Inflation, the persistent rise in the general price level of goods and services, is an enduring economic reality. The effects of Inflation quietly punctuate our financial lives, subtly influencing decisions and shaping economic landscapes. With an average annual rate of 3.27% in the United States between 1914 and 2022, it is a fundamental aspect of our financial structure that cannot be ignored.
However, the implications of inflation are not uniform. They vary depending on the rate and intensity of the inflationary environment. There are the impacts of “typical” inflation, and then there are the ramifications experienced during periods of exceptionally high inflation. Each has distinct effects on consumers, investors, and the broader economy.
In this guide, we discuss the significant effects of inflation. We delve into how it influences everyday life, the world of investment, and the health of the overall economy. A thorough understanding of these effects is critical for financial planning and economic prediction.
The causes of inflation
The following are some of the causes of inflation
- Demand-Pull Inflation: This phenomenon occurs when demand for goods and services outpaces their supply. If consumers suddenly possess more disposable income, increased purchasing can push businesses to their production limits. Unable to meet the high demand, businesses frequently react by raising their prices, resulting in demand-pull inflation;
- Cost-Push Inflation: Cost-push inflation arises when the costs of production escalate due to factors such as wage hikes, increased prices for raw materials, or heightened taxes. To maintain profit margins, businesses transfer these extra costs onto consumers by escalating their prices, leading to cost-push inflation;
- Monetary Inflation: Monetary inflation is a consequence of an excessive money supply within an economy. When central banks increase the money in circulation, the relative value of each monetary unit tends to decrease. Consequently, more money is required to purchase the same goods, leading to inflation;
- Government Policies: Certain government policies can inadvertently fuel inflation. When a government’s expenditure surpasses its revenue, it may resort to deficit financing or print more money to bridge the gap. This action expands the money supply, potentially triggering inflationary pressures;
- Speculative Behavior: Speculation in asset markets, such as real estate or stocks, can also induce inflation. If investors anticipate future price rises, they may engage in speculative buying, inflating prices in the process. This speculative behavior can result in “asset price inflation,” which can, in turn, influence overall inflation levels.
The 5 most common effects of inflation
The following are some of the effects of inflation on consumers and the economy.
1. Inflation erodes purchasing power
As prices rise over time, inflation erodes the purchasing power of consumers. Regardless of the inflation rate, a fixed amount of money can afford progressively less consumption. This means that consumers lose purchasing power, and compounding ensures that the overall price level increases even more if long-run inflation doubles.
The Consumer Price Index (CPI) and the PCE Price Index are commonly used indicators to measure inflation. (Board of Governors of the Federal Reserve System, “2020 Statement on Longer-Run Goals and Monetary Policy Strategy”)
2. Inflation disproportionately impacts lower-income consumers
Lower-income consumers bear the brunt of inflation’s impact due to spending a higher proportion of their income on necessities. With a smaller cushion against the loss of purchasing power, they are more vulnerable.
Core inflation, which excludes energy prices and food often used for analysis, may not reflect the reality for lower-income earners who spend a significant portion of their budget on these essential commodities.
Additionally, those with limited assets like real estate may lack traditional inflation hedges. However, Social Security benefits and federal transfer payments receive cost-of-living adjustments based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
3. Inflation feeds on itself when it’s high
When inflation rates are high and persistent, it can set off a self-reinforcing mechanism. As inflation remains elevated, it can shape and heighten expectations of further inflation in the future. This dynamic leads to workers pushing for substantial wage increments. To offset these rising labor costs, businesses respond by elevating their prices, instigating a wage-price spiral.
It’s imperative to understand that while instances like Zimbabwe’s hyperinflation or the Weimar Republic are outliers, the U.S. experienced its own challenges. During the 1970s, heightened inflation expectations pushed the annual inflation rate past 13%, with the federal funds rate exceeding 20%. The fallout saw significant unemployment in the subsequent recessions.
4. Inflation’s direct impact on interest rates
Central banks and governing bodies are constantly monitoring and managing inflation levels. If inflation rises towards or breaches predetermined targets, a common response is to elevate interest rates as a countermeasure. The rationale behind this is to restrict the money supply, which in turn increases borrowing costs throughout the economy.
Historically, interest rates and inflation have displayed a parallel movement. By lifting interest rates, central banks aim to temper economic activity and mitigate escalating price pressures. This maneuver, while essential for stability, increases the borrowing expenses for both individuals and businesses, directly affecting the cost of loans and bond yields.
5. Inflation’s diminishing effect on debt service costs
On the surface, it may seem counterintuitive, but inflation can present a favorable scenario for those servicing fixed-rate debts, such as traditional mortgages. With inflation in play, these borrowers effectively repay their loans with devalued currency, leading to a reduction in the real value of their outstanding debt over its tenure.
To illustrate, if a borrower secures a loan at a 5% interest rate and subsequent inflation rates climb to an annual rate of 10%, the real burden of the loan—when adjusted for inflation—diminishes at a rate that exceeds the initial interest costs. However, this silver lining does have its limits. Borrowers with adjustable-rate mortgages, credit card debts, or home equity lines of credit may not experience this advantage, as lenders possess the capability to recalibrate interest rates in alignment with prevailing inflation and central bank rate adjustments.
Inflation exerts a significant influence on individuals and economies alike
With a sound understanding of the effects of inflation, individuals can make informed financial decisions, and policymakers can implement effective strategies. From eroding purchasing power to shaping interest rates and debt service costs, inflation permeates various aspects of our lives.
For individuals, awareness of inflation’s erosion of purchasing power helps in budgeting and planning. Considering its impact on investments, savings, and debt management enables individuals to make sound financial choices.
Policymakers, on the other hand, play a vital role in monitoring and addressing inflation through appropriate measures. By employing effective monetary policies, they can strive to maintain stable prices, foster economic growth, and safeguard the well-being of individuals and businesses.