Should we be worried about inflation?

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.

Tagged as: bonds, economics, inflation