Walking the Savings Rates Tightrope

An increase in end-of-year holiday spending was generally cheered by government officials and business representatives as a sign that the economy is emerging from the Great Recession. But wait a minute--isn't one of the underlying problems with our economy the fact that Americans do not save enough? With that being the case, why is a holiday spending spree a cause for celebration?

The answer lies in a very delicate balance between not only spending and saving, but also income growth and inflation. The ability of the economy to keep a favorable balance among these factors will dictate whether it relapses into recession, enjoys a smooth recovery, or careens into another type of problem. Individuals also face a form of balancing act with their personal savings rates.

Balancing Spending, Savings Rates, Growth, and Inflation

Here's how spending, saving, income growth, and inflation affect the economy and each other:

• Spending. 2009's holiday spending was such a welcome sign because it is not yet clear that the economy has safely emerged from the recession. Consumer spending is a key to getting the economy on track, because consumers represent the largest component of the US economy. The rub is that if consumers spend simply by taking on more debt, this growth won't be sustained, and ultimately could be destabilizing if it leads to another surge in defaults.
• Savings rates. Because Americans are already at high debt levels, personal savings rates are of special importance right now. Savings rates did rise in 2009, and with higher savings rates and lower interest rates, debt service ratios (debt payments as a percentage of household income) have fallen 7.6% from the peak reached in early 2008. Still, debt service ratios are higher than they were at the start of the century, so savings rates will need to continue to improve. The trick, then, will be to build savings rates without shutting down spending that drives economic recovery.
• Income growth. The only way that both spending and savings rates can continue to grow is if personal incomes grow. With the unemployment rate still very high, there is certainly substantial room for improvement here. As employment grows, more people of course get on the payroll--but importantly, employment growth is normally accompanied by wage growth for workers in general. Income growth allows people to rein in debt without choking off spending. The only problem is if wage growth gets out of hand, which leads to inflation.
• Inflation. If economic growth heats up too quickly, it could cause inflation to flare up. International competition and the amount of slack in the labor market should help keep inflation in check for the time being, but the rate of inflation is always a macroeconomic signal worth watching.

What Does This Mean for Your Savings Rates?

How all of the above factors interact will tell the economic story of 2010, but for individuals, the message is much simpler. Even though low bank rates don't provide much incentive, attending to personal savings rates should be job one. Get your savings in order, and you'll be much better positioned to deal with whatever the economy dishes out. The more you have socked away--whether for retirement or another financial goal--the more options you have to invest that money or earn the best interest rates on savings accounts or money market accounts. With any luck, economic growth will take hold, and you might even see your income and your bank rates rise by the end of the year.

 

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