The Inflation Tax: Why Should We Be Concerned?

Are prices going up in your area?  The topic of inflation has arisen as a key concern during the current election campaign.  This, after news that inflation had risen to 3.7% in July, its highest rate in a decade.  Why do financial advisors need to be able to address this issue with investors?  Older clients who are bondholders may be especially concerned.   Here’s why, from Dr. Robert Ironside, who writes in the Knowledge Bureau’s Real Wealth Management Program.

A bond investor wants to obtain a realized yield that compensates for both the deferral of consumption as well as compensation for the loss of future purchasing power, which arises due to inflation.  Unfortunately, there is no way of measuring future or expected inflation, so investors have to extrapolate from past inflation plus estimating how inflation may change in the future.

The problem arises when inflation unexpectedly spikes upward after a bond has been acquired.  In this case, the yield-to-maturity that the bond was purchased to provide is not sufficient to compensate for the unexpected loss of purchasing power. 

It is for this reason that inflation is sometimes described as just another form of taxation.   

Any form of taxation causes a transfer of purchasing power from Party A to Party B.  With the inflation tax, the transfer of purchasing power is from creditors to debtors.  In Canada, as in many countries, the largest debtor is the Federal Government. 

The inflation tax works like this:  The government issues a fixed rate, long-term bond.  Let’s assume that the bond in question is a 6% coupon, $1,000 face value bond with ten years to maturity.  The bond sells in the market at par, based on current inflation expectations of 2%.  The bond investor is thus expecting a 4% real return as compensation for deferring consumption.

After the bond is issued, the Government allows several years of 5% inflation.  At the bond’s maturity date, it is redeemed by the payment of $1,000, but the $1,000 received will purchase a much smaller basket of goods and services than the $1,000 that was initially used to purchase the bond.

Although the bond’s coupon has compensated for a portion of the loss in purchasing power, it is not sufficient to totally offset the cost of the unexpected inflation and produce a positive real return. 

Here is the problem for the investor: The unexpected inflation has led to a confiscation of wealth that is every bit as real as an income tax, but it is so insidious that most investors are never aware that a portion of their wealth has been expropriated. 

It is for this reason that inflation has always been used by weak governments that have become over-indebted.  As long as the government’s debt is owned by the domestic population, any government can inflate its way back to fiscal solvency.  Holders of long-term government bonds become the unwilling (and often unwitting) taxpayers who make it possible.  Many would conclude that this is Japan’s situation today where most of the government debt is held by its local citizens. 

This point also suggests that the only way out for an over-indebted society is to create inflation.  This suggests that inflation, may be the greatest threat to your clients’ wealth accumulation, going forward.

This does not mean that the purchase of long Government bonds is a bad idea.  It just means that one must remain vigilant to possible changes in inflation that might erode the real (or purchasing power) value of the bond’s principal. 

Bottom Line:  In terms of current events, Dr. Jack Mintz, who will be speaking at DAC 2021 October 17-19,  relates concerns about inflation to fall 2021 election promises and the real value of money in the pockets of Canadians:   “Risky fiscal behaviour from federal leadership hopefuls who are promising big spending, post-pandemic, comes with an eventual cost:   inflation, credit downgrades and higher taxes. So far, with consumer prices rising 3.6 per cent in the first seven months of 2021, we are already taxing away that much of the purchasing value of government handouts.

What Advisors Can Do.  Some direction from the Knowledge Bureau’s RWM Designation Program: “It is incumbent upon the Real Wealth Manager™ to remain vigilant of emerging inflationary trends and their effects on family income and wealth sustainability.   It requires proactive financial planning that begins with an assessment of the impact of inflationary erosion of purchasing power.” 

What Advisors Can Do.  Some important advice from the Knowledge Bureau’s RWM Designation Program: “It is incumbent upon the Real Wealth Manager™ to remain vigilant of emerging inflationary trends and their effects on family wealth sustainability.   It requires proactive planning that begins with an assessment of the impact erosion of purchasing power.” 

Additional educational resources: to learn more, check out the Real Wealth Management™ Designation program, and the comprehensive program guide for detailed information.