Interest rates and purchasing power influence the value of money
Should excess liquidity be saved or invested? Interest rates and purchasing power provide the answer. After all, they influence the value of money in the long term and demonstrate that cash also isn't risk-free.
Should excess liquidity be saved or invested? Interest rates and purchasing power provide the answer. After all, they influence the value of money in the long term and demonstrate that cash also isn't risk-free.
The value of money is measured by interest rates
A look at the interest-rate development of most of today's industrial nations over the past 700 years shows a downward trend. That suggests that the prevailing low interest rate environment is a logical continuation of a very long-term historical trend. It is not an economic exception that will soon be remedied by a "normal" interest rate level.
Falling interest rates – for over 700 years
Nominal interest rates for private loans and the resulting real interest trend, in %
Source: Paul Schmelzing, Bank of England, Staff Working Paper no. 845, Credit Suisse AG
Last data point: 2018
Three reasons for the long-term decline in real interest rates
1. Falling demand for capital: Leading sectors, such as the software industry, require less capital thanks to advancements in technology. This also reduces real returns.
2. Rising life expectancy and aging societies: More and more people are saving for old age. This excess supply of capital is also leading to a reduction in real interest rates.
3. Falling relative growth rates: Relative growth rates are falling as a result of absolute economic development – which is having an additional dampening effect on investment returns and putting downward pressure on real interest rates.
The value of money is measured by the purchasing power
The value of money over time can be measured by the development of its purchasing power. As inflation can reduce the purchasing power of money, savers in particular should keep an eye on the development of inflation. When inflation rises, the value of real savings and assets shrinks.
Nonetheless, most central banks strive for a certain increase in price levels. The European Central Bank, for instance, aims to keep inflation rates "below, but close to, 2 percent" over the medium term. The same is true for the US Federal Reserve, the Bank of England, and the Swiss National Bank.
National banks influence purchasing power with these inflation targets
Source: Central Bank News, Credit Suisse AG
Cash carries a certain risk. Declining purchasing power proves that.
It is worth bearing in mind that an annual inflation rate of 2 percent results in a halving of purchasing power in just 35 years. Besides this invalidation a positive rate of inflation provides a degree of cushioning against negative inflation rates and the attendant, much-feared specter of deflation. For this reason, a modest degree of inflation is seen as a welcome tool for the functioning of a market economy. If prices are expected to increase continuously, people are more likely to consume and invest in the present, given that doing so in the future will cost them more.
The fact that inflation reduces purchasing power in the long term makes one thing clear: Cash is not risk-free, either. Investors should therefore take potential inflation into account when making investment decisions. Especially if only part of the excess liquidity is being invested. It is also important to not go below the base liquidity. After all, the latter is needed in case of potentially negative performance on the financial market.
