Is Inflation like a tax? It depends.

Inflation is often framed by the media, pundits, and politicians as a sort of tax. Compared to nominal returns, your ‘real’ returns are how much money you have after taking into account this deduction or debit due to inflation. I think however, this framing is to some degree wrong or incomplete. It’s not really a tax in the sense that your stock or bank account is debited by the percentage change of CPI , so what is it?

In the article I sold my bonds the author asks why anyone would buy a long-term bond that has a negative real yield, or a very low yield. It was published in May 2020; the timing would prove prescient as the bond market has since tanked due to surging inflation. The annual change in the CPI is as high as 8-9%, compared to 3% yields for 10-30 year treasuries, giving a negative 5% real yield.

He says the “30-year U.S. Treasury is the most conservative bond issued in this country,” which is wrong. 30-year bonds have considerable volatility due to duration risk and are not conservative at all. The safest bonds are T-bills, which have a maturity of 3 months. Hardly anyone though buy bonds outright. Usually people own bonds indirectly through some sort of diversified bond-stock fund, such as offered by Vanguard. Perhaps he meant to say that the safest long-duration bond is a long-duration treasury bond, after controlling for duration, which is likely true, but even then risk is hard to quantify. A short-term bond with an extremely high yield may be ‘safer’ in the sense that you have less concavity risk compared to a long-term treasury despite the latter having no default risk.

But anyway, buying a negative-yielding long-dated bond does seem like a stupid move if you view inflation as a debit, which I think is the wrong framing. I originally thought this way too, thinking “30-year bonds are sure stupid or risky” and then I realized that I was possibly mistaken. I think the correct framing is opportunity costs and consumer preferences. You’re not losing money due to inflation but rather suffering a possible opportunity cost depending on your consumption preferences.

Look at the components of the CPI. It’s mostly energy, services, and food. If your consumption preferences are aligned in such a way that all your income is going to energy and food, then it is like a tax. You suffer an opportunity cost by not spending your income immediately on food and energy, because every day that inflation goes up, means less food and energy you can buy. So for poor or low-income people, inflation is like a tax.

But for wealthy or upper-middle class people, it’s less like a tax. It’s not like someone who earns a million dollars a year is going to spend it all on energy, rent, and food. Consider someone who has $1 million in the bank and $40,000/year in annual expenses, such as insurance, food, fuel, etc. Now if the CPI rises 8%, that $40,000 becomes $43,200. So in order to offset this inflation ‘tax’, he needs to grow his $1 million by $3,200, which is a .3% increase. Given that 30-year bonds are yielding 3%, this is easily doable, with $26,800 left over. In fact, it would be doable even if 30-year bonds yielded 1.5% like they did a year ago. For such individuals, the biggest opportunity cost is delaying home ownership given that homes prices have risen 10-20%/year since the bottom of the housing market in 2008-2011, far outpacing the CPI, but home prices are not part of the CPI.

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