When Is Inflation Good?

Inflation, according to economists, occurs when the supply of money exceeds the demand for it.
When inflation helps to raise consumer demand and consumption, which drives economic growth, it is considered as a positive.
Some people believe inflation is necessary to prevent deflation, while others say it is a drag on the economy.
Some inflation, according to John Maynard Keynes, helps to avoid the Paradox of Thrift, or postponed consumption.

Inflation benefits who?

Inflation Benefits Whom? While inflation provides minimal benefit to consumers, it can provide a boost to investors who hold assets in inflation-affected countries. If energy costs rise, for example, investors who own stock in energy businesses may see their stock values climb as well.

What kind of inflation is beneficial?

The Federal Reserve has not set a formal inflation target, but policymakers usually consider that a rate of roughly 2% or somewhat less is acceptable.

Participants in the Federal Open Market Committee (FOMC), which includes members of the Board of Governors and presidents of Federal Reserve Banks, make projections for how prices of goods and services purchased by individuals (known as personal consumption expenditures, or PCE) will change over time four times a year. The FOMC’s longer-run inflation projection is the rate of inflation that it considers is most consistent with long-term price stability. The FOMC can then use monetary policy to help keep inflation at a reasonable level, one that is neither too high nor too low. If inflation is too low, the economy may be at risk of deflation, which indicates that prices and possibly wages are declining on averagea phenomena linked with extremely weak economic conditions. If the economy declines, having at least a minor degree of inflation makes it less likely that the economy will suffer from severe deflation.

The longer-run PCE inflation predictions of FOMC panelists ranged from 1.5 percent to 2.0 percent as of June 22, 2011.

Is inflation always beneficial?

Inflation isn’t always a negative thing. A small amount is actually beneficial to the economy.

Companies may be unwilling to invest in new plants and equipment if prices are falling, which is known as deflation, and unemployment may rise. Inflation can also make debt repayment easier for some people with increasing wages.

Inflation of 5% or more, on the other hand, hasn’t been observed in the United States since the early 1980s. Higher-than-normal inflation, according to economists like myself, is bad for the economy for a variety of reasons.

Higher prices on vital products such as food and gasoline may become expensive for individuals whose wages aren’t rising as quickly. Even when their earnings rise, higher inflation makes it difficult for customers to distinguish if a given item is becoming more expensive relative to other items or simply increasing in accordance with the overall price increase. This can make it more difficult for people to budget properly.

What applies to homes also applies to businesses. The cost of critical inputs, such as oil or microchips, is increasing for businesses. They may wish to pass on these expenses to consumers, but their ability to do so may be constrained. As a result, they may have to reduce production, which will exacerbate supply chain issues.

Why isn’t there any inflation?

Inflation has a variety of economic costs – uncertainty, decreased investment, and redistribution of wealth from savers to borrowers but, despite these costs, is zero inflation desirable?

Inflation is frequently targeted at roughly 2% by governments. (The UK CPI objective is 2% +/-.) There are good reasons to aim for 2% inflation rather than 0% inflation. The idea is that achieving 0% inflation will need slower economic development and result in deflationary problems (falling prices)

Potential problems of deflation/low inflation

Debt’s true value is increasing. With low inflation, people find it more difficult to repay their debts than they anticipated they must spend a bigger percentage of their income on debt repayments, leaving less money for other purposes.
Real interest rates are rising. Whether we like it or not, falling inflation raises real interest rates. Rising real interest rates make borrowing and investing less appealing, encouraging people to save. If the economy is in a slump, a rise in real interest rates could make monetary policy less effective at promoting growth.
Purchase at a later date. Falling prices may motivate customers to put off purchasing pricey luxury products for a year, believing that prices would be lower.
Inflationary pressures are a sign of slowing economy. Inflation would normally be moderate during a normal period of economic expansion (2 percent ). If inflation has dropped to 0%, it indicates that there is strong price pressure to promote spending and that the recovery is weak.
Prices and wages are more difficult to modify. When inflation reaches 2 percent, relative prices and salaries are easier to adapt because firms can freeze pay and prices – effectively a 2 percent drop in real terms. However, if inflation is zero, a company would have to decrease nominal pay by 2% – this is far more difficult psychologically because people oppose wage cuts more than they accept a nominal freeze. If businesses are unable to adjust wages, real wage unemployment may result.

