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10 Common Effects of Inflation

Inflation is the overall rise in the prices of goods and services over time. The annual inflation rate in the United States averaged 3.27% between 1914 and 2022. So moderate inflation has been a fact of life and the natural economic state for more than a century.

That makes it important to distinguish between the inherent effects of inflation of any rate and those that only come into play during periods when inflation runs unusually high. We'll do that below in identifying inflation's most important effects on consumers, investors, and the economy.

Key Takeaways

  • Inflation, the sustained and broad rise in the prices of goods and services over time, erodes purchasing power.
  • A small but positive inflation rate is economically useful, while high inflation tends to feed on itself and to impair the economy's long-term performance.
  • Real estate, energy commodities and value stocks have historically outperformed during periods of high or rising inflation.
  • Conversely, bonds and expensive growth stocks tend to lag as inflation lowers the present value of their future cash flows to investors.
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How Can Inflation Be Good For The Economy?

1. Erodes Purchasing Power

This is inflation's primary and most pervasive effect. An overall rise in prices over time reduces the purchasing power of consumers, since a fixed amount of money will afford progressively less consumption. Consumers lose purchasing power whether inflation is running at 2% or at 4%; they just lose it twice as fast at the higher rate. Compounding would ensure that the overall price level would increase more than twice as much over the long run if long-run inflation were to double.

Inflation measures the rise in prices over time for a basket of goods and services representative of overall consumer spending. The Consumer Price Index (CPI) is the best known inflation indicator, while the Federal Reserve focuses on the PCE Price Index in its inflation targeting.

Inflation, 20 Years

2. Hurts the Poor Disproportionately

Lower-income consumers tend to spend a higher proportion of their income overall and on necessities than those with higher incomes, and so have less of a cushion against the loss of purchasing power inherent in inflation. This is what economists mean when they note that lower incomes correlate with a higher marginal propensity to consume.

Policymakers and financial markets participants often focus on "core" inflation excluding the prices of food and energy, which tend to be more volatile and therefore less reflective of longer-term inflation trend. But lower-income wage earners in developed economies and most people in developing economies spend a relatively large proportion of their weekly or monthly household budgets on food and energy, commodities hard to substitute or go without when prices spike.

The poor are also less likely to own assets like real estate, which has traditionally served as an inflation hedge.

On the other hand, recipients of Social Security benefits and other federal transfer payments receive inflation protection in the form of cost of living adjustments based on an index of consumer prices for hourly wage earners and clerical workers.

3. Keeps Deflation at Bay

The Federal Reserve aims for inflation of 2% over the long run to meet its mandates for stable prices and maximum employment. It targets modest inflation rather than aiming for steady prices because a slightly positive inflation rate greases the wheels of commerce, provides a margin of error in the event inflation is overestimated, and deters deflation, the overall decline in prices that can be much more destabilizing than comparable inflation.

Inflation allows lenders to charge interest to offset the inflation likely to devalue repayments. Inflation also helps borrowers' service debt by allowing them to make future repayments with inflated currency. In contrast, deflation makes it increasingly costlier to service debt in real terms, since borrowers' income would be likely to decline alongside prices. Because deflation represents a departure from the norm, it's also more likely to trigger expectations for additional deflation, causing further spending and income declines and ultimately widespread loan defaults that can set off a banking crisis.

One reason modest inflation rather than deflation is the norm is that wages are sticky to the downside. Workers tend to resist attempts to cut their wages during an economic downturn, with layoffs the likeliest alternative for businesses facing a downturn in demand. A positive inflation rate allows a wage freeze to serve as a cut in labor costs in real terms.

Inflation's benefits as insurance against deflation decline once it exceeds the customary and expected rate, because inflation can also spiral out of control if high enough, as we'll discuss below.

4. When High, Feeds on Itself

As we've discussed, a little inflation can be a symptom of a healthy economy, and not something that's likely to cause inflation expectations to rise. If inflation was 2% last year and is 2% this year, it's mostly background noise. Businesses, workers, and consumers would likely expect inflation to remain at 2% next year in that scenario.

But when the inflation rate sharply accelerates and stays high, expectations of future inflation will eventually begin to rise accordingly. As those expectations rise, workers start demanding larger wage increases and employers pass on those costs by raising prices on output, setting off a wage-price spiral.

In the worst case scenario, a bungled policy response to high inflation can end in hyperinflation. But there's no need to count the cost of soaring inflation expectations in wheelbarrow loads of Zimbabwe dollar notes denominated in trillions or in the Weimar Republic's worthless marks from Germany's five years of hyperinflation after World War I. In the U.S., rising inflation expectations during the 1970s lifted annual inflation above 13% by 1980 and the federal funds rate to more than 20% by 1981, while unemployment topped 10% as late as mid-1983 following the ensuing recessions.

