Why low interest rates are good for savers

Many articles in the popular press have admonished banks and building societies for passing on base rate cuts in full to savers, reducing savings interest rates to pretty well zero.
In fact when you consider the true value of your savings, low rates in fact can benefit savers quite significantly.

The basis of my claim is the Fisher effect, which in broad terms says that interest rates and inflation rates move roughly in line.

Let me define the real interest rate as the increase in purchasing power at the end of a year. For example, suppose interest is 5% and inflation is 3%: at the end of the year you can afford roughly 2% more goods. (This is a slight approximation, but for small numbers it’s pretty close.) This 2% is the real interest rate. The actual 5% paid by the bank is called the nominal interest rate.

If inflation were to rise, typical monetary policy would be to increase rates. This would increase both our mortgage cost and the reward for savings, the combination of which discourages us from spending. Hence we look for better value, prices are kept down and inflation is kept at bay. By contrast, were inflation to fall, interest rates could safely reduce, allowing us to spend more without prices skyrocketing. You can see from this description that interest and inflation rates are likely to move broadly in the same direction, confirming to some extent the Fisher effect.

Let us consider a saver, Jane Bloggs, who has £100,000 in the bank. She receives the interest and uses this as income. Consider a number of scenarios that stick to the Fisher concept. Each scenario will use a real interest rate of around 2%, with nominal interest rates remaining at 2% more than inflation.

Firstly, suppose nominal interest rates are 2% and inflation is 0%. Jane receives £2,000 per year, leaving the £100,000 principal untouched. In real terms (i.e. incorporating inflation), the principal remains the same, as prices haven’t moved.

Now let interest rates rise to 5% with 3% inflation. The income is now £5,000. Should Jane spend all of this, the remaining £100,000 is now worth approximately 3% less in real terms at the end of the year, as prices have gone up by this amount. Should she instead spend only £2,000 of her interest, then £103,000 remains. This has the same spending power as the £100,000 at the start of the year (an item that used to cost £100 now costs £103). Note the similarity: if £2,000 is spent, the value of principal in real terms remains the same.

What if rates fall? Let’s say interest rates are zero and inflation is minus 2%, i.e. there is 2% deflation. Jane can again spend £2,000: the principal is now £98,000, which has the same real value as before (an item that used to cost £100 now costs just £98).

Conclusion: regardless of what the nominal interest rate is, the 2% real interest rate is what Jane can spend without losing the spending power of her savings.

A dose of reality: here comes the taxman

As it happens, Jane pays 40% tax on all interest. (For a 20% taxpayer the effect is similar to what follows, though to a lesser degree.) Let us review the scenarios one by one, starting with the highest rates.

Interest 5%, inflation 3%. Jane receives £5,000 interest, from which £2,000 tax (i.e. 40%) is removed. Her bank account shows £103,000 before any cash withdrawals, and this exactly matches inflation. In other words, her savings have exactly kept up with inflation, but she may not spend a single pound without losing real value.

Interest 2%, inflation 0%. Jane’s £100,000 now receives £1,200 interest (£2,000 minus 40% tax). She can happily spend the £1,200, as the principal maintains the same value in real terms. In other words, she has made 1.2% in real terms.

Finally interest 0%, inflation minus 2%. With zero interest, Jane suffers not a single penny of tax. As we saw above, Jane can withdraw £2,000, leaving £98,000. In real terms the principal is unchanged, and she has spent £2,000.

As these examples show, the higher the rates are, the worse off Jane is – see the diagram (which shows Jane’s position with a 2% real rate and 40% tax) for the impact. With rates above 5%, Jane’s real return is actually negative, giving her less spending power at the end of the year than at the start. Provided the Fisher effect is legitimate, savers are better off with low rates than high rates, as long as they keep their eye on the real value of their savings and not the nominal value.
In case you’re still not convinced and yearn for higher rates, my prediction is that inflation (and, with it, interest rates) will rise significantly within a year. This could be the result of many factors, including:

1. The government will need inflation to remove the (real) value of the incredible amount of debt that has been incurred in the last few years;

2. Quantitative easing will have an impact on credit creation, allowing people to borrow (and spend);

3. Recent reductions in manufacturing output will lead to higher prices when we finally start spending again (since shops, motor showrooms and factories won’t have enough stock); and

4. Oil prices, being double what they were four months ago, have pushed up manufacturing and motoring costs, and will take inflation with it.

I would hope that most savers will see the problems associated with higher interest rates for what they are, and be glad that their banks, by paying them low rates, are in fact doing them a service.