Inflation's Hidden Cost
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Why is inflation bad?
At face value the question is insipid—inflation is bad because it means things are getting more expensive. The widespread use of the phrase “cost-of-living crisis” is revealing—people feel unable to afford even the essentials of life amidst rising prices. When basic items like food, energy, housing, and cars are in shortage their prices rise and people rightly feel worse off.
Today’s economy has far, far more than its fair share of shortages—but it is also true that inflation is relatively broad-based. The share of items with increasing prices is large, and the number of items with decreasing prices is extremely tiny. If everything is going up in price (or, more precisely, the value of the dollar is declining) then a host of mainstream economic models say that things are…essentially fine?
The idea is that money is, in the long run, neutral. Short-run fluctuations in monetary policy can induce rapid shifts in output, employment, investment, and other economic variables, but long-run fluctuations should essentially leave the real economy unaffected. If everything—incomes, profits, wages, prices, etc—goes up by 10% a year (again, more precisely, if the value of the dollar goes down ~10% a year) over the long run then inflation shouldn’t affect real economic growth.
There are a number of problems with this simplistic model (not the least of which is that the long run is just a bunch of short-runs stuck together and that economists’ conception of the short run is years long) but it’s also not exactly the model that central banks actually operate on—fundamentally economic institutions tend to have a revealed preference for low, stable inflation. At times like these, they are even willing to inflict significant real economic pain in order to achieve their inflation targets.
So, why is inflation bad?
Inflation per se isn’t so much of an economic killer—inflation volatility is.
Workers, businesses, investors, and institutions have to make plenty of decisions under economic uncertainty. Do I buy this house, not knowing for certain how the local economy will evolve over the duration of my 30-year mortgage? Do I build this factory, not knowing for certain if demand for its output will stay high for long enough to recoup the investment? Do I lend this money, not knowing for certain if the borrower will be able to repay the loan?
Those questions all get massively more complicated when people have to ask another question on top—“what will the value of my money be in the future?” How many more people would have bought homes in 2019 if they knew inflation was about to skyrocked? How many fewer people would have bought homes in 2006 if they knew inflation was about to crater? More importantly, how are companies, consumers, borrowers, and lenders supposed to plan out highly complex economic transactions today when they are increasingly uncertain about what the value of money will be tomorrow?
Long run inflation itself may not have real economic impacts—but inflation volatility does. The problem is that inflation volatility and inflation uncertainty is correlated with inflation—fluctuations in the value of money rise with inflation, as do people’s uncertainty about inflation. This usually worsens people’s economic outlook—but more than that it simply makes it more difficult to make the complex economic decisions that form the bedrock of modern economies. Short-run consumer inflation uncertainty has been elevated since the start of the pandemic—but it is only recently that we have started to see a rise in long-run uncertainty.
Volatile inflation also means volatile financial markets—not least due to the rapid shifting of interest rate expectations in response to moves in inflation. Each CPI print is an event nowadays—one that can move stocks and bonds significantly if results come in different than expected. MOVE, an index of interest rate volatility, has been climbing since the Federal Reserve started signaling tighter monetary policy this time last year—reflecting just how turbulent Treasury markets have gotten as inflation rises.
However, the impacts of higher inflation don’t stop here. Rising inflation, uncertainty, and volatility can contribute to the erosion of trust—which is a critical ingredient in much of modern economic growth.
Historically, most human economies ran on systems of local trust built from kinship, repeated interactions, and community enforcement—not money. People worked together because they knew each other, owed each other, and trusted each other. Money and debt were mostly introduced by states and empires to institutionalize and formalize trust across societies too large to function off of local social trust alone. Instead of trading with someone because you knew them and could trust them to repay you, people would borrow the empire’s trust (and enforement mechanisms) by using their currency.
Even thousands of years ago economies got so hideously complex and production so specialized that money went from a useful tool to an absolute necessity. Eventually we got different, more-complex, layers of finance placed on top of money—debt, the bank, the central bank, the joint-stock company, the derivative, etc.
But at its core money remains nothing but a shared—socially, politically, and legally enforced—trust.
Inflation, inflation uncertainty, and inflation volatility all chip away at that social trust. When people trust the central bank less, they’re more likely to have higher inflation uncertainty and less-anchored inflation expectations. When people trust money itself less, they’re more likely to seek out alternatives and operate inefficiently in order to hedge their exposure to inflation. Especially in the technopopulist internet era, inflation can easily damage social trust in the institutions of economic governance. That lost trust may be difficult to fully win back and can drag on long-run economic growth.
Low, stable inflation is something of a peace dividend for modern economies—an increased bout of certainty that passes through as a boost to real output. One job—among several—of the Federal Reserve is to provide the certainty that comes with predictable movements in the value of money. But as long as inflation remains high certainty will be difficult to find, financial markets will remain turbulent, and the real economy will suffer.