Inflation, Debt, and the Price of Coffee

Inflation has non-intuitive implications on debt. Debt involves payments that go into the future where inflation can have a compounded effect. 0n a payment schedule, it looks like future debt payments are indistinguishable from current payments. But in a world with inflation that is not true. One way to make the impact of inflation on debt more clear is to think about future debt payments in terms of what they can buy, like cups of coffee at the local coffee shop.

Let’s say a cup of coffee currently costs $4. If there is no inflation at all, a cup of coffee ten years from now would probably still cost $4. But say there is inflation, and the cost of a cup of coffee goes up the same amount as inflation does.

If inflation is 2% a year, next year that $4 cup of coffee will cost $4.08. In ten years it will cost $4.78. One month of coffee at the coffee shop will cost $120 this year and $145 in ten years at 2% inflation.

If inflation is 5% a year, coffee will cost $4.20 next year and in ten years it will cost $6.21. One month of coffee will cost $120 this year and $189 in ten years at 5% inflation.

If inflation is 10% a year, coffee will cost $4.40 next year and in ten years it will cost $9.43. A 10% inflation rate is very high. One month of coffee will cost $120 this year but $287, more than twice as much, in ten years at 10% inflation.

For the debt example, let’s say we have a loan with fixed payments over 10 years of $120/month. At today’s prices, the debt payment is exactly the same amount we’d pay for a cup of coffee every day. But inflation changes things.

If inflation is 2% a year, by tenth year of the loan the loan payment would no longer cost 30 cups of coffee a month. It would only cost 25 cups of coffee a month.

If inflation is 5% a year, by the tenth year of the loan the loan payment would only cost 19 cups of coffee a month.

If inflation is 10% a year, by the tenth year of the loan the loan payment would only cost 13 cups of coffee a month.

Inflation is beneficial to borrowers because future debt payments will cost them less in real terms. Our borrower doesn’t have to give up as much in the future to make the payments.

On the flip side, say that loan was borrowed from Aunt JoJo. As the lender, she will see the opposite impact from inflation. She will get receipts sufficient to buy coffee every day for 10 years in a world with no inflation. But at 2% inflation after 10 years she will only be able to buy 25 cups of coffee a month with her receipts. And at 5% inflation after 10 years she will only be able to buy 19 cups of coffee a month. And at 10% inflation after 10 years she will only be able to buy 13 cups of coffee a month with her receipts.

So inflation hurts lenders by making their future receipts less valuable.

There are lots of examples of borrowers who can benefit from the impact of inflation on debt: consumers who borrow money to buy a house or a car, companies who borrow money to operate their businesses, and federal and state governments who issue bonds to fund governmental obligations. In fact, inflation potentially helps fix governmental payment problems by deferring outlays to the future when they will cost less in real terms. You will sometimes hear people saying the government hopes to “inflate their debt away”.

Examples of lenders who can be hurt by inflation include banks and other traditional lenders, but also individuals who buy bonds in their retirement accounts, since buying a bond is making a loan. Those future bond receipts may not have the hoped for value to the bond holders if inflation is high.

The examples above consider only at the impact of inflation on debt, ignoring everything else. There are many other factors to consider, but it’s interesting and instructive to think about how inflation affects debt.