Inflation reduces consumers’ purchasing power, making it more expensive to buy goods and services, which can lead to reduced spending and delayed purchases. For businesses, inflation increases operating costs, potentially impacting profitability and investment decisions, while for savers, it erodes the real value of their savings. It also influences interest rates, often causing them to rise, and can lead to income redistribution, as those with fixed incomes lose out to those with incomes that can adjust with rising prices.
Impact on Consumers
- Loss of Purchasing Power: With rising prices, the same amount of money buys fewer goods and services.
- Reduced Spending: Consumers may cut back on non-essential spending like travel or entertainment to focus on essential items like food and gas.
- Delayed Purchases: Large purchases, such as cars or appliances, may be postponed until inflation cools.
- Diminished Savings: The real value of money saved can decrease as prices rise, reducing future purchasing power.
Impact on Businesses
- Increased Costs: Businesses face higher expenses for raw materials, energy, and labor, which can squeeze profit margins.
- Reduced Investment: Uncertainty about future economic conditions and rising costs can discourage businesses from investing.
- Higher Interest Rates: Central banks may raise interest rates to combat inflation, making it more expensive for businesses to borrow capital.
Impact on Investments
- Eroding Returns: Inflation can diminish the real returns on investments, as the purchasing power of investment gains decreases.
- Asset Price Fluctuations: Inflation can lead to volatility in asset prices, affecting stock market performance and real estate values.
Broader Economic Impacts
- Income Redistribution: Inflation can redistribute wealth from people on fixed incomes (like pensioners) to those with incomes that rise with prices.
- Currency Devaluation: A country’s currency may lose value relative to other currencies in periods of high inflation, affecting international trade.
- Interest Rate Changes: To control inflation, central banks often raise interest rates, which can slow economic growth.
Does Inflation Harm Economic Growth?
Since 1984, inflation control has become the unquestioned mantra of economic policymakers worldwide. Even a whisper of “the I-word” by Alan Greenspan in the financial press creates havoc in global stock markets. Based in part on the 1973 to 1984 period of macroeconomic distress experienced by OECD countries, when inflation reached an average rate of 13 percent, monetary policymakers have assumed that faster sustainable growth can only occur in a climate where the inflation monster is tamed.
Unfortunately, there has been a shortage of research conducted to support this intuitive belief. In an attempt to correct this, an NBER Working Paper by Javier Andrés and Ignacio Hernando analyzes the correlation between growth and inflation in OECD countries during the 1960-92 period. In Does Inflation Harm Economic Growth? Evidence for the OECD (NBER Working Paper No. 6062), Andrés and Hernando find that even low or moderate inflation rates (as we have witnessed within the OECD) have a temporary negative impact on growth rates, leading to significant and permanent reductions in per capita income. A reduction in inflation of even a single percentage point leads to an increase in per capita income of 0.5 percent to 2 percent.
As the authors point out, their analysis leaves little room for interpretation. Inflation is not neutral, and in no case does it favor rapid economic growth. Higher inflation never leads to higher levels of income in the medium and long run, which is the time period they analyze. This negative correlation persists even when other factors are added to the analysis, including the investment rate, population growth, schooling rates, and the constant advances in technology. Even when the authors factor in the effects of supply shocks characteristic of a part of the analyzed period, there is still a significant negative correlation between inflation and growth.
Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, according to the authors, but also dependent on the rate of inflation. The lower the inflation rate, the greater are the productive effects of a reduction. For example, reducing inflation by one percentage point when the rate is 20 percent may increase growth by 0.5 percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It is therefore more costly for a low inflation country to concede an additional point of inflation than it is for a country with a higher starting rate. Given their detailed analysis, the authors conclude that “efforts to keep inflation under control will sooner or later pay off in terms of better long-run performance and higher per capita income.”
10 Common Effects of Inflation
1. Inflation 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 because a fixed amount of money will afford progressively less consumption. Consumers lose purchasing power regardless of whether the inflation rate is 2% or 4%. They simply lose it faster when it’s a higher rate. 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. The Federal Reserve focuses on the PCE Price Index in its inflation targeting.
2. Inflation Impacts Lower-Income Consumers
Low-income consumers tend to spend a higher proportion of their incomes on necessities than those with higher incomes. They have less of a cushion against the loss of purchasing power that’s inherent in inflation.
