Updated: Nov 16
Inflation, or the general increase in prices of goods and services over time, is a primary concern of financial markets these days. To combat inflation, interest rates are rising to levels not seen since the early 2000s. With this in mind, let's run through ten of the primary risks caused by inflation. A better understanding of inflation will help you to understand the current Federal policy of higher interest rates.
Here are ten risks of runaway inflation:
1. Purchasing Power Erosion Inflation erodes the purchasing power of money. As prices rise, each unit of currency buys fewer goods and services. This can impact the standard of living, especially for fixed-income individuals like retirees.
2. Uncertainty and Planning Difficulty
High inflation rates can create uncertainty in the economy. Businesses may find it challenging to plan for the future when prices are volatile, making it difficult to set prices, wages, and investment plans.
3. Interest Rate Increases
Central banks may respond to high inflation by raising interest rates to cool down economic activity. Higher interest rates can lead to increased borrowing costs, impacting businesses and consumers.
4. Distorted Resource Allocation
Inflation can distort resource allocation in the economy. For example, people may be more inclined to spend rather than save, leading to misallocation of resources and potentially speculative bubbles in certain sectors.
5. Fixed-Income Challenges.
Individuals on fixed incomes, such as retirees living off pensions, may see their real income decrease during inflationary periods, as their purchasing power diminishes.
6. International Competitiveness
Persistent inflation can erode a country's international competitiveness by making its exports more expensive. This can lead to a trade imbalance as foreign buyers seek cheaper alternatives elsewhere.
7. Asset Price Bubbles In an effort to hedge against inflation, individuals may invest more heavily in assets like real estate or stocks. This increased demand can lead to bubbles in these markets, with prices rising rapidly and then potentially crashing.
8. Social and Political Unrest High inflation rates, especially if they occur suddenly, can lead to social and political unrest. The resulting economic hardship can strain social and political systems, potentially leading to protests or other forms of instability.
9. Income Inequality
Inflation can affect different income groups differently. Those with assets that appreciate during inflationary periods may benefit, while those without such assets, or with fixed incomes, may experience greater financial challenges, contributing to income inequality.
10. Lender-Borrower Relationships
Inflation can impact the relationships between lenders and borrowers. If inflation is higher than expected, borrowers may benefit at the expense of lenders, as they repay loans with money that has lower purchasing power.
It should be noted that moderate inflation is generally considered normal and even desirable in many economies, as it encourages spending and investment. However, when inflation becomes too high or too low, it can create challenges for economic stability and growth. Central banks and policymakers often aim to maintain a target inflation rate to balance these considerations.