The inflation impact in four stages

The inflation impact in four stages
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First Published: Sat, May 17 2008. 12 40 AM IST
Updated: Sat, May 17 2008. 12 40 AM IST
What’s so bad about inflation? It may seem like a victimless disease—or even a tonic to deflationary pressure building in the global economy. But inflation is actually a scourge that will hurt lots of people. Here’s how the story will probably unfold, in four chapters.
The tale starts with the suffering of the naïve. Savers and investors don’t anticipate the dire effect that rising prices have on the value of the interest payments they receive. Inflation brings them real losses.
The experience then makes them less keen on saving in the future. That means less investment, and the whole economy loses out.
Sure, unexpected inflation gives borrowers a happy surprise. But easy repayments will only tempt them to add more debt in the future. That stores up trouble for the financial system, if inflation ever falls back.
The trouble isn’t limited to capital markets. Fixed incomes from pensions become shrinking incomes. That hurts old people who have to fend for themselves. Workers discover that constant pay actually means falling real incomes. And anybody who has signed a long-term contract to sell something finds expected profits melting away.
The next chapter is about coping. Everyone tries to keep ahead of inflation.
In capital markets, the basic strategy has two prongs—get protection and think short-term. Yields on long-term debt go up because lenders don’t want to be hurt if inflation rises even further.
Borrowers try to avoid paying this inflation-risk premium by moving to shorter maturities. All this financial manoeuvring discourages the sort of durable investments that keep economies strong.
Interest rates that are high enough to compensate for inflation risks are particularly tough on first-time home-buyers. They face punitively high mortgage payments in the early years of the loan.
Companies also have to divert a great deal of effort from actually producing to coping with inflation. Inventory management is a challenge. Reported profits are untrustworthy. Wages need to be adjusted frequently. Long-term planning is almost a waste of time.
Of course, inflation provides opportunities for clever people. Indeed, it becomes all too easy to make a fortune by taking advantage of other people’s inferior coping strategies.
Too many of the best and the brightest dedicate their time to such endeavours. Just look at all the millionaires who have profited from the last two decades of asset price inflation.
The third chapter is the wage-price spiral. For workers not to get caught out, they need wages to be indexed to the rising cost of living.
But higher wages automatically lead to higher prices—and then to yet higher wages. Such a wage-price spiral took inflation from 1% to 15% in the US between 1965 and 1980.
As the spiral picks up speed, the economy becomes more dysfunctional. Prices don’t tend to go up in a uniform way, but with many leads and lags. That makes business management a nightmare, as costs, revenues and profits all increase rapidly, but at different paces. It also makes inflation profiteering more attractive.
Politicians don’t help. They often give in to pressure to help whoever is currently losing out. But extra government spending only adds to the inflationary momentum.
The final chapter of this story begins when the authorities have had enough and decide to take the necessary action to cool the fever.
But the longer inflation has been raging, the more unpleasant the medicine—usually a combination of very high interest rates, a sharp recession and job losses.
When it is all over, the authorities may say that the eventual victory marks a happy ending. But it is a tale that should never have to be told.
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First Published: Sat, May 17 2008. 12 40 AM IST