Which is Better: High or Low Inflation?

It would seem intuitively obvious that low inflation is good for consumers, because costs are not rising faster than their paychecks.

The problem with high inflation is that even with “cost of living” increases there is a time lag between when the cost of goods increases and when you get your raise. But recently commentators have been saying that “Low inflation introduces uncertainty”. This is nonsense. During the high inflation “Eighties” I remember commentators saying “High Inflation introduces uncertainty”. This is not quite true either. The truth is that steady inflation, whatever its level, if it can be relied upon to remain steady, does not introduce uncertainty. Changing (fluctuating) inflation rates is what causes uncertainty. So the transition from rising inflation prior to 2008 to falling inflation and even deflation is what caused the uncertainty.

Eliminating Uncertainty

Of course, whether inflation is high or low, there is no guarantee that it won’t go higher… or lower. So there is always some uncertainty. However, in an effort to eliminate uncertainty, the FED has set a target rate of a steady 2% inflation. It has not always been successful in achieving that goal because there are a variety of conflicting factors at play in a large economy and sudden shocks like a market crash can cause massive shifts in the money supply.

The Effects of Inflation

As inflation rises, in addition to businesses being forced to raise their prices, banks are forced to raise interest rates in order to maintain a profit margin and higher rates means that marginal businesses will fail, thus increasing unemployment and harming the overall economy. High inflation harms everyone not just because of increased costs and increased unemployment but also due to the time lag before you get a cost of living increase. High inflation also encourages people to spend money “before it loses its value” so they will buy things they don’t need simply as a method of preserving value. They also go into debt and fail to save. In the short run this can stimulate the economy but in the long run it will result in poor choices and a less than optimal economy as everyone becomes so short sighted that they fail to plan for the long run.

The Effects of Disinflation

Disinflation (decreasing inflation rates) encourages people to reduce high debt loads and become more financially responsible (as does a rising unemployment rate and job uncertainty). As inflation comes down it becomes less advantageous to carry high debt. When inflation rates are falling, people need to eliminate their debt because in real (inflation adjusted) terms it is becoming more expensive for them. Future dollars are no longer considered worthless, they now represent real money and need to be considered in your planning. Fortunately, since most loans are written with the expectation of a margin of profit over and above inflation… as inflation rates fall so do interest rates. Therefore, as inflation rates fall it is important to refinance your debts at lower interest rates thus reducing your debt servicing costs.

As inflation rates approach zero they finally reach a point where prices are no longer rising but are in fact falling and this is called deflation.

Deflation benefits low debt consumers and those on fixed incomes, because they receive a fixed number of dollars but can buy more with each dollar

Who benefits from Deflation?

Inflation encourages debt because you can pay it off with “cheaper dollars”… Deflation (falling prices) on the other hand can be downright disastrous for those with high debt, because their debt is in a fixed number of dollars but each dollar is more valuable than when the debt was first incurred.

The obvious short-term effect is that creditors with loans on their books benefit. They loaned money and are getting paid back with dollars that have a greater purchasing power. Conversely, borrowers spent money and now have to pay it back not only with interest but with more valuable money.

The down side is that in the long run banks will not make as many loans, because people tend to avoid debt if they feel it is in their best interests to save. So banks and the FED, prefer a low stable inflationary environment, where people are confident enough to borrow but where inflation is not high enough that people become fearful of inflation outstripping wage increases.

Deflation benefits low debt consumers and those on fixed incomes, because they receive a fixed number of dollars but can buy more with each dollar but deflation hurts individuals, businesses and governments with high debt loads.

Historically, the periods in our history with the lowest inflation have also been when our gross domestic product (GDP) has grown the fastest in terms of “Real Dollars”.

(Real Dollars are measured after prices are adjusted for inflation or deflation).

In addition to encouraging fiscal responsibility on the part of consumers, low but stable inflation (or even deflation) is also good for the long term economy, because it allows producers to know their costs. This predictability allows producers to generate reliable profits which will eventually result in a strong healthy economy.

High inflation is bad for the economy because economies built upon debt and encouraging consumers to go further into debt eventually crumble of their own weight. As more and more consumers get over burdened by debt, they declare bankruptcy, introducing uncertainty to the creditors and robbing them of their rightful income.

Somehow it is difficult to feel compassion for the “rich creditors” but everyone with a bank account is a creditor.

If you were uncertain about the value of the money you put in the bank, what would you do? You would probably be less likely to put money in. Banks feel the same way, if the chances of default increase, banks are less likely to make loans and that decreases the health of the overall economy.

Rapidly falling or rising inflation is usually a sign of a suffering economy with high unemployment and a lack of spending power (i.e. recession/ depression).

The Historical Inflation Rates show that even when we have had price deflation (falling prices) the country has been prosperous if the reason for the falling prices is that goods are being produced so economically that prices can fall and producers can still make a profit. This generally occurs after major productivity enhancements like the invention of the assembly line or the completion of the transcontinental railroad.

Disinflationary pressures in the late 1990s and early 2000s were most likely the result of unleashing cheap productive capacity in China and other former communist countries coupled with the deflationary forces of the 9/11 attack and the stock market crash.

Note: The deflationary period that began in late 2008 was the direct result of a collapsing stock market which destroyed trillions of dollars of paper “wealth”. This caused a “liquidity crisis” as millions of people’s liquid assets dried up. This forced them to cut back on expenditures and banks to refuse to loan to questionable borrowers. This type of deflation is not the same as a productivity induced deflation.