The recent announcement by the US Federal Reserve Chair, Jerome Powell that it would be prepared to tolerate higher inflation in order to boost jobs growth is a major shift in policy.
Why it matters here in Ireland is because globally, what one central banker decides to do with inflation (and interest rates) very often impacts other central bankers, like our own in the European Central Bank.
Inflation is where prices rise over time. The higher the rate of inflation, the faster prices rise within a given period of time. But in addition to the rise in prices, the value of money also decreases. So, the buying power of €100 in 2020 would be lower in 2021 if inflation were high.
Fortunately, inflation to date has been fairly minimal. But with the US announcement, this could be about to change.
How inflation is controlled.
Interest rates are a primary mechanism by which inflation is controlled. Central bankers will increase interest rates if they see prices are rising too quickly for goods and services over a period of time. When times are tough and economic growth is low, they will cut interest rates in order to stimulate growth.
By raising interest rates, this makes borrowing more expensive which in turn reduces borrowing and spending and thus, prices and inflation.
Generally, inflation of 2% – 2.5% is acceptable to central bankers and anything in excess of this is monitored…and acted on when required.
What is different now?
The Coronavirus and Covid-19 have had a devastating impact on the US jobs market. The impact in the EU has been similar. In the US, for a variety of reasons, the Federal Reserve has decided that it will focus on employment growth AND inflation as it considers how it sets interest rates in the future. The reason this matters is the US Federal Reserve is making a significant policy shift; it is likely to take a softer approach to rising inflation and there is little to doubt other central banks will be paying very close attention.
What this means for savers
For those with significant savings held on deposit, the new US approach would have a very significant impact if the European Central Bank were to follow. First, it would mean that inflation could be higher and as a result, the real value of every €10,000 held on deposit would decrease faster. So, where someone holds €30,000 on deposit, if inflation rose to 4%, in 2 years time, the real value of that money would fall to about €27,600 – that is a €2,400 loss in value in just 2 years. Additionally, there would be no increase in interest rates as one might expect in normal times so the loss in buying power of that €30,000 would be permanent.
How to protect saving from inflation
The only real means of beating the impact of inflation is through investing. However, in Ireland, investing is too often seen through the prism of property or company shares. In reality, the range of choices to invest is far more complex. For those actively employed, pension contributions is one means of investing, this offers the added benefit of very generous tax benefits on contributions, investment growth and also at drawdown with tax-free lump sum withdrawal allowances. Outside of pension contributions, there are various low cost exchange traded funds which offer the advantage of low costs, risk diversification and regular fund rebalancing to ensure the risk tolerance of the investor is met. To access these options, you will need to consult with an independent financial adviser.
Inflation has been used through the ages to reduce the impact of debt. While there is no suggestion that the ECB is about to follow the lead of the US Federal Reserve, paying close attention is warranted. And while many people may take an overly simple view of the impact of inflation; higher prices for everyday goods and services, its impact goes far deeper. Inflation erodes the real value of money and this is what the forgotten impact of inflation is often generally. Following the Covid-19 lockdowns across the EU, savings have exploded. This has not gone unnoticed at the ECB. To preserve the real value of those savings, savers need to become investors too!
Frank Conway is a Qualified Financial Adviser and Founder of MoneyWhizz