Following the financial crisis of 2008-2009, the Federal Reserve made inflation targeting a top priority in January 2012. The Federal Reserve hoped that by stating inflation rates as an explicit aim, it would assist them achieve its dual mandate of low unemployment and stable prices. Despite the Federal Reserve’s best efforts, inflation tends to hover around the 2% objective for the majority of years.
What would be the optimum inflation rate?
The Federal Open Market Committee (FOMC) believes that long-term inflation of 2%, as measured by the yearly change in the personal consumption expenditures price index, is best compatible with the Federal Reserve’s objective of maximum employment and price stability. Households and businesses can make good decisions about saving, borrowing, and investing when inflation is expected to be low and stable, which adds to a well-functioning economy.
Inflation in the United States has been below the Federal Reserve’s target of 2% for several years. It’s understandable that rising prices for basic necessities like food, gasoline, and shelter add to the financial strains encountered by many families, especially those who have lost employment or income. Inflation that is excessively low, on the other hand, might harm the economy. When inflation falls far below the desired level, individuals and businesses will come to expect it, lowering future inflation expectations below the Federal Reserve’s longer-term inflation target. This can cause actual inflation to fall even more, creating a cycle of ever-lower inflation and inflation expectations.
Interest rates will fall if inflation expectations reduce. As a result, there would be less room to lower interest rates in order to stimulate employment during a slump. Evidence from around the world reveals that once this problem arises, it can be extremely difficult to solve. To address this issue, prudent monetary policy will most likely aim for inflation to remain modestly above 2% for some time after times when it has been consistently below 2%. The FOMC will work to ensure that longer-run inflation expectations remain solidly anchored at 2% by pursuing inflation that averages 2% over time.
Why is a 2 percent inflation rate desirable?
When inflation exceeds 2%, the situation gets serious. Walking inflation occurs when prices climb by 3% to 10% over the course of a year. It has the potential to fuel excessive economic expansion. Inflation at that level robs you of your hard-earned money.
What advantages does inflation provide?
1. Deflation (price declines negative inflation) is extremely dangerous. People are hesitant to spend money while prices are falling because they believe items will be cheaper in the future; as a result, they continue to postpone purchases. Furthermore, deflation raises the real worth of debt and lowers the disposable income of people who are trying to pay off debt. When consumers take on debt, such as a mortgage, they typically expect a 2% inflation rate to help erode the debt’s value over time. If the 2% inflation rate does not materialize, their debt burden will be higher than anticipated. Deflationary periods wreaked havoc on the UK in the 1920s, Japan in the 1990s and 2000s, and the Eurozone in the 2010s.
2. Wage adjustments are possible due to moderate inflation. A moderate pace of inflation, it is thought, makes relative salary adjustments easier. It may be difficult, for example, to reduce nominal wages (workers resent and resist a nominal wage cut). However, if average wages are growing due to modest inflation, it is simpler to raise the pay of productive workers; unproductive people’ earnings can be frozen, effectively resulting in a real wage reduction. If there was no inflation, there would be greater real wage unemployment, as businesses would be unable to decrease pay to recruit workers.
3. Inflation allows comparable pricing to be adjusted. Moderate inflation, like the previous argument, makes it easier to alter relative pricing. This is especially significant in the case of a single currency, such as the Eurozone. Countries in southern Europe, such as Italy, Spain, and Greece, have become uncompetitive, resulting in a high current account deficit. Because Spain and Greece are unable to weaken their currencies in the Single Currency, they must reduce comparable prices in order to recover competitiveness. Because of Europe’s low inflation, they are forced to slash prices and wages, resulting in decreased growth (due to the effects of deflation). It would be easier for southern Europe to adjust and restore competitiveness without succumbing to deflation if the Eurozone had modest inflation.
4. Inflation can help the economy grow. The economy may be locked in a recession during periods of exceptionally low inflation. Targeting a higher rate of inflation may theoretically improve economic growth. This viewpoint is divisive. Some economists oppose aiming for a higher inflation rate. Some, on the other hand, would aim for more inflation if the economy remained in a prolonged slump. See also: Inflation rate that is optimal.
