- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Is inflation profitable for banks?
They lose because they are net monetary creditors. However, they benefit as demand deposit issuers. The second effect may easily outweigh the first with more indexing and more accurate forecasting of future inflation.
Bankers have recently learned to recognize and manage interest rate risk. Bankers learned of the need to hedge their balance sheets against this risk by applying duration analysis, thanks in large part to the efforts of the editor of this journal in a series of articles in American Banker. The duration of equity (a value-weighted average of the durations of assets and liabilities) was set to zero to protect the bank from interest rate risk. With this position, the bank was considered to be immune to modest changes in interest rates. However, this immunization technique only safeguarded the bank’s nominal market value, not its real market value that is, the bank’s market value in today’s dollars, not the bank’s market value in inflation-adjusted dollars. This post aims to start a conversation on how to correct this oversight.
Do banks profit or lose money as a result of inflation? Is it the rate of inflation or the rate of change that matters? Is the impact of pricing changes symmetric? Is it true that disinflation has the same but opposite effects as inflation? What role do expectations play in the process? Is it possible for banks to avoid these consequences?
We’re mostly interested in the impact of shifting prices on net interest income and capital values here. The impact of inflation on noninterest revenue and expenses, as well as the real resource production function of banks, will be discussed in future articles. This latter assumption equates to the plausible (but controversial) belief that actual (inflation-adjusted) noninterest revenue and expense are unrelated to price changes for the purposes of this article.
The focus is on how inflation affects banks, rather than how banks have been affected by specific inflations. As a result, we exclude factors such as increased bank competition and regulatory changes (both of which have a significant impact on bank earnings), as these are not always caused by inflation.
We start by going over the economic literature and the basic “overview” ideas. We then show how both theories are subsets of a broader approach whose major components are rates of change in expectations and portfolio adjustment speeds. The more comprehensive hypothesis serves as a foundation for future research.
In the economics and finance literature, the impact of inflation on actual bank earnings has been extensively explored. There are two competing and opposing models. Banks, according to Alchian and Kessel (A-K), are net monetary creditors (i.e., their nominal assets are greater than nominal liabilities). As a result, rising prices would reduce the value of their nominal assets more than their nominal liabilities. As a result, banks will lose money during an inflationary period.
The inflation tax school, on the other hand, argues that because banks’ demand deposits account for a component of the money supply, they should be able to capture a piece of the inflation tax and so profit during an inflation….
What impact does inflation have on a bank?
Because prices are expected to rise in the future, inflation might erode the value of your investments over time. This is particularly obvious when dealing with money. If you keep $10,000 beneath your mattress, it may not be enough to buy as much in 20 years. While you haven’t actually lost money, inflation has eroded your purchasing power, resulting in a lower net worth.
You can earn interest by keeping your money in the bank, which helps to offset the effects of inflation. Banks often pay higher interest rates when inflation is strong. However, your savings may not grow quickly enough to compensate for the inflation loss.
When inflation is strong, do banks make more money?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
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.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
Why are banks so afraid of inflation?
When the rate of inflation differs from expectations, the amount of interest repaid or earned differs from what they expected. Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out.
Is inflation beneficial to debtors?
Inflation, by definition, causes the value of a currency to depreciate over time. In other words, cash now is more valuable than cash later. As a result of inflation, debtors can repay lenders with money that is worth less than it was when they borrowed it.
Is your money depreciating at a bank?
The issue is that when interest rates (what the bank pays you in exchange for establishing a deposit) are lower than inflation (the rate at which money depreciates), your money will be worth LESS in the future than it is now.
Is it beneficial to have cash during an inflationary period?
According to Arnott, cash is frequently neglected as an inflation buffer. “While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
Inflation benefits who?
Inflation benefits debtors because they can repay creditors with currency that have less purchasing power. 3. Expected inflation resulted in a considerably lower redistribution of income and wealth than unanticipated inflation.
Fixed-rate mortgage holders
According to Mark Thoma, a retired professor of economics at the University of Oregon, anyone with substantial, fixed-rate loans like mortgages benefits from increased inflation. Those interest rates are fixed for the duration of the loan, so they won’t fluctuate with inflation. Given that homes are regarded an appreciating asset over time, homeownership may also be a natural inflation hedge.
“They’re going to be paying back with depreciated money,” Thoma says of those who have fixed-rate mortgages.
Property owners will also be protected from increased rent expenses during periods of high inflation.