Inflation in Weimar Germany

By December 1923, an index of the cost of living in Germany increased to a level of more than 1.5 trillion times its pre-WWI measure.

5. Raises Interest Rates

As the examples above suggest, governments and central banks have a powerful incentive to keep inflation in check. In the U.S. and around the world over the past century, the approach has been to manage inflation using monetary policy. When inflation threatens to exceed a central bank's target (typically 2% in developed economies and 3% to 4% in emerging ones), policymakers can raise the minimum interest rate, driving borrowing costs across the economy higher by constraining money supply.

As a result, inflation and interest rates tend to move in the same direction. By raising interest rates as inflation rises, central banks can dampen the economy's animal spirits or risk appetite, and the attendant price pressures. Suddenly the expected monthly payments on that boat, or that corporate bond issue for a new expansion project, seem a bit high. Meanwhile, the risk-free rate of return available for newly issued Treasury bonds will tend to rise, rewarding savings.

6. Lowers Debt Service Costs

While new borrowers are likely to face higher interest rates when inflation rises, those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money, lowering their debt service costs after adjusting for inflation.

Say you borrow $1,000 at a 5% annual rate of interest. If annual inflation subsequently rises to 10%, the annual decline in your inflation-adjusted loan balance will outweigh your interest costs.

Note that this doesn't apply to adjustable-rate mortgages, credit card balances, or home equity lines of credit, which typically allow lenders to raise their interest rate to keep pace with inflation and Fed rate hikes.

7. Lifts Growth, Employment in the Short Term

In the short term, higher inflation can lead to faster economic growth. While the 1970s are recalled as a decade of stagflation, U.S. real Gross Domestic Product (GDP) increased 3.2% annually on average between 1970 and 1979, well above the economy's average growth rate since.

Elevated inflation discourages saving, since it erodes the purchasing power of the savings over time. That prospect can encourage consumers to spend and businesses to invest.

As a result, unemployment often declines at first as inflation climbs. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve expressing the relationship. For a time at least, higher inflation can spur demand while lowering inflation-adjusted labor costs, fueling job gains.

Eventually, though, the bill for persistently high inflation must come due in the form of a painful downturn that resets expectations, or else chronic economic underperformance.

8. Can Cause Painful Recessions

The trouble with the trade-off between inflation and unemployment, is that prolonged acceptance of higher inflation to protect jobs may cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases, as happened in the U.S. during the stagflation of the 1970s.

To regain lost credibility and convince everyone again it would control inflation, the Federal Reserve was subsequently forced to raise interest rates much higher, and to keep them high longer. That, in turn, caused unemployment to soar, and to stay high for longer than would likely have been the case had the Fed not allowed inflation to spiral so high.

9. Hurts Bonds, Growth Stocks

Normally, bonds are lower-risk investments providing regular interest income at a fixed rate. Inflation, and especially high inflation, impairs the value of bonds by lowering the present value of that income.

As interest rates increase in response to rising or elevated inflation, so does the yield on newly issued bonds. The market price of bonds issued previously at a lower yield then drops proportionally, since bond prices are the inverse of bond yields. Investors holding a Treasury bond are still in line for the expected coupon payments, followed by principal repayment at maturity. But those selling before maturity will receive less as a result of the increased market yields.

There is less of a consensus about whether high inflation hurts or helps stocks overall. Conclusions will depend on the definition of high inflation and whether the historical record cited includes the 1970s, a lost decade for U.S. stocks amid stagflation.

Growth stocks, which tend to be more expensive, are notoriously allergic to inflation, which discounts the present value of their future cash flows more heavily, just as it does for high-duration bonds. Technology and consumer stocks have lagged during past episodes of high or rising inflation.

10. Boosts Real Estate, Energy, Value Stocks

Real estate has historically served as an inflation hedge, since landlords can protect themselves against inflation by raising rents, even as inflation erodes the real cost of fixed-rate mortgages.

And while rising commodity prices can cause inflation to accelerate, once it does commodities and in particular energy commodities tend to continue to outperform, though that can change when growth slows.

Unsurprisingly, energy equities, real estate investment trusts, and value stocks have historically outperformed during episodes of high or rising inflation.

What Is Inflation's Primary Effect?

Inflation causes the purchasing power of a currency to decline, making a representative basket of goods and services increasingly more expensive.

How Can Inflation Benefit Homeowners?

Homeowners with fixed-rate mortgages benefit from inflation because is discounts the present value of their future mortgage payments. As housing prices rise as a result of inflation, home equity increases. Finally, homeowners who rent out their homes can increase rents with inflation.

What Is Deflation?

Deflation is a sustained period of broadly declining prices. Deflation is often the result of a severe economic contraction that causes consumers and businesses to curtail spending and investing. Deflation is destabilizing because it makes it harder to service debts.

Article Sources
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