If you believe the headlines, inflation is back after a long post-crisis stint of disinflation and, in some instances, outright deflation. Since investors haven’t seen significant price rises in years, it’s worth brushing up on the most common effects of inflation.
1. Erodes Purchasing Power
This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease in the purchasing power of currency due to a rise in prices across the economy. Within living memory, the average price of a cup of coffee was a dime. Today the price is closer to two dollars.
Such a price change could conceivably have resulted from a surge in the popularity of coffee, or price pooling by a cartel of coffee producers, or years of devastating drought/flooding/conflict in a key coffee-growing region. In those scenarios, the price of coffee would rise, but the rest of the economy would carry on largely unaffected. That example would not qualify as inflation, since the only the most caffeine-addled consumers would experience significant depreciation in their overall purchasing power.
Inflation requires prices to rise across a “basket” of goods and services, such as the one that comprises the most common measure of price changes, the consumer price index (CPI). When the prices of goods that are non-discretionary and impossible to substitute – food and fuel – rise, they can affect inflation all by themselves. For this reason, economists often strip out food and fuel to look at “core” inflation, a less volatile measure of price changes.
2. Encourages Spending and Investing
A predictable response to declining purchasing power is to buy now, rather than later. Cash will only lose value, so it is better to get your shopping out of the way and stock up on things that probably won’t lose value.
For consumers, that means filling up gas tanks, stuffing the freezer, buying shoes in the next size up for the kids, and so on. For businesses, it means making capital investments that, under different circumstances, might be put off until later. Many investors buy gold and other precious metals when inflation takes hold, but these assets’ volatility can cancel out the benefits of their insulation from price rises, especially in the short term.
Over the long term, equities have been among the best hedges against inflation. At close on Dec. 12, 1980, a share of Apple Inc. (AAPL) cost $29 in current (not inflation-adjusted) dollars. According to Yahoo Finance, that share would be worth $7,035.01 at close on Feb. 13, 2018, after adjusting for dividends and stock splits. The Bureau of Labor Statistics’ (BLS) CPI calculator gives that figure as $2,449.38 in 1980 dollars, implying a real (inflation-adjusted) gain of 8,346%.
Say you had buried that $29 in the backyard instead. The nominal value wouldn’t have changed when you dug it up, but the purchasing power would have fallen to $10.10 in 1980 terms; that’s about a 65% depreciation. Of course not every stock would have performed as well as Apple: you would have been better off burying your cash in 1980 than buying and holding a share of Houston Natural Gas, which would merge to become Enron.
3. Causes More Inflation
Unfortunately, the urge to spend and invest in the face of inflation tends to boost inflation in turn, creating a potentially catastrophic feedback loop. As people and businesses spend more quickly in an effort to reduce the time they hold their depreciating currency, the economy finds itself awash in cash no one particularly wants. In other words, the supply of money outstrips the demand, and the price of money – the purchasing power of currency – falls at an ever-faster rate.
When things get really bad, a sensible tendency to keep business and household supplies stocked rather than sitting on cash devolves into hoarding, leading to empty grocery store shelves. People become desperate to offload currency, so that every payday turns into a frenzy of spending on just about anything so long as it’s not ever-more-worthless money.
By December 1923, an index of the cost of living in Germany increased to a level more than 1.5 trillion times its pre-WW I measure.
The result is hyperinflation, which has seen Germans papering their walls with the Weimar Republic’s worthless marks (1920s), Peruvian cafes raising their prices multiple times a day (1980s), Zimbabwean consumers hauling around wheelbarrow-loads of million- and billion-Zim dollar notes (2000s) and Venezuelan thieves refusing even to steal bolívares (2010s).
4. Raises the Cost of Borrowing
As these examples of hyperinflation show, states have a powerful incentive to keep price rises in check. For the past century in the U.S. the approach has been to manage inflation using monetary policy. To do so, the Federal Reserve (the U.S. central bank) relies on the relationship between inflation and interest rates. If interest rates are low, companies and individuals can borrow cheaply to start a business, earn a degree, hire new workers, or buy a shiny new boat. In other words, low rates encourage spending and investing, which generally stoke inflation in turn. (See also, What is the relationship between inflation and interest rates?)
