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Should we be worried about inflation? — Pop Economics

Should we be worried about inflation?

by Pop on October 2, 2010

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If you have debt, inflation is actually good for you.

Americans hate inflation. Past studies have shown that our happiness is inversely related to how high the inflation rate is. Yale economist Robert Shiller, in a study of Americans, Germans, and Brazilians, found that non-economists almost universally believe that inflation lowers their standard of living.

Even though most economists predict that wages should keep up with inflation, non-economists believe in a “sticky wage” model, in which wages don’t rise even as prices do.

Of course, retirees, the unemployed, and anybody else relying on a fixed income should rightly be fearful of inflation, as it erodes the value of their savings. On the other hand, people with debt should be pretty happy if inflation strikes. While their wages rise with inflation, their debt stays about the same, making it easier to pay it off.

That’s also what some investors think will be the story of the U.S. government and its own debt. While raising taxes is almost universally despised by the public and politicians, inflation is a “hidden tax”.

Rather than pay its debt by taking money out of your pocket in a direct way, the government can print more dollars to pay its debt. Some investors and economists have gone so far as to say we need high inflation to get out from under trillions in dollars of debt.

First, the big disclaimer: Right now, we’re much closer to deflation than inflation—a much scarier problem that marked the Great Depression. I’ve written before about inflation-fighting tools, but I think it’s worth taking a look at what rapid inflation might actually look like for your personal finances.

For young earners, inflation might not be so bad.

As I wrote before, for people still toward the beginning of their earning years, rapid inflation shouldn’t have a large impact on their standard of living. Of course, this assumes that wages rise along with prices. How likely is that to happen?

In the late 1970s and early 1980s, inflation hit double digits. This is why some of you 30-year olds have parents who remember mortgages with 15% interest rates.

But here’s the thing, during those high inflation years, people also got outsized raises. The nominal (not inflation-adjusted) median income rose almost 8% between 1979 and 1980. This didn’t keep up with inflation—the real (inflation-adjusted) median wage fell 3%. But it wasn’t nearly as bad as a 14% inflation rate would suggest. By 1986, wages had caught up with inflation, and people were in just as good a shape as they were in 1979.

So maybe it’s good to say that wages are “kind of” sticky. It takes a little time for corporations to pass off high prices to their employees. It’s certainly not a permanent damper on standards of living though.

For those with big nest eggs, it’s a problem.

That is, if your savings aren’t keeping up with inflation.

Even though earners should theoretically get wage increases as their employers pass on gains from high prices, those living off savings don’t get that benefit. Instead with a 10% inflation rate, their $1 million nest egg suddenly has the spending power of $900,000—and so on, as inflation continues every year.

Of course, your investments are supposed to try to keep up with that trend. But in periods of especially high inflation, stocks have performed pretty poorly. It’s not that stock returns don’t eventually make up for inflation. It just takes a while.

Bonds do even worse. When interest rates rise, the value of bonds (and bond mutual funds) can drop precipitously. To see your exposure to this, you can take a look at your bond funds’ “average duration”. The Vanguard Total Bond Market Index Fund, for example, has an average duration of 4.3 years. This, roughly, means that for every 1% increase in interest rates, the fund’s value will drop 4.3%.

So if interest rates rose to the 14% or 15% that we saw in the late 1970s, the fund would theoretically lose more than half its value. (In reality, with extremely large swings in interest rates, durations are less precise, but suffice it to say, the fund price would drop by a lot.)

The price of gold—the inflation/disaster hedge du jour—has been more mixed in times of inflation. A lot of its rise happens in anticipation of inflation. The bottom line is that the price of gold, at $1,300 an ounce is still below its inflation-adjusted price in 1980 ($2,251). Not exactly a perfect inflation hedge.

All this is to say that savers don’t have many options. If they had the foresight to buy TIPS, they might be protected, but otherwise, a huge portion of their savings is thrown onto shaky ground.

Debtors should rejoice.

It’s not just the U.S. government that sees its debt devalued by the arrival of high inflation. Regular old schmoes with high debt also benefit.

Let’s say you have $300,000 in mortgage debt with a 6% fixed interest rate. If inflation skyrockets, and interest rates rise to 10%, your wages should theoretically keep up within a couple years. Suddenly your mortgage payment, which stays at about $1,800, look much less daunting.

That led John Paulson, a prominent hedge fund investor who made billions off the financial crisis, to tell members of the University Club in New York to run out and buy houses. Writes the Wall Street Journal: “If you don’t own a home, buy one,” he reportedly said. “If you own one home, buy another one, and if you own two homes buy a third and lend your relatives the money to buy a home.”

A lot more can go on behind the scenes that makes incredibly high inflation bad for the economy as a whole. If the U.S. went through a period of huge inflation, some countries might decide not to lend to the U.S. as liberally as they have in the past. But on the personal finance front, the bottom line is that we shouldn’t think of inflation as a universally bad phenomenon, and depending on your situation, it might actually benefit you in ways you might not have considered.

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{ 8 comments… read them below or add one }

Derek Illchuk October 3, 2010 at 10:23 am

Pop, great blog! I’ve gone through your archives, and I’d recommend that to others.

