Throughout 2022, we've heard a multitude of terms to describe inflation: shrinkflation, stagflation, and slumpflation to name a few. The commonality of these terms is they all describe the rising costs of living.
But is there more to the story? How does inflation impact the federal government? And how does inflation impact us?
Here are a few reasons why our federal government wins when inflation is high and our national debt is $28 trillion.
Inflation increases tax revenues because the government collects more income tax on higher incomes.
Inflation makes it easier for a government to pay its debt, especially when inflation is higher than expected.
Inflation reduces the real value of debt at the expense of bondholders. Bondholders see a drop in the real value of their bonds because it becomes easier for the government to pay back these bonds with dollars that are worth less.
Inflation enables governments to increase tax revenues without appearing to increase tax rates. By freezing income tax brackets, workers pay higher tax rates when their wages rise but the tax brackets don't. The bottom line is that the government, the borrower, is better off while the bondholders, the savers, and the taxpayers are worse off as a result of inflation.
Assume our economy has 0% inflation, with the expectation that inflation will remain at 0%. Assume the government borrows $1 billion by selling 30-year bonds worth $1 billion to the private sector. To attract the private sector to buy bonds, the government offers the bonds at an interest rate of 2%. The government will then have to pay back the full amount of the $1 billion bond offering in 30 years plus $20 million in annual interest payments on the bonds.
The investors who buy the bonds will make a profit if the inflation rate remains at 0%. That's because they will get 100% of their money back plus the interest.
Now suppose that inflation unexpectedly rises to 10% and reduces the value of the dollar. As prices are driven up by inflation, the owners of the $1 billion bond offering are now buying less goods and services with the $20 million they are receiving each year and the $1 billion they will receive when the bond matures will be worth a fraction of what it was when the bond was purchased.
In contrast, the government will receive increased tax revenue as wages and prices increase while bondholders lose out. The government is still required to pay back the $1 billion in 30 years, but $1 billion in 30 years will be much easier to pay back when that same dollar is worth a fraction of what it's worth today. Inflation has dramatically reduced the value of that bond.
Bondholders lose... the government wins.
But there's so much more to the story.
Inflation raises prices, lowering your purchasing power. This reduces your spending in areas beyond the essentials of gas and food, and this has the potential to reduce consumer spending and may cause the economy to contract.
Inflation lowers the values of pensions, savings, and nearly all other fixed-income assets.
Historically speaking, inflation has been good for hard assets such as real estate. However, today's inflation may have a negative impact on the value of your home.
With the government's hand being forced to raise interest rates to tamp down inflation, mortgage rates are now near 6% for a 30-year fixed rate mortgage. This dramatically shifts the affordability of housing and is likely to impact the demand for housing. And reduced demand for housing with a fixed or growing supply may cause housing prices to decline.
We've been saying for over a year that inflation matters because it does!
With inflation, there are losers, and there are winners (mainly one big winner). While the government gains from increased tax revenue and easier debt payoffs, taxpayers are left holding the bill with higher living expenses.
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