One group of borrowers can count themselves as ‘lucky’ during periods of inflation.
Higher prices for rental cars, airplane tickets and uncooked beef roasts have economists and consumers wondering whether we’re living through the start of an inflationary period.
It remains to be seen whether these price hikes are just a temporary blip resulting from a pandemic-era mismatch of supply and demand or an indication of inflation, an uptick in prices that continues month after month across a broad array of goods and services. If the latter holds true, at least one demographic could benefit from the trend: anyone, including consumers and governments, that holds fixed-rate debt.
“Inflation could be this giant wealth transfer,” from lenders to borrowers, said Kent Smetters, the faculty director of the Penn Wharton Budget Model, which analyzes public policy proposals’ impact on the budget and economy. “A lot of the lenders are people with wealth and a lot of the borrowers are people without wealth. It’s the lenders who are going to take a bit of a bath, and the borrowers are going to get a discount on what they have to repay.”
Here’s how that might work:
Consumers’ assets go up while their liabilities go down
Underneath it all, an increase in wages drives an inflationary period. As prices rise, companies rush to hire more workers so they can produce more goods and take advantage of the price uptick. This wage increase makes companies 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 unit of money is essentially worth less than it was in the past. But consumers who took on a fixed-rate loan before the inflationary period started are only obligated to repay the amount of money they initially agreed to.
This group of borrowers is “lucky,” Smetters said because, “you’re going to be paying back those loans with weaker purchasing power dollars than what you borrowed.” Put another way: the money these borrowers are using to repay their loans buys less stuff than it did when they took the loan out.
There are major categories of consumer loans that may benefit from this dynamic. Federal student loans, which have an interest rate that’s fixed for the lifetime of the debt, private student loans that have a fixed interest rate (some private student loans use variable interest rates, which would shift with inflation) and fixed-rate mortgage loans.
“If you’re a borrower with a fixed-rate 30 year mortgage, that’s a classic inflation hedge,” Smetters said. “Presumably your house price will keep up at least a bit with inflation, but your fixed rate loan is not going to change.”
Student loans work similarly. Theoretically, a borrower’s wages will rise with inflation, but the amount they owe on their student loan won’t change.
“Your asset,” in this case your labor or human capital, “is essentially keeping up with inflation,” Smetters said. “But your liabilities,” or your student debt, “are getting wiped out, not completely, but still getting reduced by inflation.”
Still, inflation isn’t all good news for new borrowers. Anyone taking out a fixed rate loan going forward will probably face a higher interest rate that has inflation priced in. And with inflation comes economic volatility, so even borrowers benefitting from cheaper dollars may be at higher risk of facing unemployment and other challenges that can come during a period of macroeconomic shock, Smetters said.
In addition, even if borrowers are benefiting from an inflationary period, they may not see it that way.
“People’s views about whether or not inflation is good for them, tend to diverge from the ways economists think of it,” said Jesse Schreger, an associate professor of economics at Columbia Business School.
When economists think of inflation, they assume that when prices go up, wages will go up too. But when consumers, workers and borrowers think about it, they often don’t take into account that their wages may increase, Schreger said, which means they’re likely only internalizing the increase in prices.
“It’s not immediately clear that the people I would be most inclined to say would gain from inflation would actually want it,” he said.
The government will be giving its creditors less real stuff
It’s not just individual borrowers who can benefit from inflation, governments with debt do too. In fact, historically, some governments have forced their central banks to increase the money supply to reduce the value of each unit of money in the country — essentially creating inflation — in order to bring down the value of the nation’s debt.
This is not the strategy employed by monetary policy makers in the U.S., where the Federal Reserve keeps a close eye on inflation with an aim at keeping prices stable. (The Fed balances this goal with its other mandate, to keep employment relatively high.) Still, the U.S. government can benefit from inflation, at least as far as the value of its debt is concerned.
“The higher inflation is, the less real stuff the U.S. government is giving to its creditors when it repays,” Schreger said. Another way of looking at it, he said: the share of the U.S. economy’s output that would have to be put towards taxes in order to repay the debt is going to be lower, the higher inflation is.
Because inflation compounds, even a moderate, sustained uptick in inflation can “really erode the value of government debt,” with a long maturity, Schreger said.
“What really makes it easy for governments to repay their debt is when they have inflation that wasn’t expected by the market when their debt was issued,” he said. For example, anyone who bought a 10-year or 30-year Treasury bond three years ago probably wasn’t pricing in the risk of inflation.
Still, inflation does pose a risk to the government’s priorities. If prices and wages get too high, there is a possibility that the Fed could act to try to suppress inflation. The central bank would do this by raising short-term interest rates because that discourages companies, consumers and the government from investing.
That could both deter future government investment and push up the interest rates on new money the government borrows. The latter could put pressure on the government to find more resources to repay the new loans, either through increasing taxes or cutting spending.
Credits to: Jillian Berman