Now, regarding your talk of a bond fund losing value due to interest rates, do you have a real-life example? We all “know” that bonds lose value when rates increase, but that’s not really a loss since, if we sell, we can buy the new bonds with a higher rate and we’ll end up making about the same that we expected way back in the beginning anyway. (Or, we can just not sell, and carry on with our original bond as agreed.)

So, provide an example please, without hypotheticals.

Pop October 3, 2010 at 11:11 am

@Derek Hey, thanks.

You’re right that if you own individual bonds and hold them to maturity, you’ll get your principal back as long as the company doesn’t default. But if you sell before the maturity date, the investor you’re selling to will need a discount on the bond to make up for increasing interest rates.

So let’s say you have a $1,000 bond that matures in 2020 and pays $50 per year (5% interest), and then interest rates climb by 5 percentage points. An investor isn’t going to be willing to pay $1,000 to buy the bond from you. He’s going to want a discount on the bond that lets him earn at least 10% per year. That’s why bond prices drop when interest rates go up. Between 1973 and 1981, for example, investors in 20-year government bonds would have seen the value of their bonds drop 44%.

If they held to maturity (the early 90s), they would have gotten a subpar interest rate but would have lost no principal. If they sold in 1983, they would have had to take that haircut on the principal.

Bond mutual funds—which hold hundreds of bonds that all mature at different dates—don’t have a maturity date. So there’s no time when you’re guaranteed to get back your principal.

We’ve been in a really long trend of declining interest rates, but for an example of a bond mutual fund dropping in value, look here: http://quote.morningstar.com/fund/f.aspx?t=LSBRX

More than half of that fund is in corporate bonds. So in late 2008, when everybody thought companies were going to go bankrupt all over the place, investors started requiring very high interest rates on corporate bonds. As a result, that fund, which had corporate bonds maturing decades from now, lost 25% of its value at the trough.

Barry October 3, 2010 at 11:58 am

Pop
Nice post
I sit here and wonder as we stare into the abyss which option is preferable. Deflation is an animal not easily tamed that can wreak much havoc while free. The lag
Time of wage increases in an inflationary environment can be devastating to many who are already on the edge .I particularly recall a conversation with a friend whose family endured hyper inflation in Brazil . Going forward things are going to be interesting

Rob Bennett October 3, 2010 at 2:53 pm

I’m no fan of inflation.

I can see how inflation is good for debtors. But that leads me to believe that inflation encourages debt. The appeal of saving money is less when money is losing value over time.

I have long believed that part of the reason we have inflation is that it makes it easier for us to con ourselves into thinking we are moving forward in our careers even when we are not. Our salaries go up each year. But they are not going up for a good number of us after inflation is factored in.

I don’t think it is entirely coincidence that our days of greatest growth (the post-war years up to about 1972) were years of low inflation.

Rob

Norman October 4, 2010 at 12:11 pm

Yes, I think we should be worried about inflation! As our national debt increases, the more I fear inflation. As you stated “Rather than pay its debt by taking money out of your pocket in a direct way, the government can print more dollars to pay its debt. Some investors and economists have gone so far as to say we need high inflation to get out from under trillions in dollars of debt.” As we speak, I believe our government is printing money like its going out of style. At some point, we as a nation will have to get our debt under control…before we have hyper-inflation due to the decrease in the value of our dollar. Its amazing to me how many different economic scenarios could play out…I just hope it works in MY favor! I am just going to keep it simple and do what’s right for me and keep plugging away at paying off my mortgage so I’m debt free before I retire and keep socking money away for retirement.

magnoliabel October 9, 2010 at 5:49 am

Inflation is a cancer that robs people wealth. With all fiat currency you have inflation and debt that destroys the economy. People don’t understand that inflation is just another tax put on them by their government. If people understood this tax this country would go back to a gold.

David Binkowski February 19, 2011 at 1:03 pm

Debt is never preferable to having no debt, in my humble opinion. If you can’t afford to get out of debt, then this makes an nice rationalization that inflation is “good” for debtors. Its certainly “okay” for FIXED interest debtors and yes if inflation hit I’d probably take out a big fixed loan and buy silver with it before devaluation took place. IF I could get a fixed interest loan. Certainly. Variable interest, no. Ever hear of fixed interest credit cards any more? Anyone still got a 3.9% or 4.9% Capital One card? Whats in your wallet? Mine changed to variable and I suspended it under the old rules. I paid the balance off and closed it. I then proceeded to take a 401K loan out (which is 5% interest I pay back to myself) and I paid off all my other cards in one swipe… Ask any rich person how much debt they carry, and why they aren’t increasing their debt since inflationary times are ahead. It always pays to be on the receiving side of interest, i.e. “The miracle of compound interest”. You don’t want that working against you no matter how high or low rates are.

Buy bond funds while the rates are high and the bonds are cheap, with the cash you saved up from not being in debt, buy the bonds and live off the 8% to 15% yield (depending where you bought them). And if bonds get cheaper buy more. Thats what I’m going to do when rates get high again.

Brandon August 18, 2011 at 1:19 am

Some of the most asinine s*** I’ve ever heard in a long time. I’ve got news for you when the full effects of QE1, QE2, and comming soon to a political theater near you QE3 gets underway, we will have serious inflation, and there will be no jobs so therefore wages WILL NOT go up.

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