Anxiety about inflation, among citizens and politicians alike, has been peaking recently. In the United States, the year-on-year increase in consumer prices reached 7.5% in January, the highest rate since February 1982. If people’s incomes increase by less than the rate of inflation, their real incomes decline, and they cannot afford to buy as much stuff as before. This is the “income effect” of inflation.
But, as I show in a recent research paper, there is an upside to inflation. In recent decades, in fact, inflation has been a great boon to middle-class US households’ balance sheets, and has therefore helped to mitigate the increase in overall wealth inequality.
This is the “wealth effect” of inflation, and it works in the following way. Suppose you have $100 in assets and $20 in debt, so that your net worth is $80. Suppose, too, that inflation is 5% per year and the nominal value of your assets increases at the same rate (the prices of assets such as homes tend to move in line with inflation). Then, in real terms, the value of your assets remains unchanged, but your debt is now 5% lower. So, the real value of your net worth rises to $81, an increase of 1.25%.
Moreover, the higher the ratio of debt to assets, the greater the percentage increase in net worth as a result of inflation. This is the “leverage effect”: If your debt in the previous example was $40, rather than $20, then your net worth would increase by 3.3%.
In the US, the middle class – defined as the median household – is much more indebted than the very rich (the top 1%). In 2019, the ratio of total household debt to total assets for the middle class was 36.5%, compared to a ratio of just 2.3% for the very rich. In terms of net worth, therefore, the middle class will benefit much more from inflation than the rich.
Likewise, Black and Hispanic households in the US are far more indebted than white households, with a debt-to-asset ratio almost three times higher. In wealth terms, at least, these two groups will benefit much more from inflation than white Americans.
One hallmark of US monetary policy since the early 1980s has been a moderation in inflation, which averaged 2.5% per year from 1983 to 2019 (the period I studied). Coincident with this trend has been a surge in US wealth inequality. To measure this, I used the ratio of the wealth of the top 1% of the wealth distribution to median wealth (that is, the wealth of the average household). From 1983 to 2019, this ratio more than doubled from an already high 131.4 to an even more staggering 273.8.
Yet, although wealth inequality soared during this period, inflation was actually a mitigating factor because it helped the middle class much more than the super-rich. Had inflation been zero, the wealth-inequality ratio would have risen even higher, to 385. Instead, the debt devaluation resulting from inflation led to a 76% increase in US median wealth over the 36-year period.
Inflation also helped to lower (or at least limit the increase in) racial and ethnic wealth gaps. For example, the actual ratio of mean wealth between Black and white households dropped sharply from 0.19 in 1983 to 0.14 in 2019. But with zero inflation, the ratio would have fallen to just 0.06.
The story is similar regarding the ratio of mean net worth between Latinx and white households. From 1983 to 2019, the actual ratio increased from 0.16 to 0.19. With zero inflation, it would have decreased to 0.14.
What are the policy implications of these findings? In particular, should the US Federal Reserve still try to dampen inflation, or should it take a more relaxed stance? One way to decide is to compare the income effect of inflation (which is negative) with the wealth effect (which is positive). If the income effect is greater, then inflation should be quashed. But if the wealth effect is greater, then some inflation should be encouraged.
Over the period between 1983-2019, inflation cost the average US household less than $50,000 in income but bolstered median wealth by more than $60,000. The wealth effect thus outweighed the income effect. In contrast, inflation reduced the real income of the very rich by about $600,000, while boosting their wealth by less than $500,000.
In net terms, inflation has benefited the middle class and adversely affected the very rich. It has also helped to limit both overall wealth inequality and racial and ethnic wealth gaps. Those who worry about the recent uptick in inflation – beginning with the Fed – should bear this in mind when considering whether and by how much to tamp it down.
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