It disrupts the economy through multiple mechanisms

Under elevated trend inflation, the frictions discussed previously pose potential consequences through multiple mechanisms. In this section, we discuss three of them: loss of purchasing power, capital misallocation and investment distortions, and the slope of the Phillips curve.

Loss of purchasing power. In the above discussion of wage stickiness, the purchasing power of wages erodes when frictions prevent them from adjusting at the same rate as rising prices.5 Individuals with sticky wages consume fewer goods and services as the general level of prices rises, a situation which reflects a direct loss to financial well-being. This loss is amplified when considering a subsequent drop in aggregate demand. As some individuals lower their spending, the would-be recipients of the forgone spending have a lower income, and they, in turn, reduce their spending. This pattern of reduced consumption ripples through the economy, producing an aggregate decline in welfare.

Capital misallocation and investment distortions. Under elevated trend inflation, financial frictions generate distortions in investment returns and in transfers between individuals. In sophisticated financial markets, these frictions make some asset classes better hedges against trend inflation than others. Real estate and stocks are prime examples. The price of real estate, especially residential housing, generally increases at the rate of inflation. This is true for several reasons. Because real estate requires numerous types of materials and services to maintain and construct, increases in other prices increase the price of real estate, both for new construction and existent structures. For stocks, however, the relationship is more complicated. Because stock prices reflect the present value of a company’s expected returns, lower profits reduce stock returns.6 Under elevated trend inflation, sticky prices reduce firm profitability because firms face costs for raising prices alongside inflation.7 Firms may also spend more time optimizing purchase decisions amid distorted prices, a task which also increases costs and lowers profits.

Overall, elevated trend inflation tends to favor increased returns in real estate and lower common stock returns, a situation which aligns with evidence in Fama and Schwert (1977).8 This distorted pattern of returns incentivizes the transfer of investment from stocks to real estate, with implications for macroeconomic efficiency. As investment shifts away from firms, the cost of raising capital for firms will increase, potentially generating further price increases and reducing wages. This also may reduce productivity if firms lack the funds to invest in research and development. Reduced productivity may lower economic growth over longer periods of time, and lower real wages may reduce output in the immediate term. Together, these two effects may generate losses throughout the economy that outweigh gains in real estate prices.

Slope of the Phillips curve. The Phillips curve, named after the economist A.W. Phillips, is a hypothesized inverse relationship between the inflation and unemployment rate. The theory holds that higher levels of inflation are associated with lower levels of unemployment in the short run (between one and five years). A low unemployment rate is typically evidence of a tight labor market in which employees have greater leverage in wage negotiations. Greater employee leverage leads to higher wages, a circumstance that often increases consumption and therefore prices. The slope of the Phillips curve refers to the change in the rate of inflation corresponding to a change in the unemployment rate. It depends on the flexibility of prices and wages in the economy: If prices and wages adjust quickly and frequently, small changes in the unemployment rate are associated with large changes in the rate of inflation if all else remains the same. Because elevated trend inflation requires that prices update more frequently and because individuals and firms would adapt to expect this, the slope of the Phillips curve increases with the rate of trend inflation.9

The Phillips curve can affect aggregate welfare in several ways. If the Phillips curve becomes steeper, short-term inflation, or nontrend inflation, becomes more volatile and requires more intervention by the central bank to stabilize, and this can amplify existing price distortions and distortions in asset class returns as the central bank changes interest rates to maintain the inflation rate. Increased short-term inflation volatility also increases the likelihood that the central bank will need to drop rates near zero. Encountering the zero lower bound is a binding constraint that leaves the bank unable to stimulate the economy by lowering interest rates further, and this bind can hinder economic recovery after a recession.