Policymakers and financial market participants often focus on core inflation. This measurement of inflation excludes the prices of food and energy because they tend to be more volatile and less reflective of longer-term inflation trends. But earners with lower income spend a relatively large proportion of their weekly or monthly household budgets on food and energy, commodities that are hard to substitute or go without when prices spike. Recipients of Social Security benefits and other federal transfer payments receive inflation protection in the form of annual cost of living adjustments (COLA) that are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This is an index of consumer prices for hourly wage earners and clerical workers.
3. Inflation Keeps Deflation at Bay
The Fed’s target inflation rate is set at 2% over the long run. This allows it to meet its mandates for stable prices and maximum employment. It focuses on modest inflation rather than steady prices because a slightly positive inflation rate greases the wheels of commerce. It provides a margin of error in the event inflation is overestimated and deters deflation. The overall decline in prices can be much more destabilizing than comparable inflation.
Lenders can charge interest to offset the inflation that is likely to devalue repayments. It also helps borrowers to service their debts by allowing them to make future repayments with inflated currency. But deflation makes it more expensive to service debt in real terms because incomes would be likely to decline along with prices.
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. Layoffs become the likeliest alternative for businesses facing a downturn in demand.4 A positive inflation rate allows a wage freeze to serve as a cut in labor costs in real terms.
The benefits of inflation only provide insurance against deflation until price hikes exceed the customary or expected rate because inflation can spiral out of control if it’s high enough.
4. Inflation Feeds on Itself When It’s High
A little inflation can signal a healthy economy, so it’s not likely to cause inflation expectations to rise. It’s mostly background noise if inflation was 2% last year and is 2% this year. Businesses, workers, and consumers would likely expect inflation to remain at 2% next year in that scenario.
But expectations of future inflation will begin to rise accordingly when the inflation rate accelerates sharply and stays high. Workers start demanding larger wage increases as those expectations rise and employers pass those costs on by raising prices on output, setting off a wage-price spiral.
A bungled policy response to high inflation can end in hyperinflation in a worst-case scenario. Rising inflation expectations in the United States during the 1970s lifted annual inflation above 13% by 1980 and the federal funds rate to more than 20% by 1981.5 Unemployment topped 10% as late as mid-1983 following the ensuing recessions. In a similar situation, an index of the cost of living in Germany increased to a level of more than 1.5 trillion times its pre-World War I measure by December 1923.
5. Inflation Raises Interest Rates
Governments and central banks have a powerful incentive to keep inflation in check. A common approach over the past century has been to manage inflation by using monetary policy. Policymakers can raise the minimum interest rate, driving borrowing costs higher across the economy, by constraining the money supply when inflation threatens to exceed a central bank’s target. This is typically 2% in developed economies and 3% to 4% in emerging ones.
Inflation and interest rates tend to move in the same direction as a result. Central banks can dampen the economy’s animal spirits by raising interest rates as inflation rises or risk appetite and attendant price pressures. The expected monthly payments on that boat or corporate bond issue for a new expansion project suddenly seem a bit high. The risk-free rate of return available for newly issued Treasury bonds will meanwhile tend to rise, rewarding savings.
6. Inflation Lowers Debt Service Costs
New borrowers are likely to face higher interest rates when inflation rises, but those with fixed-rate mortgages and other loans get the benefit of repaying these with inflated money. This lowers their debt service costs after adjusting for inflation.
Assume you borrow $1,000 at a 5% annual rate of interest. The annual decline in your inflation-adjusted loan balance will outweigh your interest costs if annual inflation subsequently rises to 10%.
This doesn’t apply to adjustable-rate mortgages (ARMs), credit card balances, or home equity lines of credit (HELOCs), however. These typically allow lenders to raise their interest rates to keep pace with inflation and Fed rate hikes.
7. Inflation Lifts Growth and Employment in the Short Term
Higher inflation can lead to faster economic growth in the short term. The 1970s are recalled as a decade of stagflation, but 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 then.
Elevated inflation discourages saving because it erodes the purchasing power of savings over time. That prospect can encourage consumers to spend and businesses to invest.
Unemployment often declines at first as inflation climbs as a result. Historical observations of the inverse correlation between unemployment and inflation led to the development of the Phillips curve that expresses the relationship. Higher inflation can spur demand while lowering inflation-adjusted labor costs, fueling job gains, at least for a time.
The bill for persistently high inflation must eventually come due, however, in the form of a painful downturn that resets expectations. Otherwise, the result is chronic economic underperformance.
