Brace yourself, inflation could lead to a “huge wealth transfer” from lenders to borrowers

Higher Prices for rental cars, airline tickets, and raw roast beef are making economists and consumers wonder if we are experiencing the beginning of inflation.

It remains to be seen whether these price increases are justified a temporary fade as a result of a mismatch between supply and demand during the pandemic or an indication of inflation, a rise in prices that continues month after month across a wide range of goods and services. If the latter is true, at least one demographic could benefit from the trend: everyone, including consumers and governments, holding fixed-rate debt.

“Inflation could be this gigantic transfer of wealth,” from lenders to borrowers, said Kent Smetters, faculty director of the Penn Wharton Budget Model, which analyzes the budgetary and economic impact of public policy proposals. “Many of the lenders are people with wealth and many of the borrowers are people without wealth. It’s the lenders that are going to take a dip, and the borrowers are going to get a discount on what they have to pay back.”

This is how it could work:

Consumer assets are increasing while their liabilities are decreasing

Beneath all this, a wage increase leads to a period of inflation. As prices rise, companies rush to hire more workers so they can produce more goods and take advantage of the price increase. This wage increase causes companies to charge more for their goods. Then workers demand higher wages and there can be a spiral, although we haven’t seen that since the 1970s.

The result is that a monetary unit is essentially worth less than it was in the past. However, consumers who took out a fixed-rate loan before the start of the inflationary period are only obliged to repay the originally promised amount.

This group of borrowers is “lucky,” Smetters said, because “they’re going to pay off those loans with weaker purchasing power dollars than they borrowed.” In other words, the money these borrowers are using to pay off their loans is going down Material purchased than when borrowing.

There are broad categories of consumer credit that could benefit from this dynamic. Government student loans, which have a fixed interest rate for the life of the debt, private fixed-rate student loans (some private student loans use variable interest rates that would shift with inflation), and fixed interest rates mortgage loan.

“If you’re a borrower with a 30-year fixed-rate mortgage, that’s a classic inflation hedge,” Smetters said. “Your home price will probably keep up with inflation at least a little bit, but your fixed rate loan won’t change.”

Student loans work similarly. In theory, a borrower’s wages will increase with inflation, but the amount they owe on their student loan doesn’t change.

“Your wealth,” in this case your labor or human capital, “essentially keeps pace with inflation,” Smetters said. “But your liabilities” or your student debt “will be wiped out, not entirely, but still reduced by inflation.”

Still, inflation isn’t just good news for new borrowers. Anyone who takes out a fixed-rate loan in the future will likely face a higher interest rate that has inflation priced in. And with inflation comes economic volatility, so even borrowers who benefit from cheaper dollars may be at greater risk of facing unemployment and other challenges during a period of macroeconomic shock, Smetters said.

Moreover, even if borrowers benefit from a bout of inflation, they may not see it that way.

“People’s views on whether or not inflation is good for them tend to differ from the way economists think about it,” said Jesse Schreger, associate professor of economics at Columbia Business School.

When economists think of inflation, they assume that as prices rise, so do wages. But when consumers, workers and borrowers think about it, they often don’t consider that their wages could rise, Schreger said, meaning they’re likely just internalizing the price hike.

“It’s not immediately clear that the people I would most likely say would benefit from inflation would actually want it,” he said.

The government will give its creditors less real stuff

Not only individual borrowers can benefit from inflation, but also governments with debt. Indeed, some governments have in the past forced their central banks to increase the money supply in order to decrease the value of every monetary unit in the country – essentially causing inflation – in order to reduce the value of the national debt.

This is not the strategy of policymakers in the US, where the Federal Reserve keeps a close eye on inflation to keep prices stable. (The Fed balances this goal with its other mandate of keeping employment relatively high.) Still, the US government can benefit from inflation, at least as far as the value of its debt is concerned.

“The higher the inflation, the less real stuff the US government gives its creditors when it pays back,” Schreger said. Another view, he said: the proportion of US economic output that would have to be used to pay back tax debts would decrease the higher inflation was.

Because inflation is compounded, even a modest, sustained rise in inflation “can really erode the value of long-dated government debt,” Schreger said.

“What makes it really easy for governments to pay off their debt is when they have inflation that the market wasn’t expecting when their debt was issued,” he said. For example, if you bought a 10- or 30-year government bond three years ago, you probably didn’t price in the risk of inflation.

Still, inflation poses a risk to government priorities. If prices and wages get too high, there’s a chance the Fed could act to try to quell inflation. The central bank would do this by raising short-term interest rates because that discourages businesses, consumers and the government from investing.

That could both discourage future government investment and push up interest rates on new money the government borrows. The latter could pressure the government to find more funds to pay off the new loans, either through tax hikes or spending cuts.

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