High inflation has far-reaching consequences that extend beyond the immediate challenges of higher prices for consumers. It also inflicts long-term costs on society and the economy, impacting everything from investment decisions to wage negotiations. A recent paper by the Federal Reserve Bank of Cleveland, authored by Jean-Paul L’Huillier Bowles and Martin DeLuca, highlights the enduring ramifications of elevated inflation in the paper titled, “The Long-Run Costs of Higher Inflation.”
In an ideal economy, prices are shaped by the fundamental law of supply and demand. When demand outstrips supply for a particular good or service, prices naturally rise, and vice versa.
While annual inflation rates have receded from the 40-year peak of 9.1% recorded in June 2022, the 3.7% rate registered in September still substantially exceeds the Federal Reserve’s target of 2%.
Here are some of the long-term costs associated with high inflation:
- Reduced Wealth:
Coping with rising prices compels consumers to hold more cash, decreasing their investments in stocks or mutual funds. This erosion of wealth and the need to allocate time and effort to decide how much cash to retain divert valuable resources that could be employed elsewhere.
- Sticky Wages and Taxes:
In response to price increases, workers often request higher wages. However, some employers may discourage such requests, causing workers to lose purchasing power. This can trigger a ripple effect across the economy, as decreased consumer spending leads to reduced outlays for businesses and service providers.
Additionally, certain taxes, like capital gains taxes on stocks, may increase due to inflation, resulting in higher tax bills even if the inflation-adjusted stock value remains unchanged. This could prompt individuals to alter their investment strategies, introducing further market distortions.
- Sticky Prices:
Not all businesses can easily adjust their prices. A gas station, for instance, can promptly update its prices with the push of a button on a digital sign, while a supermarket might need to manually modify prices for thousands of items.
- Lenders Falling Behind:
Interest rates may not keep pace with inflation. For instance, a bank agreeing to a 5% interest rate effectively loses money or purchasing power when faced with 10% inflation. Consequently, financial institutions may curtail lending, imposing additional costs on society.
- Stocks vs. Real Estate:
High inflation typically sees real estate values rise while stocks may stagnate or decline due to reduced company profits caused by higher costs. This might lead investors to shift their capital from stocks to real estate, further raising the cost of raising capital for companies and potentially inducing more price increases.
Moreover, businesses with reduced cash reserves may invest less in research and development, harming productivity and wages.
In summary, the consequences of high inflation extend far beyond the immediate challenge of price increases, affecting everything from investment strategies to wage negotiations and the allocation of resources. This prolonged economic impact underscores the importance of maintaining price stability and managing inflation effectively.