How Does Unexpected Inflation Affect Households?

Kyla Evans: Welcome to the Timely Topics podcast from the Saint Louis Fed. I’m your host, Kyla Evans, and with me today is St. Louis Fed economist Yu-Ting Chiang. Yu-Ting, thanks for joining us today.

Yu-Ting Chiang: Thanks for having me.

Evans: You have some really interesting research on something called “unexpected inflation” and how it affects households. Before we get into your findings, do you mind defining what “unexpected inflation” is?

Chiang: Yeah. So, like, what we have in mind is that, say, due to changes in policy or some unforeseen economic condition, sometimes there is an increase in the general price level, and what that means is that it’s not just the price of one good particularly but it’s like all the goods in your basket that you put in at your supermarket, are going up at the same time. So, that’s like a general increase of price level that we call inflation.

Evans: well, that is really interesting. So, diving right into your findings here, can you give us an example of how, for a typical household, unexpected inflation could provide a financial gain or potentially a financial loss?

Chiang: So, a lot of the assets or liabilities we have are nominal, meaning that these contracts are signed in terms of dollars. And that means like when prices go up - like, suppose I have some nominal assets, let’s say, you know, months of money in a bank - when prices go up, what I can purchase with that money goes down. But at the same time, if I owe some debt to the bank, that means like what I actually need to repay the bank actually goes down when the price level goes up.

Evans: Oh, okay. Well, that has more of an effect than you would think. So for listeners, there is one thing that you had mentioned, in your working paper called nominal maturity mismatch that has a lot to do with the understanding of how unexpected inflation can have this kind of effect. Could you just take a moment to briefly explain to our listeners why exactly nominal maturity mismatch is, and how it actually does relate to unexpected inflation?

Chiang: Yeah. So what we mean by a nominal maturity mismatch is that if you look at the balance sheet of U.S. households, a lot of the U.S. household balance sheets have the feature that they have long term nominal liability, so think about a mortgage. A mortgage is usually 20 years. But on the asset side, it’s usually much shorter term. For example, if you think about deposits, like if you have a savings account or like you have a time deposit, is usually pretty, pretty short term. And also like for example, a lot of the nominal contracts we sign, like say our salary contract, is like, you know, it can renew every year. So, these are like short term assets.

So, what that means is that you have these long-term liabilities and short-term assets in nominal terms. And that means when you have unexpected inflation, people typically gain in the long run, as the real burden of a mortgage gets reduced. But people are losing in the short run because what you own is worth less for these short-term assets.

For many households who can easily move resources around, this may not matter that much because, you know, if you’re gaining in the long run, you can just either borrow or adjust how much you save to kind of smooth it out. But for some households who find it hard to either borrow from the future or if they don’t have much cash on hand, what they lose in the short run may very much outweigh what they gain in the long run.

Evans: Oh, wow. So it would create sort of a feeling that even though you might be gaining in terms of like paying off your mortgage earlier, in the short term, you can’t pay your gas bill. So...

Chiang: Yeah, exactly.

Evans: Ah, I see. OK. And I would guess that for a lot of households that would fall into being described as nominally mismatched, liquidity constraints - in terms of like not actually having access to capital and money as you describe - would be an issue. So, are there changes in behaviors for those households that can help to mitigate and soften the effects of the unexpected inflation shocks when they happen?

Chiang: It’s generally a good idea if, you know, if everyone has some buffers like stocks, you know, like some money in the bank account, just in case of emergency, but the thing is, there are circumstances that happen to us. That’s not something we can control. So, as an economist or a researcher, our job is not really to tell people, you know, “you should do this or that”. It’s just like, we want to point out that:  there is this channel and how, you know, everyone can be affected [by it]. And then, you know, once you understand this channel, I think people are free to make whatever decision they think will be the best for them.

Evans: OK. Well, it’s always helpful to have more information. And then, as far as how these affect households over time, I know we talked a little bit about like short-term losses versus long-term gains. But, is there a change in how unexpected inflation like overall just impacts households over decades even?

Chiang: Yeah. In the 60s or 70s, inflation used to be a big topic in the US, as it is now. I think at the time there’s this – it was very common for people to sign these cost of living adjusted contracts. I think at the time, a lot of the wages are, you know, kind of linked to inflation. But these kind of practices kind of died down, you know, in the 80s after inflation was curbed. And, to be honest, I am not exactly sure why this kind of faded away. But, you know, it would be interesting to study why people, you know, decided not to do that anymore.

Evans: Oh yeah, that would be, actually. And then, following up with the time aspect, what about the relationship to income level as far as unexpected inflation shocks go? For example, do households that have greater wealth and access to capital generally have an easier time weathering these shocks than those who have less?

Chiang: Yeah, of course. So, the core idea of this channel that we’re discussing is this - for some households, who find it hard to move resources around or either borrow or adjust their savings, unexpected inflation will have a large effect on them. And, this is usually the case for people who are less wealthy or don’t have much income. In this particular case, I think what we show in the paper is that this liquidity cost of inflation is [borne] heavily by some of the households in the bottom of the wealth distribution.

Evans: while I have you with us, this research is really fascinating. Do you have any future research planned on this topic or other related topics?

Chiang: as I mentioned, I think it’s kind of interesting to me why some people decided, or why in some periods, people decided to put up this cost of living adjustment for their wage contracts but not in other times. And like, I don’t have a good explanation for that, and so I think that will be something interesting to look into.

But also, just more generally, understanding why some households are more liquidity constrained, why people find it hard to borrow, and, you know, what’s the macroeconomic implication for [that] or what that implies for a policy. I think those are also just interesting topics to explore.

Evans: Well, I would certainly love to learn more about all of those things, and I hope you’ll be able to join us for another episode.

Chiang: All right. Thanks for having me!

Evans: Well, thank you for joining us! If you’re interested in the work of Yu-Ting and other Saint Louis Fed economists, you can find it at stlouisfed.org. And, a reminder that you can subscribe to Timely Topics on Spotify, Apple Podcasts, or anywhere you get your podcasts. And from the Saint Louis Fed, you’ve been listening to Timely Topics.