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Ramblings on Inflation

Ismael Barkat, October 27th, 2020

The term "inflation" refers to rising prices of essentials such as wheat, milk, meat, clothing, medical services, coffee, electricity, etc. or, alternatively, the decline in value of money so that it takes more dollars to buy the same goods and services. A high inflation rate is anything over the 3% to 4% annual range, which is considered benign. The effect of inflation on savers and investors is that they lose purchasing power. Whether you've buried your money in a coffee can in the back yard or it is sitting in the safest bank in the world, it is becoming less valuable with the passage of time. However the effect of inflation on debtors is positive because debtors can pay their debts with money that is less valuable. If you owed $100,000 at 5% interest, but inflation suddenly spiked to 20% per year, you are effectively watching 15% of your debt get paid off each year, totally free to you. At some point, you'd be able to get a minimum wage job at McDonald's for $100 per hour and just obliterate your debt.

Inflationary problems arise when we experience unexpected inflation which is not adequately matched by a rise in people’s incomes. If incomes do not increase along with the prices of goods, everyone’s purchasing power has been effectively reduced, which can in turn lead to a slowing or stagnant economy. Moreover, excessive inflation can also wreak havoc on retirement savings as it reduces the purchasing power of the money that savers and investors have squirreled away.

Negative consequences of inflation can include the Impact of Inflation on Savers:  When inflation is high, people may lose confidence in money as the real value of savings is severely reduced. Savers will lose out if interest rates are lower than inflation – leading to negative real interest rates. This has certainly happened in the UK during 2009-2011.

Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. This process is known as a ‘wage-price spiral’.

Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with poor bargaining positions in the labor market – for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. Inflation can also favor borrowers at the expense of savers as inflation erodes the real value of existing debts.

Business Planning and Investment: Inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs – and this may reduce planned investment spending.

Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another, leading to a loss of international competitiveness and a subsequent worsening of their trade performance

Can inflation have positive consequences? The answer is yes although much depends on what else is happening in the economy. Some of the potential advantages of benign inflation are as follows:

Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% allows businesses to raise their prices, revenues and profits, whilst at the same time workers can expect to see an increase in their pay packers. This can give psychological boost and might lead to rising investment and productivity.

Tax revenues: The government gains from inflation through what is called ‘fiscal drag effects’. For example many indirect taxes are ad valor em in nature, e.g. VAT at 20% - so as prices rise, so does the amount of tax revenue flowing into the Treasury.

Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts – there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans. The government too might welcome a period of higher inflation given the huge level of public sector debt!