By raising interest rates, central banks can put a damper on these rampaging animal spirits. Suddenly the monthly payments on that boat, or that corporate bond issue, seem a bit high. Better to put some money in the bank, where it can earn interest. When there is not so much cash sloshing around, money becomes more scarce. That scarcity increases its value, although as a rule, central banks don’t want money literally to become more valuable: they fear outright deflation nearly as much as they do hyperinflation (see section 7). Rather, they tug on interest rates in either direction in order to maintain inflation close to a target rate (generally 2% in developed economies and 3% to 4% in emerging ones).
Another way of looking at central banks’ role in controlling inflation is through the money supply. If the amount of money is growing faster than the economy, money will be worth less and inflation will ensue. That’s what happened when Weimar Germany fired up the printing presses to pay its World War I reparations, and when Aztec and Inca bullion flooded Habsburg Spain in the 16th century. When central banks want to raise rates, they generally cannot do so by simple fiat; rather they sell government securities and remove the proceeds from the money supply. As the money supply decreases, so does the rate of inflation. (See also, How Central Banks Control the Supply of Money.)
5. Lowers the Cost of Borrowing
When there is no central bank, or when central bankers are beholden to elected politicians, inflation will generally lower borrowing costs.
Say you borrow $1,000 at a 5% annual rate of interest. If inflation is 10%, the real value of your debt is decreasing faster than the combined interest and principle you’re paying off. When levels of household debt are high, politicians find it electorally profitable to print money, stoking inflation and whisking away voters’ obligations. If the government itself is heavily indebted, politicians have an even more obvious incentive to print money and use it to pay down debt. If inflation is the result, so be it (once again, Weimar Germany is the most infamous example of this phenomenon).
Politicians’ occasionally detrimental fondness for inflation has convinced several countries that fiscal and monetary policymaking should be carried out by independent central banks. While the Fed has a statutory mandate to seek maximum employment and steady prices, it does not need a congressional or presidential go-ahead to make its rate-setting decisions. That does not mean the Fed has always had a totally free hand in policy-making, however. Former Minneapolis Fed president Narayana Kocherlakota wrote in 2016 that the Fed’s independence is “a post-1979 development that rests largely on the restraint of the president.” (See also, Breaking Down the Federal Reserve’s Dual Mandate.)
6. Reduces Unemployment
There is some evidence that inflation can push down unemployment. Wages tend to be sticky, meaning that they change slowly in response to economic shifts. John Maynard Keynes theorized that the Great Depression resulted in part from wages’ downward stickiness: unemployment surged because workers resisted pay cuts and were fired instead (the ultimate pay cut). The same phenomenon may also work in reverse: wages’ upward stickiness means that once inflation hits a certain rate, employers’ real payroll costs fall, and they’re able to hire more workers. (See also, Giants of Finance: John Maynard Keynes.)
That hypothesis appears to explain the inverse correlation between unemployment and inflation — a relationship known as the Phillips curve – but a more common explanation puts the onus on unemployment. As unemployment falls, the theory goes, employers are forced to pay more for workers with the skills they need. As wages rise, so does consumers’ spending power, leading the economy to heat up and spur inflation; this model is known as cost-push inflation. (See also, How Inflation and Unemployment Are Related.)
The U.S. Philips curve.
7. Increases Growth
Unless there is an attentive central bank on hand to push up interest rates, inflation discourages saving, since the purchasing power of deposits erodes over time. That prospect gives consumers and businesses an incentive to spend or invest. At least in the short term, the boost to spending and investment leads to economic growth. By the same token, inflation’s negative correlation with unemployment implies a tendency to put more people to work, spurring growth.
This effect is most conspicuous in its absence. In 2016, central banks across the developed world found themselves vexingly unable to coax inflation or growth up to healthy levels. Cutting interest rates to zero and below did not seem to be working; neither did buying trillions of dollars’ worth of bonds in a money-creation exercise known as quantitative easing. This conundrum recalled Keynes’s liquidity trap, in which central banks’ ability to spur growth by increasing the money supply (liquidity) is rendered ineffective by cash hoarding, itself the result of economic actors’ risk aversion in the wake of a financial crisis. Liquidity traps cause disinflation, if not deflation. (See also, Why Didn’t Quantitative Easing Lead to Hyperinflation?)
