8.5 Indexing and its limitations

When a price, wage, or interest rate is adjusted automatically with inflation, it is said to be indexed    . An indexed payment increases according to the index number that measures inflation. A wide array of indexing arrangements is observed in private markets and government programs. Since the negative effects of inflation depend in large part on having inflation unexpectedly affect one part of the economy but not another—say, increasing the prices that people pay but not the wages that workers receive—indexing will take some of the sting out of inflation.

Indexing in private markets

In the 1970s and 1980s, labor unions commonly negotiated wage contracts that had cost-of-living adjustments (COLAs)    which guaranteed that their wages would keep up with inflation. These contracts were sometimes written as, for example, COLA plus 3%. Thus, if inflation was 5%, the wage increase would automatically be 8%, but if inflation rose to 9%, the wage increase would automatically be 12%. COLAs are a form of indexing applied to wages.

Loans often have built-in inflation adjustments, too, so that if the inflation rate rises by two percentage points, then the interest rate charged on the loan rises by two percentage points as well. An adjustable-rate mortgage (ARM)    is a kind of loan used to purchase a home in which the interest rate varies with the rate of inflation. Often, a borrower will be able receive a lower interest rate if borrowing with an ARM, compared to a fixed-rate loan. The reason is that with an ARM, the lender is protected against the risk that higher inflation will reduce the real loan payments, and so the risk premium part of the interest rate can be correspondingly lower.

A number of ongoing or long-term business contracts also have provisions that prices will be adjusted automatically according to inflation. Sellers like such contracts because they are not locked into a low nominal selling price if inflation turns out higher than expected; buyers like such contracts because they are not locked into a high buying price if inflation turns out to be lower than expected. A contract with automatic adjustments for inflation in effect agrees on a real price to be paid, rather than a nominal price.

Indexing in government programs

Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression “move into a higher tax bracket.” For example, according to the basic tax tables from the Internal Revenue Service, in 2014 a single person owed 10% of all taxable income from $0 to $9,075; 15% of all income from $9,076 to $36,900; 25% of all taxable income from $36,901 to $89,350; 28% of all taxable income from $89,351 to $186,350; 33% of all taxable income from $186,351 to $405,100; 35% of all taxable income from $405,101 to $406,750; and 39.6% of all income from $406,751 and above.