Evaluation

There are several reasons for the absence of inflation. The drop in UK inflation in 2015 was attributed to temporary short-term factors such as lower oil and gasoline prices. These transient circumstances are unlikely to persist and have been reversed. The focus should be on underlying inflationary pressures core inflation, which includes volatile food and oil costs. Other inflation gauges, such as the RPI, were 1 percent (even though RPI is not the same as core inflation.) In that situation, inflation fell during a period of modest economic recovery. Although inflation has decreased, the economy has not entered a state of recession. In fact, the exact reverse is true.

Inflation was near to zero in several southern Eurozone economies from 2012 to 2015, although this was due to decreased demand, austerity, and attempts to re-establish competitiveness, which resulted in lower rates of economic growth and more unemployment.

It all depends on what kind of deflation you’re talking about. Real incomes could be boosted by falling prices. One of the most common concerns about deflation is that it reduces consumer spending. However, as the price of basic needs such as gasoline and food falls, consumers’ discretionary income/spending power rises, potentially leading to increased expenditure in the near term.

Wages that are realistic. Falling real earnings have been a trend of recent years, with inflation outpacing nominal wage growth. Because nominal wage growth is still low, the decrease in inflation will make people feel better about themselves and may promote spending. It is critical for economic growth to stop the decline in real wages.

Expectations for the future. Some economists believe that the decline in UK inflation is mostly due to temporary factors, while others are concerned that the ultra-low inflation may feed into persistently low inflation expectations, resulting in zero wage growth and sustained deflationary forces. This is the main source of anxiety about a 0% inflation rate.

Do we have a plan to combat deflation? There is a belief that we will be able to overcome any deflation or disinflation. However, Japan’s history demonstrates that once deflation has set in, it can be quite difficult to reverse. Reducing inflation above target is very simple; combating deflation, on the other hand, is more of a mystery.

Finances of the government In the short term, the decrease in inflation is beneficial to the government. Index-linked benefits will rise at a slower rate than predicted, reducing the UK government’s benefit bill. This might save the government a significant amount of money, reducing the deficit and freeing up funds for pre-election tax cuts.

Low inflation, on the other hand, may result in decreased government tax collections. For example, the VAT (percentage) on items will not rise as much as anticipated. Low wage growth will also reduce tax revenue.

Consumers are frequently pleased when there is little inflation. They will benefit from lower pricing and the feeling of having more money to spend. This ‘feel good’ component may stimulate increased confidence, which could lead to increased investment, spending, and growth. Low inflation could be enabling in disguise in the current context.

However, there is a real risk that if we get stuck in a time of ultra-low inflation/deflation, all of the difficulties associated with deflation would become more visible and begin to stifle regular economic growth.

Is inflation beneficial to stocks?

Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.

Is inflation harmful to the economy?

Higher prices on vital products such as food and gasoline may become expensive for individuals whose wages aren’t rising as quickly. Even if their salaries are rising, increased inflation makes it more difficult for customers to determine whether a given commodity is becoming more expensive relative to other goods or simply increasing in accordance with the overall price increase. This can make it more difficult for people to budget properly.

What applies to homes also applies to businesses. The cost of critical inputs, such as oil or microchips, is increasing for businesses. They may want to pass these expenses on to consumers, but their ability to do so may be constrained. As a result, they may have to reduce production, which will exacerbate supply chain issues.

Is low inflation beneficial to the economy?

In the case of declining oil prices, the motorist is unlikely to have much of a say in whether or not to purchase gasoline. Consider what would happen if the car’s price began to drop. Rather than buying a new automobile this year, why not wait until next year, when it would likely be hundreds of pounds cheaper? Inflation encourages people to buy earlier, which improves economic growth.

Is inflation beneficial or detrimental to savings?

Some savings accounts are index-linked, meaning they pay interest that follows inflation but may not necessarily match other interest rates.

When markets predict inflation to grow, these become more costly, therefore the overall return may not be higher than inflation.

The one guideline is that cash savings accounts aren’t the ideal long-term investments because the interest is nearly always lower than inflation, reducing your purchasing power.

Savings accounts are still useful, especially for money that has to be accessed quickly.

However, if you aim to save money for at least five years, investing may be a better option.

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.