In this environment, moderate inflation was seen as a desirable growth-driver, and markets welcomed the increase in inflation expectations due to Donald Trump‘s election. In February 2018, however, markets sold off steeply due to worries that inflation would lead to a rapid increase in interest rates. (See also, The Recovery Eats Its Children.)
8. Reduces Employment and Growth
Wistful talk about inflation’s benefits is likely to sound strange to those who remember the economic woes of the 1970s. In today’s context of low growth, high unemployment (in Europe) and menacing deflation, there are reasons think a healthy rise in prices – 2% or even 3% per year – would do more good than harm. On the other hand, when growth is slow, unemployment is high and inflation is in the double digits, you have what a British Tory MP in 1965 dubbed “stagflation.”
Economists have struggled to explain stagflation. Early on, Keynesians did not accept that it could happen, since it appeared to defy the inverse correlation between unemployment and inflation described by the Phillips curve. After reconciling themselves to the reality of the situation, they attributed the most acute phase to the supply shock caused by the 1973 oil embargo: as transportation costs spiked, the theory went, the economy ground to a halt. In other words, it was a case of cost-push inflation. Evidence for this idea can be found in five consecutive quarters of productivity decline, ending with a healthy expansion in the fourth quarter of 1974. But the 3.8% drop in productivity in the third quarter of 1973 occurred before Arab members of OPEC shut off the taps in October of that year.
The kink in the timeline points to another, earlier contributor to the 1970s’ malaise, the so-called Nixon shock. Following other countries’ departures, the U.S. pulled out of the Bretton Woods Agreement in August 1971, ending the dollar’s convertibility to gold. The greenback plunged against other currencies: for example, a dollar bought 3.48 Deutsche marks in July 1971, but just 1.75 in July 1980. Inflation is a typical result of depreciating currencies.
And yet even dollar devaluation does not fully explain stagflation, since inflation began to take off in the mid-to-late 1960s (unemployment lagged by a few years). As monetarists see it, the Fed was ultimately to blame. M2 money stock rose by 97.7% in the decade to 1970, nearly twice as fast as gross domestic product (GDP), leading to what economists commonly describe as “too much money chasing too few goods,” or demand-pull inflation.
Supply-side economists, who emerged in the 1970s as a foil to Keynesian hegemony, won the argument at the polls when Reagan swept the popular vote and electoral college. They blamed high taxes, burdensome regulation and a generous welfare state for the malaise; their policies, combined with aggressive, monetarist-inspired tightening by the Fed, put an end to stagflation. (See also, Understanding Supply-side Economics.)
9. Weakens (or Strengthens) the Currency
High inflation is usually associated with a slumping exchange rate, though this is generally a case of the weaker currency leading to inflation, not the other way around. Economies that import significant amounts of goods and services – which, for now, is just about every economy – must pay more for these imports in local-currency terms when their currencies fall against those of their trading partners. Say that Country X’s currency falls 10% against Country Y’s. The latter doesn’t have to raise the price of the products it exports to Country X for them to cost Country X 10% more; the weaker exchange rate alone has that effect. Multiply cost increases across enough trading partners selling enough products, and the result is economy-wide inflation in Country X.
But once again, inflation can do one thing, or its polar opposite, depending on the context. When you strip away most of the global economy’s moving parts it seems perfectly reasonable that rising prices lead to a weaker currency. In the wake of Trump’s election victory, however, rising inflation expectations drove the dollar higher for several months. The reason is that interest rates around the globe were dismally low – almost certainly the lowest they’ve been in human history – making markets likely to jump on any opportunity to earn a bit of money for lending, rather than paying for the privilege (as the holders of $11.7 trillion in sovereign bonds were doing in June 2016, according to Fitch). (See also, How Negative Interest Rates Work.)
Because the U.S. has a central bank (see section 4), rising inflation generally translates into higher interest rates. The Fed has raised the federal funds rate five times following the election, from 0.5%-0.75% to 1.5%-1.75%.