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Is inflation bad for the economy?

Apr 19, 2022

Kyle Wales, portfolio manager at Flagship Asset Management, gets into the nitty gritty of how inflation works and explains why it is bad for economic growth.

Is inflation bad for the economy?For the last year opinions around the future path for inflation have been divided into two camps. In the first camp are those who think that inflation is likely to be transient, due to the once-off nature of the supply-chain disruptions brought about by Covid.

The second camp believe that inflation would rise faster and persist far longer due to rising inflation expectations, and the late withdrawal of loose monetary policy.

Today, as the chart below shows, most economists still expect that inflation will be transient, with US CPI forecast to be 6.2% y-o-y in 2022, then tapering swiftly to 2.6% y-o-y in 2023 and 2.2% y-o-y in 2024 (forecast as of April 4, 2022).

Risks, however, remain to the upside. This is evident from the fact that the dispersion around 2023 forecasts has increased, with some banks saying that they expect inflation to be as high as 3.6% in 2023.

Is inflation bad for the economy?

The war in Ukraine has played a substantial role in the increased dispersion around inflation rates. The removal of Russia from global markets will have a huge impact globally due to the outsized role Russia plays in many of these markets.

In commodities as diverse as crude oil, petrochemicals, wheat, nickel, diamonds, and platinum-group metals, Russia is either the largest or second-largest producer. Of these the rise in the price of oil to north of $130 per barrel will be most keenly felt because it affects the prices of a myriad of other items.

But let’s take a step back.

Instead of merely observing that inflation rates are rising globally, and with them interest rate expectations, a question that I believe is not asked often enough in the first place, is: “Why is inflation bad for the economy?”

Is moderate inflation bad?

Opinion is divided as to whether moderate inflation is bad for the economy.

The reasons for this are far from clear cut. Academic research on the subject is actually divided as to whether moderately high inflation, which is currently the case, is a bad thing for the economy.

It is only when inflation crosses a certain (high) threshold, that opinions on this subject begin to align. When this high level is reached, everyone pretty much agrees that it has deleterious effects on economic growth. There are three main reasons for this.

Purchasing power is eroded

The first reason is that very high rates of inflation erode the purchasing power of economic actors. If the same basket of basic items costs a lot more than it used to, ordinary people have less money to spend on discretionary items. Consequently, the businesses which sell these items experience a decline in their sales.

Yes, workers may be successful at negotiating higher wages to compensate for higher prices, but this normally happens with a lag, so there will be a period where workers are out of pocket and therefore spending less. This is especially the case when there is very high – and rising – inflation.

Investment is discouraged

The second reason that very high inflation is bad for the economy is because it discourages investment, which is a key driver of economic growth. Robert Solow’s growth accounting equation deconstructs economic growth into three factors:

Rate of economic growth = (1) (rate of) increase of productive labour + (2) (rate of) increase in physical (as opposed to financial) capital + (3) increase in productivity.

Looking at number (2), when inflation is very high, people are less likely to leave money sitting idle in their bank accounts and it is this money which banks loan to aspiring entrepreneurs to invest in physical capital or invest in productivity-enhancing measures.

Inflation is bad for asset prices

The final reason that very high inflation is bad for economic growth is that it is bad for asset prices. It is no secret that inflation is bad for nominal bonds because it reduces real (after-inflation) interest rates. What may come as more of a surprise is that very high rates of inflation are bad for equity prices as well.

The table below from Bernstein research assesses the whole range of possible return streams in the context of their returns as inflation rises. It shows the average return of a range of assets/factors since 1970 conditioned on the level of inflation in a given year. Equities are one of the most effective assets to hold as inflation rises, at least until it reaches the 5% level.

Factor and asset performance in different inflation regimes

While equities, especially high-quality equities which are able to pass on rising costs, do a pretty good job of preserving their earnings in real terms in the long term, in the short term they are likely to sell off alongside everything else when inflation is very high because they are long-duration assets.

During the decade of the 1970s – which is the decade best remembered for its high inflation rates – the returns US equities provided were two percentage points below the inflation rate itself.

Why is this relevant? In economics there is a behavioural effect known as the “wealth effect” which suggests people spend more money as the value of their assets rise. This provides stimulus to the economy as a whole.

The inverse is also true. When the value of people’s assets decline, they spend less and this withdraws stimulus from the economy.

Conclusion

The world has benefitted from stable, low inflation for a number of decades. In this respect, it has been helped by the shift of supply chains from high labour cost regions like the United States to low labour cost regions like China and other places in Asia. This trend may be reversing.

It has also benefitted from a shift to a knowledge-based economy where there isn’t a 1:1 relationship between inputs and outputs. Software companies, for example, do not have to increase their labour force at the same rate they increase their sales. Fortunately, this trend remains intact.

My base case would be for current situation to be temporary, assuming we get the correct monetary-policy response from the Fed.

This bodes well for equities. However, this does not detract from the fact that policymakers as well as investors need to monitor the situation carefully. Holding commodities and gold will serve investors well should inflation expectations become unanchored.

This post was based on a press release issued on behalf of Flagship Asset Management.

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Maya Fisher-French author of Money Questions Answered

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