The price hikes for rental cars, airline tickets, and uncooked beef roasts are making economists and consumers wonder if we’re during an inflationary period.
Whether these price hikes are just a temporary blip because of a supply and demand mismatch resulting from the pandemic or a sign of inflation, an uptick in prices that continues month after month across a broad range of goods and services, remains to be seen. A demographic that could benefit from the trend is anyone who holds the fixed-rate debt, including consumers and governments.
Kent Smetters, faculty director of the Penn Wharton Budget Model, which evaluates the impact of public policies on the budget and economy, said inflation could result from a huge transfer of wealth from lenders to borrowers. Many of the lenders are people of wealth, while many of the borrowers do not have wealth. The lenders stand to lose a few bucks, and borrowers stand to save money.”
The following is a solution:
As consumers’ assets increase, their liabilities decrease
Inflation occurs because wages rise. As prices rise, companies are rushing to hire more workers to take advantage of the price increase. This wage increase makes companies charge more for their goods and workers than demand higher wages. However, an inflationary spiral hasn’t occurred since the 1970s.
The effect of this is that a unit of money today is worth less than it used to be. However, consumers who took out a fixed-rate loan before the inflationary period began are only responsible for repaying the amount of money they originally agreed to.
The borrowers in this group are fortunate because they will pay back their loans using weaker purchasing power dollars than they borrowed. Or said another way, the money they are using to repay their loans will buy fewer goods than it did when they had the loans.
Several major categories of consumer loans might benefit from this dynamic: federal student loans, which have fixed interest rates for the lifetime of the debt, private student loans (some private student loans have variable interest rates which change with inflation) and fixed-rate mortgages.
If you have a 30-year fixed-rate mortgage, you are hedging against inflation, Smetters said. “Your house price will probably keep up with inflation, but your loan terms will not change.”
Students’ loans work similarly. While their wages will increase as inflation increases, their student loan balance will remain the same.
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According to Smetters, “your asset, namely labour, keeps up with inflation. “However, your liability, or your student debt, will be reduced by inflation, but not completely wiped out.”
Inflation may help new borrowers get comfortable with higher interest rates. However, inflation also comes with economic volatility, so even borrowers who benefit from cheaper dollars may face risks associated with unemployment and macroeconomic disruptions.
Even if borrowers are benefitting from an inflationary period, they may not perceive it that way.
Jesse Schreger, an associate professor of economics at Columbia Business School, says people’s views about whether inflation is good for them often diverge from economists’.
According to Schreger, economists often assume that when prices rise, wages will increase as well. However, consumers, workers, and borrowers often neglect to account for the possibility that their wages may rise, which means they’re likely just internalizing increases in prices.
The people who I would think would most benefit from inflation may not actually like it, the economist said.
Creditors will receive less real estate from the government
Governments with debt can benefit from inflation just as much as individual borrowers. In fact, some governments have forced central banks to increase the money supply to reduce the value of each unit of currency in the country – essentially creating inflation – to reduce the value of the nation’s debt.
Unlike in the U.S., where Federal Reserve officials closely monitor inflation to keep prices stable, this is not the strategy used by monetary policymakers there. However, the U.S. government can benefit from inflation, at least as far as the value of its debt is concerned (the Fed balances this goal with its other mandate to keep employment relatively high).
“The higher inflation is, the less proper stuff the U.S. government gives to its creditors when it repays,” Schreger noted. In addition, he said, the higher inflation is, the lower the share of the U.S. economy’s output that will have to be used to repay the debt.
According to Schreger, the compound effects of inflation can cause even a moderate, sustained inflation uptick to “really erode the actual value of government debt,” the longer its maturity.
“When the market did not expect inflation when the debt was issued, that really enables governments to repay their debts,” he said. Anyone who bought a 10-year or 30-year Treasury bond three years ago probably didn’t factor inflation into their purchase.
Inflation poses a risk to the government’s priorities. If prices and wages get too high, there is a possibility that the Fed could act to suppress inflation. This would be accomplished by raising short-term interest rates, which would discourage companies, consumers, and the government from investing.
Besides preventing future government investment, it could raise interest rates on extra money the government borrows. As a result, the government could face increased pressure to find additional resources to repay the new loans, either through increased taxation or spending cuts.