Why an Interest Rate Rise Won’t Save the Savers

10 April 2017  |  Simon Miller
Why an Interest Rate Rise Won’t Save the Savers
Cash savers are calling for the Bank of England to raise interest rates from their record low.
These savers seem to forget that using deposit accounts to save isn’t going to make them rich. Once inflation is taken into account, returns on cash don’t look particularly appealing. Exposure to capital markets is far more likely to generate savers the returns they need to better prepare for their retirement.

The good old days. For many savers that was decades ago. In 1980, for example, anyone who invested money with their bank could have received an average return of 17 percent. 17 percent! For any post-financial crisis investors, that must sound almost inconceivable.

The world looks completely different today. The Bank of England’s (BoE) low interest rate policy has certainly thrown a cat among the pigeons. Deposits with a notice period of up to three months now return just 0.2 percent on average. For this reason, politicians and savers alike are calling for an end to the monetary policy deadlock and want to see an interest rate rise. We believe that those who are calling for change overlook a crucial point: an increase in interest rates will not solve the problem of a lack of wealth in the UK.

Let’s take a look at real interest rates – interest rates minus the rate of inflation. Real interest rates indicate the returns an investor would receive when the loss of purchasing power through rising consumer prices (inflation) is taken into account. They give savers a much more realistic idea of returns. Real interest rates don’t play much of a role in the minds of some savers as inflation can be a tenuous concept to grasp. To explain, the balance in an account may remain at £100 over time, but the purchasing power of that sum will gradually be in decline.

Inflation and Interest Rates Tend to Move Together

High Interest Rates Don’t Benefit Cash Savers When Inflation Is Taken into Account

High Interest Rates Don’t Benefit Cash Savers When Inflation Is Taken into Account

But inflation is important. Understand purchasing power, and the high interest rates of the late 1970s suddenly don’t seem quite so attractive. The rate of inflation in 1980 was around 18 percent. Investors were actually losing one percent of their assets every year even though interest rates were at an all-time high.

The low interest rates of the past few years seem fairly harmless by contrast. After all, in 2016 the real interest rate averaged 0.2 percent; it was at least positive. Movements in inflation and interest rates tend to follow a similar direction and when inflation is higher than interest rates, real returns are negative.

Saving cash does not seem terribly attractive when you look back over the past few years. Interest rates have been in decline almost continuously since the late 1980s and real returns haven’t always been positive. Interest rates fell to one percent in 2009 and are yet to pick back up again. Howard Archer, an economist at the consultancy IHS Markit recently said: “We maintain the view that the Bank of England is highly likely to sit tight on interest rates through 2017 and 2018 – and very possibly beyond.”

No Rich Pickings in Cash Savings

The value of £1,000 cash, in a bank account since 1995, would have increased by about 30 percent today in real terms. The effect of inflation offsetting gains from interest rates, has prevented the value from rising any further. By contrast, the FTSE-100 Total Return Index has risen almost 300 percent over the same period. There will have been some ups and downs that the equity investor may have found difficult to endure but had they survived the turbulence, they would be in a much better position today than their cash counterpart.

There is only one conclusion to be reached. Cash does not generate decent real returns over the long term. Those that want to build up their savings and prepare for retirement would be well advised to invest in capital markets. There are no rich pickings to be found in deposit accounts. Over the past few years, inflation has run higher than interest rates which means that real returns have been negative.

The current climate looks particularly bleak for savers. Over the next couple of years, UK inflation is predicted to rise above the target two percent and interest rates are predicted to stay at 0.25 percent. Real returns will be negative for some time to come. Is there a better time to say goodbye to your savings account and invest your money in the markets? Unlikely.

Source: Office of National Statistics, Bloomberg and the Bank of England

Image: Josefa Holland Merten/Unsplash

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Simon Miller
Formerly a derivatives trader at Barclays Capital, Simon merges capital markets knowledge and business development skills with an academic background in Economics, Business and Mathematics.