Inflation has risen to levels not seen in decades. While we aren’t quite at the point where we were in the 1970sand we may hope that the Federal Reserve will restore control before we get therethere are still plenty of reasons to be concerned about inflation.
Inflation is typically defined as a general increase in prices that reduces the purchasing power of our money. Workers effectively take a pay cut when the price of goods and services rises faster than earnings. Those who save and get interest payments both lose out. When the value of money saved is depreciated due to inflation, it loses its purchasing power.
Of course, salaries and interest rates will ultimately adjust, but for many people and businesses, the wait can be excruciating.
Moreover, while the tax law has improved since the 1970s, it still contains various characteristics that interact with inflation to penalise people unfairly. When there is inflation, for example, investments and savings can be taxed away. Former President Trump’s senior economist, Larry Kudlow, outlined the issue for capital gains as follows:
“You put $1,000 into an investment and sell it for $1,200 after ten years. However, if inflation averaged 2.5 percent throughout that time, the $1,200 you receive will be worth less than the $1,000 you invested in real terms. Despite this, you will be taxed on your $200 capital gain under existing law.”
Tax specialists have well-documented this occurrence. Inflation’s punishing effect on firms is the same. They must follow a depreciation plan as the money loses value, rather than fully and immediately deducting investment expenditures from their taxes. “If a corporation spends $39,000 on a building, the $1,000 deduction in year 39 is worth a lot less than the $1,000 deduction in year 1,” two Tax Foundation researchers explained.
When inflation occurs unexpectedly, however, not everyone loses. Debtors, for example, can return their loans in less worth dollars. No one benefits more than the United States government, which is the world’s largest debtor. Consider the following scenario: With cumulative inflation of 6.8% over the past year, the value of Uncle Sam’s roughly $24 trillion debt to the public has become less burdensome, notwithstanding Congress’s lack of fiscal restraint.
Inflation has been used by monarchs and governments throughout history to decrease debt obligations. Holders of debt bonds are understandably concerned when heavily indebted governments take too long to rein down inflation.
Inflation can also help people who have fixed-rate mortgages and other loans. If the trend continues, interest rates may begin to rise to compensate, as they did in the 1970s. Everyone who owes money with adjustable interest rates will see their payments increase if this happens. Borrowers could rapidly find themselves owing a lot more depending on how quickly rates and inflation rise.
The federal government, like everyday debtors, might suffer a financial crisis. Our debt has a one-year maturity of $6 trillion, or 25% of our total debt. That sum needs to be paid back and borrowed every year or so. If inflation continues, creditors will demand greater loan rates the next time around. Given the scale of our national debt, even a minor increase could result in considerably higher interest payments.
According to the Congressional Budget Office, the Treasury Department will have to pay somewhere around $5.4 trillion in interest payments over the next decade. A 1% increase in interest rates would add $250 billion per year to that total. The federal government does not currently have this money and would have to borrow it at higher interest rates.
To put it another way, inflation, when combined with the massive government debt and short-term financing, might have disastrous effects. This danger should serve as a strong motivator to clean up America’s finances, particularly moving away from short-term borrowing. But no one appears to be willing to make the difficult decision thus far.
While these are just a few of the issues that inflation causes, they all have significant, long-term consequences for real individuals. It’s something else to consider before committing to more aggressive, costly government programs.
What happens if inflation isn’t managed properly?
) Hamed Mokhtar, Managing Director of Fortress Investments, recently spoke to investors on the hazards of unchecked inflation and the risks it poses to economic recovery. The cost of living, the cost of doing business, bond yields, and the cost of borrowing money are all affected by inflation, which is defined as an increase in prices. If inflation is left unregulated and rises too quickly, it is harmful to economic recovery because as the cost of things rises, savings are lost and purchasing power is diminished. The economy may suffer if inflation rises too high; on the other hand, if inflation is kept under control and at normal levels, the economy may flourish. When inflation is kept under control and reduced, employment rises, customers have more money to spend on goods and services, and the economy benefits and expands.
When inflation gets out of hand, what do you call it?