8. Inflation Can Cause Painful Recessions
The trouble with the trade-off between inflation and unemployment is that prolonged acceptance of higher inflation to protect jobs can cause inflation expectations to rise to the point where they set off an inflationary spiral of price hikes and pay increases. This happened in the U.S. during the stagflation of the 1970s.
The Fed was subsequently forced to raise interest rates much higher to regain lost credibility and to convince everyone again that it would control inflation and then keep interest rates high for a longer period. This caused unemployment to soar and to stay high for longer than would likely have been the case if the Fed hadn’t allowed inflation to spiral so high.
9. Inflation Hurts Bonds and Growth Stocks
Bonds are generally considered to be low-risk investments that provide regular interest income at a fixed rate. Inflation and especially high inflation impair the value of bonds by lowering the present value of that income.
The yield on newly issued bonds increases as interest rates rise in response to rising or elevated inflation. The market price of bonds issued previously at a lower yield then drops proportionally because bond prices are the inverse of bond yields. Investors with Treasury bonds are still in line for the expected coupon payments followed by principal repayment at maturity, but those who sell their bonds before maturity will receive less as a result of the increased market yields.
There’s less of a consensus about whether high inflation hurts or helps stocks overall. Conclusions 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 tend to be more expensive and are notoriously allergic to inflation. Inflation 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. Inflation Boosts Real Estate, Energy, and Value Stocks
Real estate has historically served as a hedge against inflation because landlords can protect themselves by raising rents even as inflation erodes the real cost of fixed-rate mortgages.
Rising commodity prices can cause inflation to accelerate. Commodities can change when growth slows when it does. This is particularly true of energy commodities that tend to continue to outperform.
Energy equities, real estate investment trusts (REITs), and value stocks have historically outperformed during episodes of high or rising inflation.
Areas Impacted
Inflation can have a positive impact on the economy. People continue to spend rather than save their cash when prices rise at a moderate rate. Most consumers open up their wallets even when there’s a slight increase in prices because they often expect things to get more expensive in the future. But savers will take a hit as inflation continues to rise because:
- You will have to increase the amount of money you save for retirement because the target amount you set to match your current lifestyle won’t be enough when it comes time to leave the workforce. You won’t be able to support yourself in retirement if you don’t adjust how much you’re saving based on inflation.
- The value of certain fixed-income investments drops. The rate of return on government-issued securities drops as inflation increases. And more people may decide to sell them when returns drop, which decreases their value.
- The value of the national debt rises because the amount of interest owed on that debt increases. Governments may be forced to raise taxes or cut down on spending when this happens.
Not every asset’s value moves in the same direction because of inflation. One may drop just because another rises. Mortgage rates may rise but the value of your home may drop.
Who Benefits and Who Doesn’t?
Inflation comes with both winners and losers, just as with any other economic phenomenon.
Who Benefits?
Inflation can be a boon for certain borrowers. Consider mortgagors who have fixed-rate loans on their homes. You won’t be affected if you have a rate locked in at 5% and inflation causes interest rates to rise. That can’t be said for your neighbor who may have an Adjustable Rate Mortgage (ARM) that changes based on market rates.
You’re probably going to be in luck if you’re in the market for a new home because higher prices and higher interest rates often knock out the competition, boosting the amount of inventory available. You’re likely going to be able to get the pick of the lot if you can afford it.
Who Doesn’t Benefit?
Inflation reduces purchasing power so consumers represent the primary group who stands to lose when prices rise. Their money doesn’t go nearly as far, and it allows them a limited number of goods and services that they can purchase. Most consumers tend to think twice about buying a big-ticket item such as a new appliance or a new car when inflation is high.
Home buyers may also feel the pinch during these times because higher prices mean higher interest rates, making borrowing more expensive.
People on fixed incomes are also negatively affected by inflation. Consider retirees who receive Social Security. They may receive COLA increases on their benefits, but this may not be enough to sustain the same standard of living they’re used to when prices increase to certain levels.
What Is Inflation’s Primary Effect?
Inflation is the rise in prices of goods and services. It causes the purchasing power of a currency to decline, making a representative basket of goods and services increasingly more expensive.
The Bottom Line
Inflation can be a blessing and a curse, depending on how you look at it.
Governments and central banks plan for manageable price increases by setting inflationary targets, and consumers respond by spending as prices tend to increase at a nominal rate. But that changes when inflation overheats. This can diminish the purchasing power of consumers. Governments generally raise interest rates, reduce the amount of money banks must have on reserve, and cut back on the money supply when inflation runs rampant.