For example, in 2013-14, the Eurozone experienced a relatively low inflation rate, which was accompanied by very slow economic development and high unemployment. We may have witnessed a rise in Eurozone GDP if the ECB had been willing to aim higher inflation.
The Phillips Curve argues that inflation and unemployment are mutually exclusive. Higher inflation reduces unemployment (at least in the short term), but the significance of this trade-off is debatable.
5. Deflation is preferable to inflation. Economists joke that the only thing worse than inflation is deflation. A drop in prices can increase actual debt burdens while also discouraging spending and investment. The Great Depression of the 1930s was exacerbated by deflation.
Disadvantages of inflation
When the inflation rate exceeds 2%, it is usually considered a problem. The more inflation there is, the more serious the matter becomes. Hyperinflation can wipe out people’s savings and produce considerable instability in severe cases, such as in Germany in the 1920s, Hungary in the 1940s, and Zimbabwe in the 2000s. This type of hyperinflation, on the other hand, is uncommon in today’s economy. Inflation is usually accompanied by increased interest rates, so savers don’t lose their money. Inflation, on the other hand, can still be an issue.
- Inflationary expansion is often unsustainable, resulting in harmful boom-bust economic cycles. For example, in the late 1980s, the United Kingdom experienced substantial inflation, but this economic boom was unsustainable, and attempts by the government to curb inflation resulted in the recession of 1990-92.
- Inflation tends to inhibit long-term economic growth and investment. This is due to the increased likelihood of uncertainty and misunderstanding during periods of high inflation. Low inflation is said to promote better stability and encourage businesses to invest and take risks.
- Inflation can make a business unprofitable. A significantly greater rate of inflation in Italy, for example, can render Italian exports uncompetitive, resulting in a lower AD, a current account deficit, and slower economic growth. This is especially crucial for Euro-zone countries, as they are unable to devalue in order to regain competitiveness.
- Reduce the worth of your savings. Money loses its worth as a result of inflation. If inflation is higher than interest rates, savers will be worse off. Inflationary pressures can cause income redistribution in society. The elderly are frequently the ones that suffer the most from inflation. This is especially true when inflation is strong and interest rates are low.
- Menu costs – during periods of strong inflation, the cost of revising price lists increases. With modern technologies, this isn’t as important.
- Real wages are falling. In some cases, significant inflation might result in a decrease in real earnings. Real incomes decline when inflation is higher than nominal salaries. During the Great Recession of 2008-16, this was a concern, as prices rose faster than incomes.
Inflation (CPI) outpaced pay growth from 2008 to 2014, resulting in a drop in living standards, particularly for low-paid, zero-hour contract workers.
Why is low inflation beneficial?
A low rate of inflation encourages the most effective use of economic resources. When inflation is strong, a significant amount of time and resources from the economy are spent by individuals looking for ways to protect themselves from inflation.
Governments seek inflation for what reason?
Question from a reader: Why does inflation make it easier for governments to repay their debts?
During the 1950s, 1960s, and 1970s, when inflation was quite high, the national debt as a percentage of GDP dropped dramatically. Deflation and massive debt characterized the 1920s and 1930s.
Inflation makes it easier for a government to pay its debt for a variety of reasons, especially when inflation is larger than planned. In conclusion:
- Nominal tax collections rise as inflation rises (if prices are higher, the government will collect more VAT, workers pay more income tax)
- Higher inflation lowers the actual worth of debt; bondholders with fixed interest rates will see their bonds’ real value diminish, making it easier for the government to repay them.
- Higher inflation allows the government to lock income tax levels, allowing more workers to pay higher tax rates thereby increasing tax revenue without raising rates.
Why inflation can benefit the government at the expense of bondholders
- Let’s pretend that an economy has 0% inflation and that people anticipate it to stay that way.
- Let’s say the government needs to borrow 2 billion and sells 1,000 30-year bonds to the private sector. The government may give a 2% annual interest rate to entice individuals to acquire bonds.