Hyperinflation is a phrase used to describe an economy’s rapid, excessive, and out-of-control price increases. While inflation is a measure of the rate at which prices for goods and services rise, hyperinflation is when prices rise at a rate of more than 50% each month.
What happens if inflation becomes too high?
If inflation continues to rise over an extended period of time, economists refer to this as hyperinflation. Expectations that prices will continue to rise fuel inflation, which lowers the real worth of each dollar in your wallet.
Spiraling prices can lead to a currency’s value collapsing in the most extreme instances imagine Zimbabwe in the late 2000s. People will want to spend any money they have as soon as possible, fearing that prices may rise, even if only temporarily.
Although the United States is far from this situation, central banks such as the Federal Reserve want to prevent it at all costs, so they normally intervene to attempt to curb inflation before it spirals out of control.
The issue is that the primary means of doing so is by rising interest rates, which slows the economy. If the Fed is compelled to raise interest rates too quickly, it might trigger a recession and increase unemployment, as happened in the United States in the early 1980s, when inflation was at its peak. Then-Fed head Paul Volcker was successful in bringing inflation down from a high of over 14% in 1980, but at the expense of double-digit unemployment rates.
Americans aren’t experiencing inflation anywhere near that level yet, but Jerome Powell, the Fed’s current chairman, is almost likely thinking about how to keep the country from getting there.
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Prices for used cars and trucks are up 31% year over year. David Zalubowski/AP Photo
Is it possible for inflation to become uncontrollable?
NEW YORK (AP) President of the Federal Reserve Bank of St. Louis, James Bullard, warned on Thursday that without central bank action on interest rates, inflation might worsen.
During a panel discussion at Columbia University, he observed, “We’re at more risk now than we’ve been in a generation that this may get out of control.” “One scenario would be… a new surprise that we can’t predict right now, but it would result in even greater inflation. That’s the kind of circumstance we want to avoid at all costs.”
What is creating 2021 inflation?
As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.
Is it critical to keep inflation under control?
Expectations have a critical role in economic well-being, as evidenced by Federal Reserve Chairman Alan Greenspan’s management of interest rates to regulate the stock market and the economy. Economists have learnt a lot about how interest rates can help keep inflation at bay in recent years. Now, economist Peter Henry of Stanford Business School has gathered further evidence to back up his claim that expectations matter and that inflation can be successfully handled.
When double-digit inflation plagued the US economy in the early 1980s, orthodox economists believed that any attempt to reduce inflation would necessarily result in a recession. The reasoning was that raising interest rates to lower inflation would come at a considerable cost in terms of weaker economic growth. Businesses would lose money, unemployment would rise, and a recession would loom.
In contrast to the traditional perspective, some economists have claimed that if policymakers can influence the public’s expectations about inflation, inflation can be decreased with few short-term costs. If policymakers commit to lowering inflation, the public will believe them, and inflation will fall without causing the economy to stall dramatically. Because government actions firmly set expectations, countries in post-World War I Europe offer case studies of countries that quickly halted massive inflation rates with essentially no loss to output. Other research have found that while trying to combat excessive inflation, a number of emerging economies enjoyed economic booms.
So, which viewpoint is the correct one? Neither point of view, according to Henry, an associate professor of economics, addresses the most crucial question: Do the long-term benefits of lowering inflation exceed the short-term costs? Economists have been so preoccupied with calculating costs that they have failed to consider whether the benefit of lower inflation outweighs the effort required to achieve it. Henry assesses the net consequences by looking at the stock market.
Changes in stock prices, he says, reflect changed expectations about future company profits and interest rates in a well-functioning and rational stock market. In order to keep inflation under control, policymakers may need to hike interest rates and cut profits in the short term, which is terrible for the stock market. Reduced inflation, on the other hand, may boost future earnings and lower interest rates, which is beneficial for the market. As a result, the stock market’s reaction to the announcement of a program aimed at lowering inflation determines whether the benefits of lowering inflation outweigh the drawbacks.
Over a 20-year span ending in 1995, Henry built a database on 81 different episodes of inflation in 21 rising economies, including Chile, Argentina, Indonesia, and Mexico. He found 25 instances in which inflation was greater than 40%. During those occurrences, the median inflation rate was 118 percent. The median rate of inflation in the moderate group of inflation events he looked at was 15%.
