This article expands on a question in last week’s editorial with additional contributions from four leading economists.
As media attention focuses on borrowers’ concern about rising interest rates, are borrowers gaining from rising inflation in another way?
It is generally claimed that governments can ‘inflate the debt’ because they are paying off their maturing bonds with money that is worth less in the future than when they borrowed it. In effect, debt requires a smaller amount of government revenue because inflation eats away at the value of the loan.
Does the same argument apply to households?
Inflation doesn’t seem to help borrowers
Recently a friend asked if, as a borrower with a large mortgage, he should be happy to see high inflation. In other words, inflation ‘inflate one’s debt’? In theory, if wages increase with the CPI, he still owes the same amount of money but earns more. He said rising inflation was causing interest rates on his mortgage to rise, but his salary was not rising to match the CPI. So how can his debt be ‘swollen’ while it costs him more and he does not earn the corresponding salary. How is its debt decreasing? How can someone with a lot of debt enjoy high inflation when all they see is the pain of a mortgage?
Good question. How have governmentsinflated their debt‘ in the past, but the same logic no longer applies to households?
We posed this question to four economists who responded as follows:
Shane Oliver, CHA
Governments managed to inflate the high debts left over from the end of World War II, as post-war inflation combined with strong economic growth helped reduce the value of their debts relative to GDP. But it was a period of low bond yields. If bond yields had risen more in line with inflation, governments would have found it much more difficult.
It is more difficult for individuals. High inflation can help reduce a person’s mortgage debt burden if interest rates remain low and wage growth is strong. This happened at the start of the inflationary spurt of the first half of the 1970s, when wage growth was well above inflation (in 1974, inflation rose to almost 18%, but the wage growth was around 25%) and interest rates were slow to rise. with inflation. And back then, mortgage debt was relatively low (compared to people’s salaries anyway). My parents took advantage of this period.
But right now, we have the worst possible combination of high levels of mortgage debt, rapidly rising interest rates and wage growth well below the rate of inflation. Wages are far from compensating for the increase in interest payments on mortgages. So while the real value of debt may decline in the sense that consumer prices are rising faster than the value of debt, this does not help people with mortgages due to slow growth. salaries.
It’s not just inflation that matters. From the mid-1970s, bond yields didn’t really compensate for investor inflation, but for most of the 1980s they more than compensated for it (essentially because inflation expectations move with a lag, so bond yields were slow to adjust to high inflation throughout the period). 1970s and then slow to adapt to its downfall in the early 1980s). Which made the early 1980s horrible for borrowers but great for bond investors (bond yields were around 14% when I started working and inflation was “only” 8%) .
So I don’t think the old concept of “bloating the debt” now applies to those who have a mortgage. Under current inflationary conditions, it is savers who feel better off than mortgage holders.
Saul Eslake, Independent Economist at Corinna
Governments have always been able to “inflate” their debt in the past when, with docile central banks, they were able to “create” higher inflation (for example by allowing the economy to “overheat”) and prevent interest rates from rising. in response to the resulting rise in inflation. At that time, well into the 1970s and 1980s, households with large mortgages or other forms of personal debt were also, in a sense, the “beneficiaries” of higher inflation, as wages tended to to increase in line with, or (in the 1970s) at a faster rate. rates than prices.
But these conditions have not really applied since the 1990s, at least in Australia and most other developed economies. Central banks are independent of governments (as they demonstrate right now) and will not participate in any attempt by governments to create higher rates of inflation in order to reduce the real value of public debt. And of course, wages are much less likely to keep up with inflation when inflation is high. So your friend is essentially right – any possible benefit to him from a period of high inflation in reducing the real value of his outstanding debt is likely to be outweighed, and perhaps more than outweighed, by the pain associated with higher mortgage rates
Stephen Miller, GSFM
The notion that high inflation favors borrowers over lenders applies only when the interest payable on that debt is in fixed rate form. When price inflation accelerates, the real burden of servicing this debt decreases. In general, wage inflation accompanies price inflation, sometimes leading and sometimes lagging. As wage inflation accelerates, the real burden of servicing fixed-rate household debt will be at the expense of the lender and to the benefit of the borrower.
When the debt in question is the subject of a floating or variable rate, it is not certain that the borrower will benefit. Indeed, it is likely that the lender receives an advantage. During periods of high inflation, central banks adjust the (floating) policy rate upwards. Moreover, the magnitude of this adjustment must often exceed the increase in inflation, because central banks must move policy rates into “tight” territory, which means raising the real rate (nominal rate minus inflation prices or wages). This means that debtor households face a higher real debt service burden, while borrowers receive higher real interest.
In a floating rate environment, households may also suffer because the price of the asset on which the mortgage is held (mainly residential real estate) also falls as interest rates rise.
Moreover, in the United States, most household debt is subject to a fixed rate, hence the “conceived wisdom” that inflation favors debtors at the expense of borrowers. In Australia, most household debt is subject to a variable rate and this “received wisdom” does not apply.
Russell Chesler, VanEck Australia
In my opinion, inflation is not good for households in this environment. Property values are falling and mortgage payments are rising rapidly because the RBA is raising interest rates to fight inflation.
To inflate mortgage debt, you need strong wage growth, rising property values, and stable or moderately rising interest rates. The first two are not evident now and we do not believe the economic environment will change enough to lead to this scenario. House prices are falling and the pace of the fall could accelerate as interest rates reach levels not seen in several years.
We have seen the RBA cash rate rise from 0.1% to 2.35% and expect it to be above 3% by the end of the year. Interest-only mortgage repayments will more than double by then. To date, wage growth has remained benign with an annual increase as of May 31, 2022 of 1.9% against inflation of 6.1%, so that real wages are falling significantly. At the same time, falling real estate values are reducing homeowners’ equity and we expect this to continue as interest rates rise.
Borrowing households hoping that a high CPI will inflate their debt are out of luck in the face of rising interest rates, falling house prices and falling real wages. Of course, when they bought their property influences the bottom line, as prices peaked in early 2022. Rents are rising fast and everyone needs a home, and buying your own home is generally profitable in the long run.
Graham Hand is editor of Firstlinks. This article is general information and does not take into account anyone’s situation.