- The government will thereafter be required to repay the full amount of the bonds (1,000) as well as the annual interest payments (20 per year at 2%).
- Investors who purchase the bonds will profit. The bond yield (2%) is higher than the inflation rate. They get their bonds back, plus interest.
- Assume, however, that inflation of 10% occurred unexpectedly. Money loses its worth as a result of this. As prices rise as a result of inflation, 1,000 will buy fewer products and services.
- As salaries and prices rise, the government will receive more tax money as a result of inflation (for example, if prices rise 10%, the government’s VAT receipts will rise 10%).
- As a result, inflation aids the government in collecting more tax income.
- Bondholders, on the other hand, lose out. The government still owes only 1,000 in repayment. However, inflation has lowered the value of that 1,000 bond (it now has a real value of 900). Because the inflation rate (ten percent) is higher than the bond’s interest rate (two percent), their funds are losing actual value.
- Because of inflation, repaying bondholders needs a lesser percentage of the government’s overall tax collection, making it easier for the government to repay the original loan.
As a result of inflation, the government (borrower) is better off, whereas bondholders (savers) are worse off.
Evaluation (index-linked bonds)
Some bondholders will purchase index-linked bonds as a result of this risk. This means that if inflation rises, the maturity value and interest rate on the bond will rise in lockstep with inflation, protecting the bond’s real value. The government does not benefit from inflation in this instance since it pays greater interest payments and is unable to discount the debt through inflation.
Inflation and benefits
Inflation is expected to peak at 6.2 percent in 2022 in the United Kingdom, resulting in a significant increase in nominal tax receipts. The government, on the other hand, has expanded benefits and public sector salaries at a lower inflation rate. In April 2022, inflation-linked benefits and tax credits will increase by 3.1%, as determined by the Consumer Price Index (CPI) inflation rate in September 2021.
As a result, public employees and benefit recipients will suffer a genuine drop in income their benefits will increase by 3.1 percent, but inflation might reach 6.2 percent. The government’s financial condition will improve in this case by increasing benefits at a slower rate than inflation.
Only by making the purposeful decision to raise benefits and wages at a slower rate than inflation can debt be reduced.
Inflation and bracket creep
Another approach for the government to benefit from inflation is to maintain a constant income tax level. The basic rate of income tax (20%), for example, begins at 12,501. At 50,000, the tax rate is 40%, and at 150,000, the tax rate is 50%. As a result of inflation, nominal earnings will rise, and more workers will begin to pay higher rates of income tax. As a result, even though the tax rate appears to be unchanged, the government has effectively raised average tax rates.
Long Term Implications of inflation on bonds
People will be hesitant to buy bonds if they expect low inflation and subsequently lose the real worth of their savings due to high inflation. They know that inflation might lower the value of bondholders’ money.
If bondholders are concerned that the government will generate inflation, greater bond rates will be desired to compensate for the risk of losing money due to inflation. As a result, the likelihood of high inflation may make borrowing more onerous for the government.
Bondholders may not expect zero inflation; yet, bondholders are harmed by unexpected inflation.
Example Post War Britain
Inflation was fairly low throughout the 1930s. This is one of the reasons why individuals were willing to pay low interest rates for UK government bonds (in the 1950s, the national debt increased to over 230 percent of GDP). Inflationary effects lowered the debt burden in the postwar period, making it simpler for the government to satisfy its repayment obligations.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
Inflation helped to expedite the decline of UK national debt as a percentage of GDP in the postwar period, lowering the real burden of debt. However, debt declined as a result of a sustained period of economic development and increased tax collections.
Economic Growth and Government Debt
Another concern is that if the government reflates the economy (for example, by pursuing quantitative easing), it may increase both economic activity and inflation. A higher GDP is a crucial component in the government’s ability to raise more tax money to pay off its debt.
Bondholders may be concerned about an economy that is expected to experience deflation and negative growth. Although deflation might increase the real value of bonds, they may be concerned that the economy is stagnating too much and that the government would struggle to satisfy its debt obligations.