Inflation’s Saving Grace

by Ramesh Ponnuru

Exchequer argues that even an annual inflation rate of 2 percent (which is higher than TIPS spreads suggest the market expects over the next ten years) “costs a big fat $1.4 trillion a year.” He gets that figure by applying the inflation rate to Americans’ net worth (in other words, he takes 2 percent of $70 trillion). He admits it’s an “imperfect” estimate.

So it is. Exchequer understates some costs of inflation, but more importantly overstates them in the present context. To my mind, the main understatement is the omission of the effect of inflation on effective capital-gains tax rates. We don’t index the tax for inflation. We should do so (or, better yet, eliminate the tax).

One major overstatement comes from the fact that inflation is likely to boost the nominal value of much of that $70 trillion. A large chunk of it will keep up with the inflation.


And, under some circumstances, it can more than keep up with any additional inflation. If looser money increases both inflation expectations and expectations of real economic growth, it can boost real asset values. While I can’t prove that QE2 has had this effect, I can say that since it was announced the TIPS spreads have shown a modest increase in inflation expectations and stocks have gained much more than that in percentage terms.

Exchequer writes, “Of course there are trade-offs from inflation: but practically all of the costs fall on savers and investors, and all of the benefits accrue to debtors and spenders.” Sometimes that’s the way the costs and benefits split, but not always, and there is reason to think this is one of the exceptions.

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