This article develops a question in last week's editorial with additional input from four leading economists.
While the media attention focusses on the disquiet of borrowers facing rising interest rates, are borrowers winning from rising inflation in another way?
It's commonly argued that governments can 'inflate away their debt' because they repay their maturing bonds with money that is worth less in future than when they borrowed it. In effect, the debt requires a smaller amount of the government's revenue as inflation eats away at the value of the borrowing.
Does the same argument apply for households?
It doesn't feel like inflation is helping borrowers
Recently, a friend asked whether, as a borrower with a large mortgage, he should be happy to see high inflation. That is, does inflation 'inflate away his debt'? In theory, if wages increase in line with the CPI, he still owes the same amount of money but he earns more. He said that rising inflation is leading to higher interest rates on his mortgage, but his salary is not increasing to match CPI. So how can his debt be ‘inflated away’ when it is costing him more and he does not earn the salary to match it. In what sense is his debt becoming less? How can someone with a large debt be pleased by high inflation when all he sees is mortgage pain?
Good question. How have governments 'inflated away their debt' in the past but the same logic does not apply now for households?
We put this question to four economists who responded as follows:
Shane Oliver, AMP
Governments did inflate their way out of high debts left over from the end of World War 2 because post-war inflation combined with strong economic growth helped reduce the value of their debts relative to GDP. But that was a period of low bond yields. If bond yields had risen more in line with inflation, then governments would have found it a lot tougher.
It's harder for individuals. High inflation can help reduce a person's mortgage debt burden if interest rates stay low and wages growth is strong. This happened in the early part of the inflation surge in the first half of the 1970s when wages growth was well above inflation (in 1974 inflation rose to nearly 18% but wages growth was 25% or so) and interest rates were slow to move up with inflation. And back then, mortgage debt was relatively low (compared to people’s wages anyway). My parents benefitted in that period.
But right now we have the worst possible combination of high mortgage debt levels, rapidly rising interest rates and wages growth running well below the rate of inflation. Wages are nowhere near making up for the rise in interest payments on mortgages. So while the real value of the debt may be falling in the sense that consumer prices are rising faster than the value of the debt, it's not helping people with a mortgage due to slow wages growth.
It is more than just inflation that matters. From the mid-1970s, bond yields didn’t really compensate investors for inflation but through much of the 1980s, they more than compensated for it (basically because inflation expectations move with a lag so bond yields were slow to adjust to high inflation through the 1970s and then slow to adjust to its fall from the early 1980s). Which made the early 1980s horrible for borrowers but great for bond investors (bond yields were around 14% when I started work and inflation was 'only' 8%).
So I don’t think the old concept of 'inflating the debt away' applies now to those with a mortgage. In the current inflationary conditions, it is the savers who feel better off than the mortgage holders.
Saul Eslake, Independent Economist at Corinna
Governments have historically been able to 'inflate away' their debt in times gone by when, with compliant central banks, they were able to ‘engineer' higher inflation (for example by allowing the economy to ‘overheat’) and preventing interest rates from rising in response to the ensuing higher inflation. In those days, up to the 1970s and 1980s, households with large mortgages or other forms of personal debt were also in a sense beneficiaries of higher inflation because wages tended to rise in line with, or (in the 1970s), at a faster rate than prices.
But these conditions haven’t really applied since the 1990s, at least in Australia and most other developed economies. Central banks are independent of governments (as they’re demonstrating at the moment), and aren’t going to be party to any attempts by governments to engineer higher inflation rates in order to reduce the real value of government debt. And of course wages are much less likely to match inflation when inflation is high.
So your friend is essentially correct. Any possible advantage to him from a period of high inflation in reducing the real value of his outstanding debt is likely to be offset, and possibly more than offset, by the pain associated with higher mortgage rates
Stephen Miller, GSFM
The notion that high inflation favours borrowers over lenders only applies when the interest payable on that debt is in fixed rate form. When price inflation accelerates, the real burden of servicing that debt falls. In general wage inflation accompanies price inflation, sometimes leading and sometime lagging. As wage inflation gathers pace the real burden of servicing household debt subject to a fixed rate will occur to the detriment of the lender and the advantage of the borrower.
When the debt in question is subject to a floating or variable rate, it is not clear that the borrower is advantaged. Indeed, it is likely that the lender may receive an advantage. During periods of high inflation central banks adjust the (floating) policy rate upwards. Moreover, the magnitude of that adjustment often must exceed the increase in inflation as central banks need to move policy rates to 'restrictive' territory which means increasing the real rate (nominal rate less price or wage inflation) higher. That means household debtors face a higher real debt servicing burden while borrowers receive higher real interest returns.
In a floating rate environment, householders may also suffer as the asset over which the mortgage is held (mostly residential real estate) also falls in price as interest rates rise.
In the US, the bulk of household debt is subject to a fixed rate hence the 'received wisdom' regarding inflation. In Australia, most household debt is subject to a floating rate and that 'received wisdom' does not apply.
Russel Chesler, VanEck Australia
In my opinion inflation is not good for households in this environment. Property values are falling and mortgage repayments are rapidly increasing because the Reserve Bank is raising interest rates to combat inflation.
To inflate away mortgage debt, you need strong wages growth, increasing property values and stable or moderately increasing interest rates. The first two are not evident now and we don’t believe that the economic environment will change sufficiently to lead to this scenario. Property prices are falling and the rate of the fall could accelerate as interest rates rise to the highest levels for several years.
We have seen the cash rate increase from 0.1% to 2.35% and we expect it to be over 3% by the year’s end. Repayments on interest-only mortgages will have more than doubled by then. To date, wage growth has remained benign with the annual increase to 31 May 2022 of 1.9% compared with inflation of 6.1%, so real wages are falling significantly. At the same time, falling property values are reducing home owners’ equity and we expect this continue with interest rates rising.
In summary
Household borrowers who hope a high CPI will inflate their debt away are out of luck, facing rising interest rates, falling property prices and lower real wages. Of course, when they bought their property influences the net outcome as prices peaked in early 2022. Rents are rising rapidly and everyone needs a place to live, and buying your own home usually pays off in the long run.
Graham Hand is Editor-At-Large for Firstlinks. This article is general information and does not consider the circumstances of any person.