The Entanglement Between Inflation and Loans
Inflation has gained a bad reputation among economists and policymakers. However, as with most financial tools, it has both pros and cons. The inflation level of an economy influences many factors, such as loan interest rates, GDP, unemployment rate, and taxes.
Lenders and borrowers are directly and inversely affected by various inflation levels. Some inflation is needed for economic growth. However, too much or too little of it can drastically impact money flow.
Determined by the total demand and total supply of a country’s products and services, inflation is a yearly percentage representing a cumulative increase in that country’s prices. In the United States, inflation is measured using the Consumer Price Index (CPI), according to which, the rate has been fluctuating between 1% and 3% since 2010 except for the past two years.
Currently marked at 7.9%, US inflation has hit its highest record in the past two decades. This has had a ripple effect globally, as well. It is of no surprise, then, that inflation has become a hot topic nowadays, with many economists bringing back the old debate on whether a rise in prices is good for the economy or not.
The Two Sides of the Coin
The argument against inflation is that, since capital circulation, as defined by both spending power and new investments, leads to economic growth, then inflation would negatively impact the economy. The expectation during high inflation periods is for both the cost of living and the cost of borrowing money to increase, leading to fewer investments, higher savings (less spending), and a downward trend in the stock market, in the short run. However, in-depth studies across multiple economies paint a different picture, particularly in the long run.
Multiple studies have proven time and time again that the relationship between inflation and economic growth is non-linear. This means that low-to-moderate inflation rates have a positive effect on economic growth, and only after a certain threshold does that trend reverse. That threshold can be both a too low (close to 0%) rate and a too high one. This has been the case for both industrialized and developing countries. The only exception was when the drop in the inflation rate was a drastic one or had reached single-digit numbers for countries where they had previously gone to double-digit percentages.
A Comparative Perspective
Defining what a high inflation rate means will depend on each country; this should be done in comparison with its own previous recorded rates and not against those of other countries. For example, Sri Lanka has rarely seen rates lower than 6% with multiple spikes reaching percentages in the 10s and even 20s. On the other hand, the US has rarely achieved rates as high as 6% with very few in the double digits or larger than 14%. We can therefore conclude that Sri Lanka’s extremely volatile inflation situation has led to consistent decreases in GDP (gross domestic product) and output, a conclusion verified by literature as well.
Sri Lanka isn’t the only country with similar rates. Many developing countries, such as Ghana or Azerbaijan, have double-digit inflation rates and low economic growth. However, Azerbaijan’s economy only tumbled when inflation rates went over 13%. This goes to further prove the non-linear relationship mentioned earlier. In fact, a study of 165 countries, done for the period between 1960 and 2007, has found an average threshold of 10% where that relationship starts to reverse for most economies (except those of industrialized countries where it is lower overall). It is around that point where both GDP and investments in GDP begin to decrease.
Inflation targeting is a common strategy to prevent high inflation rates and achieve economic stability. It has been adopted by multiple countries. But, as we saw earlier, one inflation rate wouldn’t apply to all economies and especially not to those of developing countries. Further, it’s important to keep in mind that inflation targeting only works as a long-term strategy, with some flexibility in short-term policies.
The Role of Lending Stakeholders in the Economy
An economy’s financial web structure is highly dependent on the cash flow generated by lenders, borrowers, and investors. Many economically impactful players come into the lending game. Some of them, such as banks or the government, are both on the receiving and giving end. Others, like regular consumers or corporations, may be more predominant in one area or another (borrowing or investing, respectively). However, all of them have an impact on the inflation level, while also being impacted by it. It’s a tight circle, inflation being particularly important when setting nominal interest rates.
Governments have multiple ways of influencing the financial course of an economy. Some of those include printing money, investing, lending money, and borrowing money. They may borrow money internally (e.g. through government securities and bonds) or externally, from other foreign nations.
Government borrowing usually leads to increased taxes, lower subsidies, decreased consumption, and increased consumer borrowing. Purchasing power then shifts to the higher income bracket of the population, often leaving low-to-middle income groups in debt and increasing inflation rates. If not kept in check, too much government borrowing could lead to a period of stagflation (high inflation combined with slow economic growth and high unemployment levels).
