The Federal Reserve (Fed) has at last acknowledged inflation, and it is taking steps – albeit very preliminary ones – to deal with it. Governments in other countries have admitted possible inflation problems, but most have taken no action. Unless the inflation in the U.S. goes away on its own (highly unlikely at this point), Washington will have to act. Both the inflation and Washington’s eventual response will affect all of our well-being, the extent and direction of which will depend on our personal circumstances. I’ll outline winners and losers here, first from the inflation itself, and then from Washington’s anti-inflation efforts.
From the Inflation
Inflation does its greatest damage to the value of anything with a fixed dollar price or return. When that price or return is allowed to vary, some things keep up with the rising cost of living, some outpace it, and some fall behind. Here is inflation’s impact on various sectors in society. Individuals, of course, can be in more than one sector.
- Bond holders are probably the biggest losers to inflation. Because bonds offer a fixed dollar payout (which is why they often carry the moniker, “fixed-income instruments”), inflation directly undermines the real buying power of what the bonds return. But there is more: because bonds have an eroding real value in an inflationary period, investors will flee them, depressing bond prices until the percentage of their return rises above the inflation rate. Here is an explanation of how bonds adjust: Bonds with a fixed dollar payment of, say, 3 percent of their purchase price will, in an inflation of, say, 7 percent, sink in value until that dollar payout amounts to 7 percent or more of the purchase price. Anyone who invested in bonds will suffer that value loss in addition to the loss of real purchasing power in the original dollar payout.
- Stockholders tend to lose in inflation, but after a time – sometimes a long time – they catch up. Initially, the uncertainty caused by the inflation and by turmoil in bond markets depresses stock prices. After companies adjust, however, profits catch up with inflation, and stock prices rise in tandem with the cost of living.
- Pensioners will lose in varying amounts during an inflation. Clearly, fixed dollar pensions lose because of the decline in the real buying power of that dollar amount. Some pensions – such as Social Security – have escalators that raise the dollar payout to keep up with inflation. These escalators moderate the real loss imposed by inflation, but even when that arrangement matches the inflation rate, it happens after the fact, so that the pensioner will be playing catch up for as long as the inflation lasts. As well, some pension plans adjust for inflation less completely than others.
- Wage earners tend to suffer from inflation in two stages. Inflation at first lowers the real buying power of their fixed-dollar paycheck. In time, if workers have bargaining power, they can negotiate wage hikes that compensate for their inflationary losses. But employers then raise their prices to compensate for the additional wages they must pay workers –– and the workers must come back again for further wage hikes to compensate for the latest increase in their cost of living. This “wage-price spiral,” as it is called, tends to sustain inflation. It also means that workers at best are always playing catch-up, and only when they have bargaining power.
- Property owners win during inflation. Real estate typically rises together with the cost of living, or even faster. Commodities – metals, construction materials, and the like – will do the same, while gold and other precious metals are the classic hedge against loss in an inflation.
- Borrowers, if their loan rate is fixed, also win during inflation: They have the use of someone else’s money to put into investments that presumably keep up with inflation and they can repay the lender in dollars that have less real buying power every year. And they can win doubly if they use the borrowed funds to invest in real estate, commodities, precious metals –– investments that can keep up with, or do even better than, inflation. But if the loan contract allows the rate to change from time to time (“float,” in financial jargon) then they lose the benefit of paying a fixed rate that decreases in real buying power each year.
From Policy Responses
Inflation typically prompts more restrictive monetary and fiscal policies. The Fed will try to raise interest rates abovethe inflation rate so that borrowers must pay a real cost for the funds they borrow and so will do less of the borrowing and spending that feeds inflationary pressure. For the same reasons, the government will try to reduce its spending which, when excessive, also feeds inflationary pressures. Governments will also raise taxes in order to slow individual spending and to close gaps in the federal budget. Keep in mind that such measures, even if ultimately successful, worsen the immediate ill effects of inflation on bond holders, stockholders, pensioners, and wage earners, and also blunt the benefits of inflation to property owners and debtors.
Bitesize Investing 