Nov 162017
 

Why Do Governments Target 2% Inflation?

The Bank of Canada maintains an inflation rate target of 2%. The official websites of Central Banks in the U.S., in Europe, and in Japan all appear to target this magical number when deciding how to conduct their monetary policies. But why? Inflation isn’t necessarily a good thing. There are ways to grow the economy and generate prosperity without increasing the cost of goods and services. But inflation does provide the government with two major advantages!

Governments tend to target 2% inflation rate

1. Taxation by Inflation

In the book, The Greatest Con, author Irwin Schiff explains that, “inflation is the government’s silent partner,” because it allows the government to earn more tax revenue, without officially increasing tax rates. For example, a mechanic who made $40,000/yr in the 1980s could be making $80,000/yr doing the same work today due to inflation. If his cost of living also doubled then this looks fine on the surface. However, an $80,000 income is subject to a higher tax bracket than $40,000. Since his marginal tax rate went up, the mechanic will pay a larger proportion of his earned income to taxes today than in the past. This is how federal income tax rates can remain the same, but workers end up paying more tax over time.

2. Eroding the Value of Debt

Inflation reduces the value of money. Let’s say we owe $100 to a friend and inflation is at 2%. We can pay back the $100 after a year. But by then its value would only be $98. Just about every major country in the world owes debt. The U.S. owes about $20 trillion. At 2% inflation, the value of this huge liability would fall by $400 billion a year. That’s a lot of debt to be forgiven. 🙂 The typical investor who buys fixed income funds would likely have government bonds in their portfolios. Unfortunately as a result of inflation, the bond holders (savers) get the short end of the stick while the government (borrower) becomes better off.

“As inflation shrinks the value of currency, it increases the relative value of equity investment. Thus, inflation is a process by which purchasing power is shifted from the middle and lower classes, who have their savings in fixed dollar investments, to the upper classes, who have the bulk of their wealth in equities.” ~Irwin Schiff

Inflation indirectly increases revenue for the government while reducing its debt load at the same time. But if inflation gets too high then consumers would start to complain. Do we want the price of groceries to go up 10% a year? Of course not. 😛 Central Banks like to target the 2% inflation rate most likely because this is a sustainable rate where the economy can handle the inflationary pressure and remain stable.

Since the government has control over the money supply, it can influence inflation as it sees fit. Similar to a private business or family household, the government wants to maximize its income and minimize its expenses. It’s managed to successfully do both through inflation without most people even realizing it. Unfortunately this often comes at the expense of the country’s unsuspecting citizens. :/

 

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Random Useless Fact

About half of all dogs and cats in the U.S. are overweight or obese.

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12 Comments on "The Ugly Truth About Inflation"

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Tom @ Dividends Diversify
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I think there is a flaw in the authors point on taxation by inflation. It works fine if the government collects more tax revenue than it spends. In a deficit spending situation like here in the U.S., inflation is having a greater impact on spending since we are spending more than we are collecting in tax revenue. All else being equal, the inflation will increase the governments national deficit over time. Do I have this right or am I missing something? Tom

Steveark
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Steveark

The only time it is good to be the old guy in the room is when a topic like this comes up. When I started my engineering career inflation was double digit, like 13% annually and interest rates for a new car loan with good credit hit 18%. Can you imagine? Probably not, people literally got double digit raises every year and lost buying power. In fact house loans got as high as 18.5% for a fixed interest 30 year mortgage. Just think how high house payments were at those interest rates and how much it killed the housing market. I got a “low income” subsidized loan in the middle of that period, 30 years at 8.75% and felt like I had won the lottery! Crazy I know, I eventually had to refinance it.

Finance Journey
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Great post Liquid,I won’t pay-down my debts 🙂

I feel like minimum wage increase also helps governments to collect more taxes from low income workers, but it doesn’t help for workers as they need to pay more taxes for their income.

Also, prices will go higher as companies will increase their prices to meet their profit margin and people are willing to pay more money.

Phil
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Phil

… until they are not willing, or worse, are no longer able to… Take your blinders off, this is an ever increasing demographic, do not kid yourself.

Phil
Guest
Phil

The quote in the middle of the article is the reason I got interested in being an equity investor 20 years ago… I could not stand to see our money stand still, or become worth…less 😉 I’ve never considered myself upper class, but… Humm, where’s my bourbon glass, let’s see if I can pull this off 😛 – Cheers

Jeff
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Jeff

Great post.

I wish that book wasn’t so expensive. Over $50 on eBay!

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[…] don’t see the point of buying a bond that pays less than 2% interest when the Bank of Canada openly declared it wants to erode the Canadian dollar’s value by 2% a year. That effectively creates a […]

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[…] see the point of buying a bond that pays less than 2% interest when the Bank of Canada openly declared it wants to erode the Canadian dollar’s value by 2% a year. That effectively creates a […]

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