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Is Inflation Good? Why There are Positive Effects of Inflation

June 27th, 2012 by 
CameronDaniels
Helium balloons in the air flying away

Inflation gets a bad rap. Generally, people argue inflation lowers the real rate of return and thus discourages savings at the expense of debtors. On the contrary – inflation is good

Well, at least sometimes. In moderate doses.

Assets Tend to Track Inflation

There is ample evidence that nominal interest rates for different asset classes really follow the inflation rate. When inflation is high, your savings account interest rate, dividend yield or mortgage interest rate will reasonably follow the trend. Ditto for when inflation is low - you won't see much return.

The economic reasoning is simple: money will flow to the highest value.

The purchases and sales of these assets (whether CDs, TIPS, bonds, stocks, or real estate) should reflect expected return – including what the market expects in inflation.

Inflation and Debt

During the early Volcker era, it wasn't unheard of to see 18-22% mortgages and 16-19% CDs.

Inflation is seen as a way to relieve debtors and burden savers. While this is true in the short-term, it also allows shrewd investors and households to make wiser choices in regard to investments.

It's disingenuous to instigate a call to arms over discouraged savings without acclaim for the relief of the collective burdens of debt.

That argument applies both to individual investors and the Federal government. At our current debt loads, every percentage in inflation is a pretty large windfall for the Treasury - the amount of nominal dollars owed doesn't drop, but it's easier to pay off debt with current money. With a 0% inflation rate the government and individual savers are stuck paying dollars worth the same as they were the previous year.

Positive Effects of Inflation

What's good for a country and consumers (sometimes a subset) often differs. For instance, it's often useful for a government to encourage spending and relieve debt burdens through inflation at the expense of savers.

Gross Domestic Product relies on people spending money on goods and services, not saving it. (Although saving takes different forms - in whole, saving is good). Inflation encourages personal leverage and spending.

That spending can jumpstart spending in a number of industries:

  • Auto
  • Consumer discretionary
  • Technology
  • Housing

and, of course, a number of others.

To summarize, moderate, predictable inflation is good for quite a few things. Chief among them:

  • Spending encouragement
  • Debtor relief
  • Avoidance of a deflationary spiral

More on that last one in a second...

Deflation is Worse than Inflation

The last important note on inflation will compare it to the alternative: deflation. When central banks encourage inflation we call them expansionary. In the opposite scenario when central banks encourage deflation we say they have a contractionary monetary policy.

When recessions hit and interest rates plummet, not having enough money in the system causes deflation.

To savers, deflation may seem a positive outcome: your dollars are worth more tomorrow than they are today. However, the problem is much larger than that.

If there is an incentive to not spend money since your money will appreciate then there will be a dearth of spending!

During deflation, the economy will contract, making things even worse. We might hit the 0% lower bound on interest in your bank account (again). Banks and financial institutions will lose their access to funding. The economy will rapidly deleverage, encouraging even less spending... and ever more deflation as scarce dollars have increasing demand.

This process is known as a deflationary spiral.

Deflation Example: Japan

One of the biggest examples of deflation in recent history is Japan’s lost decade. In short, Japan did not see meaningful GDP growth for roughly 17 years from 1991-2008. This came immediately after Japan’s rapid expansion in real estate pricing.

Low, Moderate Inflation is Good

In conclusion, systemic, moderate inflation rates should be the stated goal of a properly functioning monetary regime. Inflation has many positive effects.

Of course, excessive amounts of inflation discourage savings to the point that there is zero investment in the economy. But, yes, on the whole inflation is good.

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