The economy during inflation
Inflation is one of those economic terms that everyone has heard of but few actually know what it means. Inflation is defined as a sustained increase in the prices of goods and services. It is usually measured as an annual percentage change. For example, if inflation is 2% per year, this means that, on average, prices have doubled every 36 years. inflation can be caused by an increase in the money supply or a decrease in the production of goods and services. While inflation can have some positive effects, such as encouraging companies to invest in new technologies and increasing wages, it can also have negative effects, such as reducing purchasing power and increasing the cost of living. The key to managing inflation is to find the right balance between inflation and economic growth. Too much inflation can stifle economic growth, while too little inflation can lead to stagnation. The role of inflation in the economy is complex, but it is one of the most important factors that central banks take into account when making monetary policy decisions.
Let us read on.
Inflation is the overall rise in the prices of goods and services over time. The annual inflation rate averaged 3.8% over the last 100 years. So, moderate inflation has been a fact of life and the natural economic state for more than a century. Currently, the inflation in the Eurozone is above 12% (excluding energy prices).
That makes it essential to distinguish between the inherent effects of inflation at any rate and those that only come into play during periods when inflation runs unusually high. Below you find inflation’s most significant impact on consumers, investors, and the economy.
How Can Inflation Be Good For The Economy?
Erodes Purchasing Power
The primary and most pervasive effect of inflation is eroding purchasing power. 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 4%; they lose it twice as fast at a higher rate. Compounding would ensure that the overall price level would increase more than twice over the long run if long-run inflation doubled.
Inflation measures the rise in prices over time for a basket of goods and services representative of overall consumer spending.
It hurts the Poor Disproportionately.
Lower-income consumers spend more of their income overall on necessities than those with higher incomes. They have less cushion against the loss of purchasing power inherent in inflation. Economists identify that lower payments correlate with a higher marginal propensity to consume.
Policymakers and financial market 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 trends. 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.
Keeps Deflation at Bay
The Central bank 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. 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 likely decline alongside prices. Moreover, because deflation represents a departure from the norm, it’s more likely to trigger expectations for further deflation, causing additional 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. As a result, 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 is insurance against deflation decline once it exceeds the standard and expected rate because inflation can spiral out of control if high enough, as discussed below.
When High, it Feeds on Itself
As we’ve discussed, a little inflation can be a symptom of a healthy economy and not something likely to cause inflation expectations to rise. For example, 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 demand more significant wage increases, and employers pass on those costs by raising output prices, setting off a wage-price spiral.
In the worst-case scenario, a bungled policy response to high inflation can end in hyperinflation. No need to count the cost of soaring inflation expectations in wheelbarrow loads of Zimbabwe dollar notes denominated in trillions. Or 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. Unemployment topped 10% as late as mid-1983 following the ensuing recessions.789
Inflation in Weimar Germany by December 1923, Germany’s index of the cost of living increased to more than 1.5 trillion times its pre-WWI measure.
Raises Interest Rates
As the examples above suggest, governments and central banks have a powerful incentive to keep inflation in check. Around the world over the past century, the approach has been to manage inflation using the correct 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 the money supply.
As a result, inflation and interest rates tend to move in the same direction. As a result, central banks can dampen the economy’s animal spirits, risk appetite, and attendant price pressures by raising interest rates as inflation rises. 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 government bonds will tend to rise, rewarding savings.
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 benefit from 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. Then, if yearly inflation 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 rates to keep pace with inflation and Fed rate hikes.
Lifts Growth, Employment in the Short Term
In the short term, higher inflation can lead to faster economic growth. For example, while the 1970s are the decade of stagflation, U.S. real Gross Domestic Product (GDP) increased 3.2% annually 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. But on the other hand, 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 chronic economic underperformance.
It 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 it would control inflation again, the Federal Reserve had to raise interest rates much higher and 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.
Hurts Bonds, Growth Stocks
Typically, bonds are lower-risk investments providing regular interest income at a fixed rate. Inflation, and exceptionally high inflation, impair 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 previously issued 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 due to the increased market yields.
There is less 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. As a result, technology and consumer stocks have lagged during past high or rising inflation episodes.
Boosts Real Estate, Energy, and 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, particularly energy commodities, tend to continue to outperform. However, that can change when growth slows.
Unsurprisingly, energy equities, real estate investment trusts, and value stocks have historically outperformed during high or rising inflation episodes.
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 it 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.
Based on: https://www.investopedia.com/articles/insights/122016/9-common-effects-inflation.asp