Inflation: How Inflation and Consumer Spending Impacts Borrowers and Lenders


With inflation being consistently underwhelming so far in 2017, there has been concern among economists and investors alike that our country's economic growth is stagnating. The good news is that there was a slight uptick in core consumer prices in October, which rose 1.8 percent year over year, up from the 1.7 percent rise in September.

In the wake of this minor jump in consumer prices, outgoing Federal Reserve Chair Janet Yellen predicted a rebound of U.S. inflation while hedging at the same time by admitting that she was "very uncertain" about her prediction. In fact, Yellen affirmed that low U.S. inflation over the past year has been "a mystery." While we wait for that mystery to play out, here is what we know about inflation, how it is measured and caused, as well as the ways that inflation impacts borrowers and lenders.

Inflation Defined

Inflation refers to the average price changes throughout the U.S. economy. Inflation is a rate that measures the increase in the general price of goods and service over a period of time. In other words, it doesn't refer to a specific industry or prices at one point in time. A fair example is a consumer that is facing a 10% annual inflation rate will be able to afford to purchase 10% fewer goods and services at the end of the year if their income remains the same. Inflation might also be defined as the change, or decline, in purchasing power of the U.S. dollar.

How Inflation is Measured

While there is no perfect measure of inflation, the Consumer Price Index (CPI) is the figure most often used as an inflation gauge. The CPI is a monthly figure released by the Bureau of Labor Statistics (BLS) that represents a basket of U.S. goods and services. The data is collected monthly, and those figures are compared to prior months, or years, to measure changes in prices.

The BLS computes the annual inflation rate by subtracting last year's CPI figure from this year's CPI figure, dividing the difference by last year's CPI figure and multiplying by 100.

For example, if the current year CPI is equal to 160, and last year's CPI value was 147, the inflation rate is:

Inflation rate = (160-147)/147 x 100 = 8.84

Unfortunately, the CPI isn't a perfect measure of inflation. There are several sources of bias that could impact the figure, including:

New Goods. In this innovative age, new goods and services could enter the market which the CPI fails to measure.
Quality Adjustments. The quality of our goods and services continues to soar with technology and innovation. CPI doesn't always adjust for price increases that account for new features and instead marks them as "inflation."
Substitution. When prices go up for one good or service, consumers may switch to another and not be any worse off financially. The CPI doesn't account for these substitutions.
There are alternative inflation measures and indices, such as the Producer Price Index (PPI) which measures the change in revenue that producers receive for goods and services. Other common price index formulas are the Laspeyres price index and the Paasche index.

What Causes Inflation?

No consumer is happy when the price of a gallon of milk or, worse, a Jeep Cherokee increases from one month or year to the next. In the most extreme cases, high inflation can prevent a consumer from living where they want, retiring according to schedule, and even paying monthly bills without worry. So, what causes high inflation? In most countries, there are two primary causes of soaring inflation rates.

First: Inflation can begin an upward climb when there is a greater demand for goods and services relative to supply. Basic economic principles dictate that, when people fight over scarce goods, the prices for those goods will go up. Goods and services that rely on oil are a prime example. When oil is in short supply and more expensive, the prices for those products and services will also climb, causing inflation. There are more industrialized nations in the world today that are battling for oil and other scarce commodities which can also impact the prices of goods and services.

Second: Inflation is caused by a reduction in the value of the underlying currency, such as the U.S. dollar. A government could create this problem when they flood the market with additional currency (this is done electronically now). This currency must actually be in circulation to create an effect, but, when there are more dollars chasing fewer goods, prices will tend to rise. For example, if everyone's income doubled tomorrow, there's a good chance that the prices for goods and services would follow suit, placing everyone in the same purchasing power position as they were before the increase. This act of "printing money" can also devalue the U.S. dollar against other currencies, so it is a dangerous monetary practice.


Increased consumer spending and confidence is good news for lenders.

How Inflation Impacts Borrowers

The answer to how inflation impacts borrowers depends on several other factors. For example, if wages increase in tandem with inflation, a consumer will continue to have the same purchasing power. If that same consumer already had a fixed-rate loan before the inflation occurred, their position would be improved because they would still owe the same amount of money yet they'd have more wages to pay off the loan.

Assuming earnings don't increase at the same time as inflation, the result would be different. The cost of living for a borrower goes up, and there is always the chance that borrowers won't be able to meet their current obligations. If borrowers are paying more for consumer goods without the benefit of a wage bump, they may also not have the means to buy big ticket items with cash on hand or savings.

Many borrowers will increase their search for favorable credit terms because they no longer have the cash reserves for large purchases. In fact, inflation reduces the true cost of borrowing since the money in hand today is worth more because its buying power is expected to deteriorate in the future.

The Impact of Inflation on Lenders

While inflation is not necessarily a good deal for lenders, the volume of loans resulting from it could be a boon for the lending industry. Provided the "real" interest on loan products is sufficient for a lender's return, the increase in loan originations due to inflation could fill some of the gap created by inflation.

The good news is that consumer confidence remains high, which is going to encourage loan originations going forward. According to Bloomberg, the Consumer Confidence Index not only rose higher than anticipated in October (to 125.9), but it's also at its highest level in 17 years. Many consumers (22.9 percent) not only expect their incomes to go up in the next six months, but are also planning major purchases over the same period.

Optimize Your Loan Portfolio in the Face of Softened Inflation

Low interest rates coupled with continued growth in consumer spending is good news for lenders. U.S. consumer confidence remains high, and there is still a willingness to take out loans for large purchases.

Additional mild increases in interest rates in the coming months and new year shouldn't bring drastic changes to the current trend and monetary policy. Improving loan portfolios is one of the best ways that lenders can position themselves to minimize risk and maximize returns.