Banks and Private Lenders
Banks are one of the primary financial institutions that can dictate economic growth, along with stock markets (aka equity markets). Banks meet the needs of individuals, businesses, and governments, while effectively distributing a country’s resources to sustain growth.
Stock market liquidity closely impacts capital accumulation and, hence, economic growth. However, stock market size, volatility, and international integration are much less relevant in this equation. It is, in fact, banks, through their savings and reinvestment of those savings, that dictate how well an economy fares and how much cash is in flow.
Banks receive deposits and accumulate individual savings, which they then use to reinvest and lend. This leads to more available capital for further investing by borrowers. They, in turn, may choose to invest in the stock market or in other assets. This entire cycle contributes to the economic development of a country.
Unexpected changes in inflation can affect labor contracts which are written in nominal wages rather than real wages. This means workers’ salaries will not go as far as before, leading them to borrow money. Consumer borrowing also seems to be highly influenced by media outlets and by (often biased) inflation expectations. More specifically, during times of economic uncertainty, consumers may tend to overestimate upcoming inflation rates and restrict their spending prematurely.
We saw earlier that modest inflation can lead to job and economic growth. The opposite is also true; a booming economy can keep inflation low and discourage borrowing. A combination of decent wages and a low unemployment rate seems to be the influencing variable here. As this study confirms, “an economy with a low level of inflation tends to converge towards a less level of unemployment than that implied by the natural rate of unemployment, or to a less level of unemployment than that would have been reached in case of no inflation.”
Inflation raises interest rates, making existing, unindexed corporate loans more expensive to repay. An increase in a company’s debt can, in turn, affect its market value and the value of its liabilities.
With a low market value, it is cheaper and better for a firm to acquire debt than go the equity financing route (aka selling shares). Consequently, many companies would run the risk of going bankrupt or accumulating large amounts of debt. If this happens to multiple large corporations, the government may be incentivized to intervene and bail out some of them.
Factors Connecting Lending, Investments, and Inflation
For an economy to grow, money has to keep changing hands. But, as mentioned earlier, inflation can stunt or pause this flow. So understanding the factors that influence inflation can help an economy continue growing at a steady pace.
Anticipated inflation plays a key role in determining interest rates and helps banks stay profitable. However, unexpected inflation hurts lenders (banks and private lenders) because the money they receive back has less purchasing power. This, in turn, causes a credit crunch or a credit shock, which has been proven to have a large impact on both economic output and inflation.
A good case in point is the US Great Inflation of the 1970s. The extremely high and unexpected inflation rate, combined with that period’s baby boom, led to less financial wealth per individual. This resulted in lower savings and, due to an unchanged asset supply, it also meant a lower value per asset. That is why, developing countries, where inflation rates are more volatile, have both a small banking system and a reduced equity market. This makes sense, given that stock market development is directly related to a country’s bank system size.
In the case of the Great Inflation period, however, the unexpected high inflation may have lowered stock and bond investments, but the attractive real estate tax code encouraged housing investments. Once the price of houses grew, so did the number of mortgages which ended up helping the economy. The gains from this trend were limited though, as only older individuals who had experienced the low inflation of the 1950s and 1960s were willing to invest in real estate. This shows that inflation impacts investments both directly and indirectly, by affecting individuals’ propensity for financial risks.
Monetary policy is one of the forces affecting banks’ cash flow and capital supply. For example, an increase in interest rates by a country’s monetary authority would cause banks to pay more for overnight loans. This would result in an increased risk aversion and a lower credit supply from the banks.
At the same time, higher interest rates would translate to lower deposits and less spending. All of these factors would then cause lending and, consequently, investments to decrease. Prices would also decrease soon after, which could lead to a too low inflation rate.
One strategy to minimize the impact of inflation is investing in gold. Governments, fund managers, and individuals alike have used gold as a “hedge” against inflation. However, its effectiveness depends on when and where it is applied. Investments done during an overall high stock market momentum are more likely to succeed. Also, multiple studies have shown that highly competitive gold markets respond better to this strategy than small or emerging gold markets. For example, investing in gold is effective in the short run in countries like the UK, India, and USA, but not in countries like Japan, China, or France. In the long run, some effectiveness is noticed in the US and very little in Japan. The US might stand out due to its low overall price rigidity in response to gold demand which took place with the collapse of the Bretton Woods agreement. This separated, once and for all, the value of the US dollar from the value of gold.
