The answer might surprise you.
- The Federal Reserve on Wednesday raised interest rates by half a percentage point.
- This will likely result in a slight increase in savings account returns.
- This does not necessarily mean that it is advisable to put a lot more money into savings.
On Wednesday, May 4, 2022, the Federal Reserve raised the federal funds rate to the highest since 2000.
In an ongoing effort to tackle decades-high inflation, the Federal Reserve raised rates by half a percentage point. This follows an earlier rate increase in mid-March and the benchmark rate is now 0.75% to 1.00%, down from nearly 0% amid the COVID-19 pandemic.
With the increase in the federal funds rate, banks are expected to raise interest rates on savings accounts. But does that mean you should put more money into savings?
Do higher savings rates justify higher investments?
When the Fed raised rates by 25 basis points in mid-March, it had an undeniable impact on savings account rates. Specifically, the average yield offered by online high-yield savings accounts increased by four basis points. Since the rate increase is larger this time, it is likely that the APY on savings accounts will also increase a bit more than after the last rate increase.
However, even after savings accounts surged following the latest rate hike, average returns were still just 0.54%. Needless to say, this means you won’t see a very impressive ROI on the money you save.
Unfortunately, the Fed was pushed to raise rates in order to combat record inflation. Prices were up 8.5% year-over-year to March 2022, meaning goods and services cost significantly more last March than the year before.
With inflation at 8.5% and typical savings account returns still well below 1%, the money you have in savings is not keeping up with rising prices and its purchasing power is eroding. This will not change, even with rising rates.
Therefore, increasing the amount you invest in savings accounts makes no sense just because the rates will increase slightly.
The amount you have in savings should be dictated by your financial goals
Ultimately, you shouldn’t put money in a savings account because of the returns you can earn. The money should be saved because you need the money to be in a liquid state and a risk-free investment.
It is important to keep certain types of money in savings. For example, you want the money from your emergency fund to be in a savings account so you can easily access it when you need it. And if you’re saving money that you’ll need in the next few years, that should also be in savings. This way, you can access it when you need it without having to worry about timing your withdrawals based on economic conditions.
The amount of money you will need for emergency savings and for these short-term financial goals is dictated by your financial goals. In other words, it’s a good idea to have three to six months of expenses in an emergency account. And if you need to save for a down payment to buy a house in two years, you’ll want to put as much into your account as you need for the property.
However, any money you hope to invest for long-term goals should be in the stock market or other assets that have a chance of producing much higher returns than a savings account. And that doesn’t change just because savings account rates go up a little.
You should still keep exactly as much money in savings as you need for your short- and medium-term financial goals. Put the rest in the market where you can hopefully earn the kind of returns that will not only keep pace with inflation, but also allow you to build wealth.