High inflation doesn’t just leave you with less money in your wallet and difficulty making ends meet.
It also imposes long-term costs on society and the economy by forcing consumers to invest less, negotiate wages more frequently and devote time and energy to coping with rapidly rising prices, according to a new paper from the Federal Reserve Bank of Cleveland.
The result: distorted markets and an even greater loss of consumer purchasing power, according to analysis by Cleveland Fed Senior Economist Jean-Paul L’Huillier Bowles and Research Analyst Martin DeLuca.
“These frictions (…) suggest that inflation imposes significant costs on society,” say the authors in the article entitled “The Long-Run Costs of Higher inflation”.
In an economy without these disruptions, prices are determined by the law of supply and demand: if demand for a good or service exceeds supply, prices rise, and vice versa.
Annual inflation has fallen since reaching 9.1% in June 2022, its highest level in 40 years, but at 3.7% in September, it remains well above the Federal Reserve’s 2% target.
Here are some of the hidden long-term costs of high inflation, according to the Cleveland Fed:
To cope with rising prices, consumers must hold more cash and fewer stocks or mutual funds. This reduces their wealth and forces them to spend time and effort figuring out how much money to hold, resources “that could be used elsewhere,” according to the report.
Sticky wages and taxes
As prices rise, employees are often forced to ask for raises. However, some workplaces may discourage employees from asking for more money, causing them to lose purchasing power. This can have cascading effects on the economy as a whole: when workers buy fewer goods and services, the retailers or service providers who would have benefited from their purchases also reduce their spending.
In addition, some taxes, such as capital gains on shares, can rise due to inflation, resulting in a higher tax bill for investors, even if the inflation-adjusted value of shares has not changed. This can prompt people to change their investments, creating new market distortions.
Similarly, it may be easier for some companies to raise their prices than others. A gas station may press a button to change a digital display, while a supermarket may have to manually update prices on thousands of items.
As a result, lower-cost businesses can change their prices more frequently, distorting consumers’ purchasing decisions.
Lenders fall behind
Interest rates may not keep pace with inflation. So a lender, such as a bank, that accepts a 5% interest rate loses money or purchasing power if inflation rises to 10%. These financial institutions will probably reduce their lending, imposing additional costs on society.
The U.S. pension system: more or lessHow does the U.S. pension system compare with that of other countries? A little better than average.
Stocks vs. real estate
When inflation is high, the value of real estate generally rises, while that of equities may fall or remain stable, as rising costs reduce corporate profits. Investors can then transfer money from equities to real estate, further raising the cost of raising capital for companies and causing further price rises.
In addition, companies with less money may invest less in research and development, which hurts productivity, or output per worker, and reduces wages.