Inflation causes inequality

“2021 Annual Economic Report,” Bank for International Settlements, June 2021, https://www.bis.org/publ/arpdf/ar2021e.pdf

Inequality and inflation

In most AEs and in several EMEs, inflation has been low and stable over the past several decades. Yet it would be imprudent to forget the costs of high and runaway inflation. It is well understood that uncontrolled inflation leads to a significant misallocation of resources and numerous inefficiencies and hence to overall lower economic growth.11 While high and runaway inflation, such as that experienced by many AEs in the 1970s, can hamper growth, hyperinflation of the likes of Germany in the 1920s or Latin America in the 1980s can wreak economic havoc and in the process destroy public trust in governments and institutions.

The impact of inflation on inequality has been widely studied. Inflation shifts income and wealth away from those who are least aware of it, or least able to protect against it. These segments of the population often coincide with lowerincome groups, which explains why inflation has often been portrayed as a most regressive form of tax. The “inflation tax” takes its toll through the erosion of the value of financial assets and contracts fixed in nominal terms.

As regards wealth distribution, the financial assets that are most vulnerable to inflation are cash and bank accounts – the typical savings vehicles held by the poorest segments of the population. This is mostly because the poorest have access only to limited investment options to protect their savings. By contrast, not only can richer households avail themselves of more sophisticated inflation hedges; they may also be able to easily transfer their assets abroad, thus shielding their wealth from depreciations of the domestic currency.

As regards income distribution, wages and pensions – the main sources of income for a large majority of households and even more so for the poorest half of the population – are typically fixed in nominal terms and hence vulnerable to inflation. Indexation mechanisms, such as those adopted in many AEs in the 1970s, are no panacea: they may fail to keep pace as inflation accelerates (Graph II.4, lefthand panel); and they may themselves fuel and entrench inflation further.

The impact of inflation on income inequality depends on how high the inflation rate is. In particular, the erosion of real wages (Graph II.4, right-hand panel) is very small for an inflation rate of 5% (or less) per year, but becomes sizeable when inflation steps up to 20% – even when wages are adjusted at a quarterly frequency. The cost of 20% inflation is about 2% of annual earnings when there are quarterly wage adjustments, but jumps to 8.5% when wages are adjusted only once a year. The impact on wages is the most sizeable effect of inflation on the bottom of the income distribution; only a tiny share of the overall loss is due to the erosion of cash savings for the poor, given their relatively small holdings.

Bringing runaway inflation under control not only improves growth prospects; it also mitigates inequality, all else equal. Empirical evidence shows that this is especially the case for EMEs, where the “conquest of inflation” has often been associated with reductions in income inequality. As an illustration, it is sufficient to ook at the cross-country evolution of the income Gini index around 34 “conquests of inflation” during the past 30 years. In the cases involving EMEs, the median income Gini index declined by two points in the seven to eight years after central banks reduced annual inflation below 5% on a sustained basis (Graph II.5, left-hand panel). The benefits of lower inflation in the form of a more equal income distribution may partly reflect that it brings an overall improvement in the business environment, thereby boosting economic growth.12

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By contrast, other countries that did not sustainably reduce inflation or whose inflation was already below 5% – the non-event countries – experienced a mild increase in inequality. That said, for AEs which sustainably reduced inflation to below 5%, the relationship between inflation and income inequality is similar to that for the group of countries that did not attain such a reduction, suggesting that other factors have prevailed in pushing up inequality.

Exchange rate fluctuations are an important factor strengthening the link between inflation and income inequality in EMEs. Naturally, high inflation rates do not bode well for the stability of the domestic currency. In turn, exchange rate depreciations pass through domestic prices more strongly than in AEs, which fuels and entrenches inflation. The frequency of large currency depreciations clearly increases with the level of inflation (Graph II.5, right-hand panel). This, in turn, raises the risk of outright crises, which increase unemployment and inequality.