Inflation: The Good, The Bad and The Terrible
The coming months are likely to see higher U.S inflation. In part, this is a calendar effect: inflation was incredibly low last year, so it will now seem abruptly higher. Inflation is complicated, and as many Federal Reserve officials acknowledge, it is incredibly hard to forecast and control. Cookson of Bloomberg has said, “Generally, the best forecast is what inflation is at the moment. Central banks have been neither good at forecasting inflation nor creating it. This is because, in essence, classical economics largely assumes that, all things being equal, increasing the supply of money pushes inflation higher.” Inflation is not one-sided. In some ways, inflation can be good, in other ways bad, and in some cases, positively terrible.
The Good:
For one, inflation increases overall spending, as people are encouraged to borrow and lend. If inflation is controlled, consumers will have more to spend, and the economy benefits. In addition, inflation can possibly create a “hot” economy. An economy that is allowed to run hot is more likely to bring higher wages, lower unemployment, and reduce income inequality. “Good” inflation is often just describing reflation — that is, inflation that comes as part of a strengthened economy. As demand for workers rises, wages also advance, giving people more spending power. This spending helps companies, so they in turn can hire more workers or invest in things that will help them succeed. Thus, “good” inflation perpetuates a cycle of more jobs.
Another way to think about good inflation is the inverse — when prices are falling (deflation). One might think falling prices are good. It’s like a sale — you can get the same thing with less money. But if people expect prices to keep falling, they might postpone spending, expecting to get an even better “sale” in the future. This can slow down overall consumption, which in turn hurts the economy. Japan is a good example of this — the country has struggled to get inflation going for decades by making saving less attractive. Other countries have followed suit, and we often see this today through negative interest rates. According to the World Population Review 2021, Switzerland, Denmark and Japan currently have negative interest rates. This risk of deflation is a major reason why central banks around the world have targeted a positive inflation rate in the last few decades, often around 2% per year. In fact, the Federal Reserve announced a new framework in its inflation policy last year. It is now planning to let inflation go over 2% for some period of time to make sure that over a business cycle, inflation averages 2%.
The Bad:
While gradual, modest rates of inflation alongside a growing economy can be largely beneficial for both consumers and companies, there are still costs.
Inflation effectively raises the prices of necessities, like houses and food. If wages are outpaced by these increasing prices, people are unable to purchase as much as they want. This has been a hotly debated topic in recent years as falling unemployment has not resulted in higher wages the way it has in the past. This relationship, known as the Phillips Curve, has been thrown into doubt because although the unemployment rate fell to 3.6% before the pandemic, wage growth was very modest in comparison. This tradeoff has existed historically, but in recent years the curve has flattened, signifying that labor market performance is not a reliable indicator of inflation. While this weakened relationship can be attributed to many factors, it is principally due to the Fed’s targeting of inflation.
Inflation can also harm companies to the degree that they can’t raise prices. In these cases, companies may have to accept higher input costs and steady final prices, taking the difference in lower profits. One way to see if this is happening is a regular survey by the Federal Reserve called the Beige Book. Fed officials interview companies around the country and ask about demand, prices and other trends. In the latest Beige Book, they reported the following: “Growth in input prices continuing to outpace that of finished goods and services. Most notably, prices for construction and building materials, steel products, and shipping services were reported to have risen further.” To put it simply, higher input prices mean the cost of producing the good increases, resulting in lower net profits for the company. There are also growing fears that the economy will overheat once vaccines are rolled out and service industries fully reopen. Joe Biden’s stimulus plan plays a key role in this fear: the planned $1.9 trillion, including $1,400 checks for many Americans, could pave the way for higher inflation. In no way is stimulus itself harmful; however, if high inflation occurs, it will only exacerbate federal debt and harm Americans who have been disproportionately affected by the pandemic.
The Terrible:
Even if the rate of inflation is not very high, it can still have long-term effects that destroy wealth. If you have $100 today, and inflation is rising by 2% a year, that money will buy significantly less in the years to come as prices increase. This is particularly detrimental to savers — especially retirees who need to be able to count on their purchasing power after stopping work. Even in the best-case scenario where inflation remains low, seniors are more likely than younger consumers to spend money on things that increase in price, like housing, healthcare and travel. The other, more immediate “really bad” inflation is known as hyperinflation. This usually refers to a rate of inflation that is significantly higher than what the country would like. As noted above, inflation destroys wealth, so hyperinflation reduces the value of money very rapidly.
The most recent example of hyperinflation is Venezuela. Hyperinflation throughout the country began in 2016, during a time of social, political and economic crisis. As a result of plummeting oil prices, government revenue declined, leaving little to no money for imports. The country faced a scarcity of many products and became exceedingly reliant on the government for distribution of goods. By August 2019, Venezuela’s hyperinflation rate had increased from 9.02 percent to 10 million percent, according to the International Monetary Fund. Poverty increased exponentially, life savings became virtually worthless as the value of the bolivar continually declined, and unemployment rose.
Other than this recent example, the best-known example of hyperinflation is Germany post-World War I, or the Weimar Republic. The government’s principal crisis occured in 1923, after it failed to pay reparations to the French. The country was already experiencing high inflation caused by increasing government debt and war spending. In response to striking workers, the government started printing more and more money, leading to hyperinflation. The price of printing a note grew higher than the worth of the currency itself. A loaf of bread, which cost 250 marks in January 1923, had risen to 200,000 million marks in November 1923. The inflation hurt those with fixed incomes, which were being outpaced by rising costs. Additionally, people that saved during this period of time or lent money to the government faced great economic loss.
Conclusion:
As we look ahead, could inflation in the US really reach such terrible precedents? In answering this question, we must consider the new Fed framework. If inflation does rise above 2% this year, suggesting a very low unemployment rate, and the Fed starts to raise rates to prevent overheating of the economy, what will happen? Will financial markets remain stable as the extremely cheap borrowing costs fall sharply? Will higher interest rates contribute to the worry regarding the increasing levels of US debt? One of the reasons policymakers say we can increase debt comfortably is because of the cheap cost to service that debt (low interest). This may play out on a global scale, as other countries worry about the US’ ability to service debt, driving them away from wanting to own dollars. A weaker dollar could fuel inflation further and only make the Fed’s job harder. While it seems unlikely, it’s a risk the US hasn’t had to grapple with for over fifty years.
