Why inflation could create a ‘giant wealth transfer’ from lenders to borrowers – About Your Online Magazine


Higher prices for car rentals, airline tickets and raw roast beef, economists and consumers are asking whether we are living in the beginning of an inflationary period.

It remains to be seen whether these price increases are just a temporary dot resulting from a pandemic-era mismatch of supply and demand or an indication of inflation, an increase in prices that continues month after month across a wide range of goods and services. If the latter is true, at least one demographic group could benefit from the trend: anyone, including consumers and governments, who has fixed-rate debt.

“Inflation could be this giant transfer of wealth” from lenders to borrowers, said Kent Smetters, director of the Penn Wharton Budget Model, which analyzes the impact of policy proposals on the budget and the economy. “Many of the lenders are rich people and many of the borrowers are people without wealth. It is the lenders who are going to take a shower, and the borrowers are going to have a discount on what they have to pay”.

See how this can work:

Consumers’ assets increase while their liabilities decrease

Behind all this, an increase in wages leads to an inflationary period. As prices rise, companies rush to hire more workers so they can produce more goods and take advantage of rising prices. This salary increase makes companies charge more for their goods. So workers demand higher wages and there could be a spiral, although we haven’t seen it since the 1970s.

The result is that a unit of money is worth less than in the past. But consumers who took out a fixed-rate loan before the start of the inflationary period are only required to pay the amount they initially agreed to.

This group of borrowers is “lucky,” Smetters said, because “you’re going to repay these loans with dollars of weaker purchasing power than what you borrowed.” In other words, the money these borrowers are using to repay their loans buys less stuff than when they took out the loan.

There are important categories of consumer loans that can benefit from this dynamic. Federal student loans, which have an interest rate that is fixed over the life of the debt, private student loans that have a fixed interest rate (some private student loans use variable interest rates, which would change with inflation) and a fixed rate mortgage loans.

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

Student loans work in a similar way. Theoretically, the borrower’s salary will increase with inflation, but the amount he owes on his student loan will not change.

“Your asset,” in this case, your labor or human capital, “is essentially keeping up with inflation,” Smetters said. “But their liabilities” or their student debt “are being eliminated, not completely, but still being reduced by inflation.”

Still, inflation is not always good news for new borrowers. Anyone who takes out a fixed-rate loan in the future will likely face a higher interest rate that is inflation-priced. 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 that can arise during a period of macroeconomic shock, Smetters said.

Also, even if borrowers are benefiting from an inflationary period, they may not see it that way.

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

When economists think about inflation, they assume that when prices go up, wages go up. But when consumers, workers and debtors think about it, they often don’t take into account that their wages may rise, Schreger said, meaning they’re probably just internalizing the price rise.

“It’s not immediately clear whether the people I’d be more inclined to say would gain from inflation would really want this,” he said.

The government will give your creditors less real things

It’s not just individual borrowers who can benefit from inflation, governments with debt as well. In fact, historically, some governments have forced their central banks to increase the money supply to reduce the value of every unit of money in the country – essentially creating inflation – in order to reduce the value of the country’s debt.

This is not the strategy of US monetary policymakers, where the Federal Reserve keeps an eye on inflation in order to keep prices stable. (The Fed balances this goal with its other mandate, to keep 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 is giving its creditors when it pays,” Schreger said. Another way of looking at things, he said: the share of output in the US economy that would have to go to taxes to pay off the debt will be smaller, the higher the inflation.

As inflation rises, even a moderate and sustained rise in inflation can “really erode the value of government debt” with a longer term to maturity, Schreger said.

“What really makes it easier for governments to pay their debts is when they have inflation that was not expected by the market when their debt was issued,” he said. For example, if you bought a 10- or 30-year Treasury bond three years ago, you probably weren’t evaluating the risk of inflation.

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

This could deter future government investments and raise interest rates on new money the government borrows. The latter could pressure the government to find more resources to repay the new loans, either through tax increases or spending cuts.

Paula Fonseca