Inflation’s impact: A comparative study of American and Euro Area households

Distributional Impacts of Inflation in the Euro Area

Filippo Pallotti et al. explore the heterogeneous welfare effects of the inflation surge across individual households in the four largest euro area countries: Germany, France, Italy and Spain during 2021-2022. Their model decomposes the welfare change into four components:

1. Direct Component: Measures the immediate impact of inflation on household resources, excluding government interventions and equilibrium effects.
2. Unconventional Fiscal Policy Component: Captures the effects of government interventions, such as subsidies and transfers, aimed at mitigating the shock.
3. Indirect Equilibrium Component: Accounts for changes in nominal wages, taxes, and asset prices in response to the shock.
4. Long-Run Adjustment Component: Reflects the revaluation of net nominal positions as relative prices realign to the new price

Here are the main findings from the paper:

• Welfare Costs Across Countries: The study finds that the welfare costs of inflation, expressed as a share of 2021-2022 income, were significant and varied across countries. For instance, the costs were around 3% in France and 8% in Italy, which are larger than those typically associated with a recession.
• Age-Dependent Impact: The inflation episode acted like an age-dependent tax. Elderly households, who generally hold more nominal assets, faced losses of up to 20%, while around half of the 25-44 year-olds experienced gains. This is because younger households often have nominal debts, such as mortgages, which decrease in real value with inflation[1].
• Uniform Losses Across Consumption Quantiles: Despite expectations, losses were relatively uniform across different consumption quantiles. This uniformity is attributed to rigid rents, which provided a hedge for poorer households, as rents did not increase as rapidly as other prices.
• Drivers of Heterogeneity: The primary driver of heterogeneity in the impact of inflation across households was nominal net positions. Households with significant nominal assets experienced more substantial losses. Additionally, the rise in energy prices led to considerable variation in individual inflation rates, but unconventional fiscal policies helped shield the most vulnerable households.
• Role of Fiscal Policies: Unconventional fiscal policies, such as subsidies and direct transfers, played a crucial role in mitigating the impact of inflation on household welfare. These policies were particularly effective in reducing the burden on low-income retirees.
• Country-Specific Dynamics: The paper highlights that the variation in welfare costs across countries was influenced by different inflation rates, the structure of energy markets, and the nature of government interventions. For example, Italy faced higher raw price shocks due to its energy import dependence, while France had more effective fiscal measures to offset these shocks.

Who Bears the Costs of Inflation? Euro Area Households and the 2021–2022 Shock
Authors: Filippo Pallotti, Gonzalo Paz-Pardo, Jiri Slacalek, Oreste Tristani, Giovanni L. Violante
From: UCL, ECB, Princeton University

Distributional Impacts of Inflation in the U.S.

David Altig et al. examine how inflation affects the fiscal system and, consequently, the lifetime spending of American households. The authors use a Fiscal Analyzer (TFA), a life-cycle consumption-smoothing tool, to analyze data from the 2019 Survey of Consumer Finances. This tool incorporates all major federal and state tax and transfer programs to assess the fiscal impacts of inflation on expected remaining lifetime spending. To isolate the fiscal effects of inflation, the study adjusts the data to neutralize non-fiscal effects, ensuring that any observed impacts are due to fiscal policy interactions with inflation. The main findings from the paper:

• Impact on Lifetime Spending: The study finds that a permanent increase in the inflation rate from zero to 10 percent reduces median lifetime spending by 6.09 percent. This reduction is slightly less, at 4.99 percent, when fiscal cost-of-living adjustments (COLAs) are timely rather than lagged.
• Progressivity of Inflation’s Impact: Inflation acts as a progressive form of net taxation. The top 1 percent of households experience a median lifetime spending loss of 15 percent from 10 percent inflation, which is roughly double the loss experienced by the bottom quintile. This is largely because wealthier households have more asset income, which is taxed more heavily under inflation.
• Age and Asset Income: Middle-aged households are more adversely affected by inflation due to their higher asset income, which is taxed at a higher effective rate. The study shows significant variation in the impact of inflation across different age cohorts.
• Heterogeneity in Impact: There is considerable heterogeneity in how inflation affects households. For instance, the 25th percentile of spending changes is a reduction of 9.60 percent, while the 75th percentile sees a reduction of only 4.07 percent. Some households experience extreme changes, with the maximum spending decline reaching 64.9 percent and the maximum increase 46.4 percent.
• Fiscal System’s Role: The U.S. fiscal system is not inflation-neutral. Several factors contribute to this, including the taxation of nominal rather than real asset income, the lack of indexation for certain income thresholds, and delays in adjusting benefits like Social Security COLAs.

The findings suggest that the fiscal system’s interaction with inflation can lead to significant and varied impacts on household welfare. This highlights the need for potential policy reforms to address the non-neutrality of the fiscal system in the face of inflation, especially considering its progressive nature and the disproportionate impact on middle-aged and wealthier households.

Inflation’s Fiscal Impact on American Households
Authors: David Altig, Alan J. Auerbach, Erin Eidschun, Laurence Kotlikoff, Victor Yifan Ye
From: Federal Reserve Bank of Atlanta, University of California, Berkeley, Boston University