenge but is it a real possibility. The data is not convincing.

    Where to put the money, no time to swop out of sterling just be happy to have and sidelined for the moment.
    JKA