When countries attempted to moderate rising inflation, Henry discovered that the stock market rose by an average of 24%. To put it another way, lowering excessive inflation has a significant beneficial impact on the stock market. He discovered, on the other hand, that lowering mild inflation had no influence on the stock market. He also discovered that the stock market’s reaction to attempts to stabilize inflation is a good predictor of future inflation and economic development. In other words, a positive stock market reaction to inflation stability foreshadows future lower inflation and quicker economic growth, and vice versa.
Inflation rates in the United States are not as high as they are in emerging nations. So, how does Henry’s work relate to the American economy? “What our research implies is that there is validity to the story that expectations matter a lot,” Henry says, saying that managing stock market expectations appears to be a key aspect of managing the American economy at the time. Emerging economies, on the other hand, have the most dramatic examples of expectation-setting. In Peru, for example, inflation reached 344 percent in 1989. A new government was elected the next year, fresh policies were introduced, and inflation fell to 44 percent by 1991. The real GDP increased by 6.7 percent.
“This research shows that reducing high inflation has distinct repercussions for the economy than reducing moderate inflation,” Henry adds. People appear to assume that lowering high inflation will have significant long-term advantages and almost no short-term drawbacks. The presumption appears to be that the advantages of moderate inflation reduction will not outweigh the drawbacks.”
“The findings give crucial new evidence that high and moderate inflation create quite distinct policy difficulties,” he says. More broadly, it shows that carefully examining the relationship of the stock market and the real economy can yield a wealth of useful information.” Indeed, Henry just received a five-year, $250,000 grant from the National Science Foundation to continue his research on the financial and economic implications of policy reform in emerging nations.
What happens to debt in a hyperinflationary environment?
For new debtors, hyperinflation makes debt more expensive. As the economy worsens, fewer lenders will be ready to lend money, thus borrowers may expect to pay higher interest rates. If someone takes on debt before hyperinflation occurs, on the other hand, the borrower gains since the currency’s value declines. In theory, repaying a given sum of money should be easier because the borrower can make more for their goods and services.
What is the best way to recover from hyperinflation?
Extreme measures, such as implementing shock treatment by cutting government spending or changing the currency foundation, are used to terminate hyperinflation. Dollarization, the use of a foreign currency (not necessarily the US dollar) as a national unit of money, is one example. Dollarization in Ecuador, for example, was implemented in September 2000 in response to a 75 percent drop in the value of the Ecuadorian sucre in early 2000. In most cases, “dollarization” occurs despite the government’s best efforts to prevent it through exchange regulations, high fines, and penalties. As a result, the government must attempt to construct a successful currency reform that will stabilize the currency’s value. If this reform fails, the process of replacing inflation with stable money will continue. As a result, it’s not surprising that the use of good (foreign) money has completely displaced the use of inflated currency in at least seven historical examples. In the end, the government had no choice but to legalize the former, or its income would have dwindled to nil.
People who have experienced hyperinflation have always found it to be a horrific experience, and the next political regime almost always enacts regulations to try to prevent it from happening again. Often, this entails making the central bank assertive in its pursuit of price stability, as the German Bundesbank did, or changing to a hard currency base, such as a currency board. In the aftermath of hyperinflation, several governments adopted extremely strict wage and price controls, but this does not prevent the central bank from inflating the money supply further, and it inevitably leads to widespread shortages of consumer goods if the limits are strictly enforced.
What do you do with cash in a hyperinflationary environment?
“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.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
Is inflation capable of causing a depression?
Low inflation typically indicates that demand for products and services is lower than it should be, slowing economic growth and lowering salaries. Low demand might even trigger a recession, resulting in higher unemployment, as we witnessed during the Great Recession a decade ago.
Deflation, or price declines, is extremely harmful. Consumers will put off purchases when prices are falling. Why buy a new washing machine today if you could save money by waiting a few months?
Deflation also discourages lending because lower interest rates are associated with it. Lenders are unlikely to lend money at rates that provide them with a low return.