Two other forces that impact lending and inflation include innovations to increase the lending supply (aka “lending multiplier”) and exogenous (aka external) lending demand shocks. The latter causes a decrease in currency investments (both domestic and foreign) and a tightening of monetary policy, which puts us back to the previous case where bank rates increased and prices decreased.
Credit shocks by lending multipliers (e.g. securitization markets, advanced bank intermediaries, syndicated loan markets, credit derivatives, etc.) are the most impactful force, accounting for about 75% of the long-run inflation in a study. The short-run impact (around 6 months) is negligible, but after one year, they start to have a significant impact on the economy. Securitization, in particular, increases banks’ credit supply by selling their outstanding loans to private financial institutions. This frees their reserves and allows them to lend more. Securities can also be used as collateral when borrowing, making it even easier to acquire capital, and therefore invest more.
All of these forces come down to one single factor, however – banks’ willingness to take risks. Banks get braver when policy-induced rates are lower, and vice versa.
The interconnectedness between inflation, lending / borrowing (aka money flow), and economic growth cannot be easily dismissed. While moderate amounts of inflation may be helpful, too much (or too little) too soon can disrupt the proper functioning of the lending system and, thus, jeopardize a nation’s economic wellbeing. Therefore, keeping in mind all the factors that can impact inflation and proactively addressing them, helps both private lenders and governments manage their finances properly.
Atta-Mensah, Joseph, and Ali Dib. “Bank Lending, Credit Shocks, and the Transmission of Canadian Monetary Policy.” Bank of Canada, Bank of Canada Monetary and Financial Analysis Department, Apr. 2003, https://publications.gc.ca/collections/collection_2014/banque-bank-canada/FB3-2-103-26-eng.pdf.
Benhabib, Jess, and Mark Spiegel. “Moderate Inflation and the Deflation–Depression Link .” Wiley Online Library, Journal of Money, Credit, and Banking, 13 May 2009, https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1538-4616.2009.00232.x.
Bernanke, Ben. “Inflation Targeting.” NBER | National Bureau of Economic Research, The Reporter, Mar. 1999, https://www.nber.org/reporter/spring99/inflation-targeting.
Blejer, Mario I, et al. “Exogenous Shocks, Deposit Runs and Bank Soundness: A Macroeconomic Framework.” IMF Working Paper, Monetary and Exchange Affairs Department, International Monetary Fund, July 1997, https://www.imf.org/external/pubs/ft/wp/wp9791.pdf.
Bryan, Michael. “The Great Inflation.” Federal Reserve History, 22 Nov. 2013, https://www.federalreservehistory.org/essays/great-inflation.
CoinNews Media, Group LLC. “Historical Inflation Rates: 1914-2022: US Inflation Calculator.” US Inflation Calculator , 15 Mar. 2022, https://www.usinflationcalculator.com/inflation/historical-inflation-rates/.
Davis, Marc. “US Government Financial Bailouts.” Investopedia, Investopedia, 8 Feb. 2022, https://www.investopedia.com/articles/economics/08/government-financial-bailout.asp.
Fawley, Brett W, and Yi Wen. “Low Inflation in a World of Securitization.” Economic Synopses, Federal Reserve Bank of St Louis, 2013, https://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.423.5123&rep=rep1&type=pdf.
Ferrell, Christine. “Inflation Is Healthy for the Economy – but Too Much Can Trigger a Recession.” News at Poole College, NC State University, 13 June 2019, https://poole.ncsu.edu/news/2019/06/13/inflation-is-healthy-for-the-economy-but-too-much-can-trigger-a-recession/.
Gordon, Roger. “Interest Rates, Inflation, and Corporate Financial Policy.” Brookings, Brookings Papers on Economic Activity, 1982, https://www.brookings.edu/wp-content/uploads/1982/06/1982b_bpea_gordon_shoven.pdf.
John, Andrew, and Russell Cooper. “Macroeconomics Theory through Applications.” The Costs of Inflation, Saylor Academy, 2012, https://saylordotorg.github.io/text_macroeconomics-theory-through-applications/s15-04-the-costs-of-inflation.html.
