How does inflation affect the need for emergency savings?

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Devin Miller
January 23, 2023

Many Americans want to save for hard times, but current inflation rates make that goal seem impractical. 

While it's impossible to predict inflation rates and what the Federal Reserve (the Fed) will do, most experts expect rates to continue to rise through 2023. For the millions of Americans already struggling with the current inflation rates, this isn't good news. 

A recent Gallup poll found that 55% of Americans are experiencing hardship due to the rising price of goods. According to the latest data from the U.S. Census Bureau, ~56% of people find it "very difficult" to pay their regular household expenses on time. 

As a result, people are increasingly pulling from their savings accounts and forgoing savings contributions altogether. While we understand the impulse, halting savings is one of the worst actions to take in turbulent financial times.

Here's everything to know about inflation and its effects on savings, as well as some tips for saving despite the inflation turbulence.

A brief introduction to inflation

According to The Washington Post, the Fed raised the federal funds rate seven times in 2022. The federal fund rate is the Federal Reserve's primary benchmark interest rate. When people talk about the Fed raising or hiking interest rates, they’re actually talking about the federal funds rate.

In its simplest definition, the federal funds rate is the interest rate banks (and other depository institutions) charge each other to borrow funds.

Why do banks have to borrow funds? Essentially, banks are required to maintain a certain minimum level of funds in their accounts at the Federal Reserve.

Some banks have more than they need, while others don't have enough to meet their daily requirements. As a result, the banks with extra funds can offer loans to those in need with an applicable interest rate, forming the basis of the federal funds rate.

When the Fed raises the federal funds rate, banks pass the increased interest cost to everyday consumers via things like higher loan rates and credit card interest.

Based on these factors, higher interest rates are one contributing factor to inflation.

This begs the question: why does the Fed raise rates if it negatively impacts consumers? The Fed’s primary goal is to maintain the economic stability of the country, and the federal fund rate is one way they do that. The short and fast of it is that increasing interest rates encourages reduced spending, with the intention of protecting the economy from hyperinflation.

The Fed bases its decision on when to raise or lower the rate based on several indicators, including government policy, foreign markets, and The Consumer Price Index (CPI).

The CPI (aka inflation rate) is a measure of how much prices for goods and services have changed over time for consumers.

The Bureau of Labor Statistics uses the CPI to calculate inflation and other economic indicators. Interestingly, when people talk about "inflation rates," they’re simply talking about the percentage change in the CPI over a certain period.

The CPI (or inflation rate) reached the highest peak at 9.1% during the summer months. Now, the latest Fool data puts it between 4.25% - 4.50%. That rate is still much higher than what's considered a healthy interest rate, which according to the Fed, is around 2%. And when inflation rates are high, your dollar doesn't go as far as it used to, which can affect many things, including your savings.

How does inflation affect consumers? 

Aside from the rising price of goods, interest rate hikes also affect the following:

  • Mortgage rates: When the federal rate changes, the cost of borrowing money to purchase a home (mortgage rate) may also change. Generally speaking, higher federal funds rates cause mortgage rates to rise, making homeownership more expensive for consumers.
  • Auto loans: As with mortgage loans, higher federal funds rates typically cause the rate of interest for auto loans to rise, making it more expensive for consumers to finance the purchase of a car.
  • Credit cards: Credit card issuers often adjust the interest rate they charge customers when the federal rate changes. When the federal funds rate goes up, the interest rate charged by credit card issuers will also likely rise, making it more expensive for consumers to carry balances on their credit cards.
  • Student loans: Student loan rates are typically linked to federal funds rates, meaning when federal funds rates increase, the interest rates on student loans may also go up. This makes it more expensive for students to finance their education. 

While interest rate hikes impact these areas negatively, the impact on savings is more complex. 

How does inflation affect savings? (this part might surprise you).

When the Fed raises federal funds interest rates, they're trying to curb spending. Consequently, higher federal funds rates typically mean higher interest rates for savings accounts, increasing the return for consumers.

This means that banks tend to increase interest rates on savings accounts to encourage saving and dissuade spending. For you, this could lead to your savings increasing during this period if you know how to take advantage of it. 

Unfortunately, when times are tough, prioritizing saving can be more challenging. Still, times like these also illustrate why having an emergency savings fund is critical for the average American. Rapidly rising costs can lead to quickly eroding savings accounts.

It's easy to dip into your savings to make ends meet when everything costs more. However, given the unpredictability of inflation, it's too dangerous not to have an emergency savings fund. Consider these factors:

  • What if you lose your job?
  • What if the rates keep rising?
  • What if your landlord raises rent… again?
  • What if you have a major medical emergency? 
  • What if AI or robots make your position irrelevant? 
  • What if your car needs a major repair?

Do you have enough money in your emergency savings fund to cover an unexpected expense like those listed above? If you're already living paycheck to paycheck or struggling with inflation, these sorts of events will cripple you. That's why having an emergency savings account is so important. 

But how can you save if you're already strapped?

Figure out how much you need to save 

Before you can figure out how to save, it’s important to know how much you actually need. You can't reach a goal if you don't have a target in mind. Consider two things:

  • Everyday emergencies 
  • Income loss 

The other thing to consider is potential job loss. While no one wants to think about losing their job, it happens. From companies going under to unexpected disability, joblessness is a real danger you must prepare for. In general, aim to have between three and six months of income saved in case an unexpected emergency or job loss happens. That gives you plenty of time to find another source of income or a way to make ends meet. 

How to save when expenses are on the rise 

So, how can you get that amount saved up? There are several ways to make the most of your money and save up for the unexpected:  

Set a reasonable budget. Now is an ideal time to reassess your budget. Get rid of the monthly subscriptions you don't need, swap to a cheaper grocery store, or eliminate unnecessary spending. 

Clip coupons and look for deals. Now's a great time to “clip” coupons and hunt for the best deals on must-have items. Consider second-hand stores and community swap meets to help you save. 

Leave yourself some recreational money. Don't completely deprive yourself of fun. Instead, include it in the budget. Decide how much you can afford to devote each week (and still have enough left to save) and treat yourself with something small each week, whether it’s a meal out or a family outing. 

Make saving non-negotiable and automatic. Automatically withdraw a part of every paycheck and have it deposited directly into your emergency savings account. This makes it easy to keep saving, no matter what happens. You can do this through an emergency savings solution like SecureSave through your employer.

Don't let inflation stop you from saving and preparing for emergencies 

While inflation might make saving and preparing for emergencies more difficult, don't let it stop you from doing it altogether. In turbulent financial times, having an emergency savings account is more critical than ever. 

Want to make saving for emergencies easy and automatic? Tell your employer to look into SecureSave.

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