Econompic - negative real interest rates encourage savings

The basic premise behind stimulatory monetary policy is that lower interest rates reduce the cost of debt, and decrease the returns to savings, encouraging present spending and maintaining asset values. But recent experience (particularly in the US) has shown that in a low (or negative) real interest rate environment, savings rates are climbing.

Jake over at Econompic has put forward a reason this might be the case. He argues that if an individual needs to save a certain amount for future consumption, for example someone who wishes to fund their retirement, a low interest rate means they need to SAVE MORE NOW to reach that point.

What surprises me is that Jake’s hypothesis is fairly consistent with Milton Friedman’s permanent income hypothesis, which asserts that people will try and smooth out their earnings over their lifetime (through savings decisions) to maintain a relatively constant level of expenditure. In Friedman’s model, a transitory income, like prize money, would not be spent all at once, but mostly saved and spent over the rest of one’s lifetime. While the reduced debt burden from low interest rates may been seen as temporary by some people and not greatly affect their spending, the reduced return on savings DEFINITELY means that smoothing out income for retirement requires greater levels of saving.

For example, if interest rates are 5%, someone might want to save $1million in order to earn $50,000 per year in returns on which to live during retirement. But if interest rates are 1%, that person needs to save $5million in order to earn $50,000 in returns to fund their retirement.

One might suggest that low interest rates mean that people who need to save will save more, and people who don’t, will save less. This might translate to quite a variation in saving patterns by age, with the soon to retire boomers increasing savings, with the young workers saving less.

The low interest rates and high savings rate correlation probably also has a lot to do with household repairing their balance sheets following massive losses on equities and housing (particularly in the US and the UK).

Over to Jake for the details (original post here).

"At current interest rates, an individual will lose purchasing power in their savings account if there is even an inkling of inflation. A common assumption is that the Fed has done this (i.e. pushed interest rates to historic lows) to increase aggregate demand (i.e. if you are earning nothing, you might as well spend it) or to move investors to riskier investments that might provide better momentum for the underlying economy (i.e. an investment in a corporate bond that makes it cheaper for corporations to borrow).

But what if low to negative interest rates in fact causes the opposite... an increase in the savings rate and derisking by investors? This post is based on a very quick and dirty framework I've been thinking about and focuses on the savings rate, but the same framework could (in my opinion) justify why investors may choose to derisk as well. Any feedback would be greatly appreciated.

Getting to $100 Saved

Let's assume our saver knows that in ten years they will need to have $100 saved (for retirement, college education for their kids, a new car, etc...). Earning 0% on their savings, they would need to save $10 / year. If they were to earn a rate of return on that $10 saved each year, by the tenth year they would have excess savings (i.e. the blue and yellow lines).

As a result, if an investor can earn more than 0%, they do not need to save $10 / year, but a smaller amount. The chart below shows how much that $10 can be reduced based on various rates of return on their savings.

Assuming the individual earned $200 / year, the original $10 was 5% of their income (i.e. a 5% savings rate). The various amounts needed to save each year is converted to a savings rate below. It clearly shows that if a saver can earn a rate of return greater than 0% (i.e. if interest rates were higher), they can save less to get to their goal.

Unfortunately, savers aren't currently able to earn 0% on their checking / savings accounts. With any inflation, an investors is faced with negative interest rates. So, to get to a $100 real level of savings, an investors will need to save more than the $10 / year.

 

I know some readers will point out that an individual can always choose to add more risk to increase their returns, but what happens if that investment doesn't work out? An even higher level of savings, which they may not be willing or able to do.

So there's the very basic framework. What am I missing? "