Media and fellow bloggers alike enjoy bemoaning the hazardous plague of inflation. The argument generally centers around the idea that inflation lowers the real rate of return and thus discourages savings at the expense of debtors. I will show that not only is this argument not grounded in reality, but that it also ignores many ancillary benefits of an inflationary rate: spending encouragement, debtor relief and avoidance of a deflationary spiral.
There is ample evidence that nominal interest rates (just the number) for different asset classes follow the inflation rate. This means that when inflation is high, the actual number that you will see on your savings rate, dividend yield or mortgage interest rate will reasonably follow. The economic reasoning behind this is simple: money will flow to the highest value and the purchases and sales of these assets (whether it’s CD’s, TIPS, bonds, stocks or real estate) should reflect expected return. Those who were purchasing a house during the early Volcker era are familiar with the concept of 18-22% mortgages and 16-19% CDs. Note to the wise: if you are still holding one of those mortgages, it may be time to refinance.
Inflation is generally seen as a way to relieve debtors and burden savers. While this may be true looking at the short-term, it allows shrewd investors and households to make wiser choices in regard to investments. Don’t consider me a Polyanna when it comes to the housing market, but inflation encourages personal leverage and can help jumpstart a lot of the lending industry, fueling growth in many aspects of consumer demand: auto, consumer discretionary, technology and housing. It seems disingenuous to instigate a call to arms when savings is discouraged but no acclaim when millions of mortgage holders are ‘relieved’ by 2-3% of their debt. The same argument could be made for the federal budget. With our current debt load at $15.7 trillion (!!!), a 3% inflation rate is essentially a $471 billion boon for our budget deficit. With a 0% inflation rate, $471 billion of ‘budget surplus’ is ignored. (Yes, the argument could be made that we are essentially compensating for this in our treasury yields held by Chinese government)
My last important note will be to compare the opposite policy: contractionary monetary policy. When recessions hit and interest rates naturally plummet, there is a risk that not enough money in the system will cause deflation. To those with savings, deflation may seem like a positive outcome: your dollars are naturally worth more tomorrow than they are today. But, the problem is much larger than that. If there is an incentive to not spend money at all (or even invest) since your money will appreciate then there will be no spending. This will force the economy to contract, further dampening the process. Also, since bank deposits naturally have a 0.00% floor on their deposits (who would put money in a bank paying -0.10% interest when they can keep it in their mattress?) then banks and financial institutions will lose their access to funding. This will further deleverage the economy, encouraging even less spending and more deflation. This is what is referred to as a deflationary spiral. One of the biggest examples in recent history is Japan’s lost decade. In short, Japan had not seen meaningful GDP growth for roughly 17 years (from 1991-2008) and only recently started to turn this around. An important point to note is that this followed Japan’s rapid expansion in real estate pricing. Sound familiar?
In conclusion, systemic, low inflation rates should be the goal of a properly function currency due to many of its positive effects, although excessive amounts would discourage savings to the point that there is no investment in the economy.