Kasidi, Faraji, and Kenani Mwakanemela. “View of Impact of Inflation on Economic Growth: A Case Study of Tanzania.” Asian Journal of Empirical Research,3(4)2013: 363-380, Asian Economic and Social Society, 2013, https://archive.aessweb.com/index.php/5004/article/view/3366/5381.
Kay, John Anderson. “Economics of Government Borrowing.” Encyclopædia Britannica, Encyclopædia Britannica, Inc., 1998, https://www.britannica.com/topic/government-budget/Economics-of-government-borrowing.
Korkmaz, Suna. “Impact of Bank Credits on Economic Growth and Inflation.” Research Gate, Journal of Applied Finance & Banking, Vol. 5, No. 1, 2015, https://www.researchgate.net/profile/Suna-Korkmaz/publication/307575219_Impact_of_Bank_Credits_on_Economic_Growth_and_Inflation/
Labor Statistics, Bureau of. “Consumer Price Index.” U.S. Bureau of Labor Statistics, U.S. Bureau of Labor Statistics, 2022, https://www.bls.gov/cpi/.
Labor Statistics, Bureau of. “Historical Inflation Rates: 1914-2022: US Inflation Calculator.” US Inflation Calculator |, Mar. 2022, https://www.usinflationcalculator.com/inflation/historical-inflation-rates/.
Lamla, Michael J., and Sarah M. Lein. “The Role of Media for Consumers’ Inflation Expectation Formation.” Science Direct , Journal of Economic Behavior & Organization, 2 June 2014, https://www.sciencedirect.com/science/article/abs/pii/S0167268114001450.
López-Villavicencio, Antonia, and Valérie Mignon. “On the Impact of Inflation on Output Growth: Does the Level of Inflation Matter?” Journal of Macroeconomics, North-Holland, 16 Mar. 2011, https://www.sciencedirect.com/science/article/abs/pii/S0164070411000176.
Madurapperuma, Wasanthi. “Impact of Inflation on Economic Growth in Sri Lanka.” SSRN, Journal of World Economic Research, 2016, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3375693.
Malmendier, Ulrike, and Stefan Nagel. “Learning from Inflation Experiences.” EML Berkeley, Econometrics Laboratory (EML) – University of California at Berkeley, 4 Apr. 2013, https://eml.berkeley.edu/~ulrike/Papers/InflExp_44.pdf.
Meyler, Aidan, and Lovisa Reiche. “Making Sense of Consumers’ Inflation Perceptions and Expectations – the Role of (Un)Certainty.” IDEAS, Economic Bulletin Articles, European Central Bank, 2021, https://ideas.repec.org/a/ecb/ecbart/202100022.html.
Peersman, Gert. “Bank Lending Shocks and the Euro Area Business Cycle.” Ghent University, Feb. 2012, https://users.ugent.be/~gpeersma/gert_files/research/multiplier_february2012.pdf.
Piazzesi, Monika, and Martin Schneider. “Inflation and the Price of Real Assets.” Bank of Canada, Apr. 2008, https://www.bankofcanada.ca/wp-content/uploads/2010/09/inflationAP.pdf.
Smialek, Jeanna. “The Economy Is Strong and Inflation Is Low. That’s What Worries the Fed.” The New York Times, The New York Times – Economy, 21 May 2019, https://www.nytimes.com/2019/05/21/business/economy/economy-inflation-fed.html.
Tan, Yong Aaron, and Chirstos Floros. “Bank Profitability and Inflation: The Case of China.” Research Gate, Journal of Economic Studies, 39 (6), https://www.researchgat
Wang, Kuan-Min, et al. “Does Gold Act as Inflation Hedge in the USA and Japan?” Transformations in Business & Economics, Transformations in Business & Economics – Vol. 12, No 2 (29), Sept. 2013, http://www.transformations.knf.vu.lt/29/article/ed.
Weber, Axel. “Rethinking Inflation Targeting.” Project Syndicate, University of Toronto – Economics, 8 June 2015, https://www.economics.utoronto.ca/gindart/2015-03-06%20-%20Canadian%20economy%20suffers%20from%20the%20myth%20of%20comparative%
World Bank, Group. “Inflation, Consumer Prices (Annual %) – Sri Lanka.” The World Bank | Data, International Monetary Fund, International Financial Statistics and Data Files, 2020, https://data.worldbank.org/indicator/FP.CPI.TOTL.ZG?locations=LK.