Why does Inflation matter?

Financial Autonomy - Blog
Why does Inflation matter?

Most of us recognise that interest rates were unusually low for a time, to counter the economic effect of the COVID pandemic. We knew that at some point they would return to normal. But what is normal, why are they going up now, and why has this got share and property markets so rattled? One word – inflation.

Inflation is all over the news at the moment. On financial markets, inflation has been the driving force for at least the past six months. So this week I thought we’d do a quick inflation 101 session to ensure you understand why it matters and perhaps consider whether there’s anything you should be doing to stay ahead.

 

 

Let’s start with the definition to ensure we’re all on the same page. Wikipedia says:

Inflation refers to a general increase in prices of goods and services in an economy. 

Inflation is quite simply prices going up. Some inflation is good, but too much is bad. We need some inflation because without it there is little incentive for people to undertake economic activity, for instance building a house or buying some new clothes. If they felt that the costs a year or two from now would be either the same or perhaps even less, then their incentive would be to do nothing. And if enough people do nothing, the economy grinds to a halt. So some inflation is useful because it drives economic activity. The longer you delay and procrastinate, the more you will ultimately pay.

However high inflation, and we’ll look into how that might be defined shortly, is something all economic managers work very hard to avoid. There was a podcast episode I did way back in 2019 that you might want to scroll back and have a listen to. It looked at hyperinflation and the economy in Germany after World War Two. You’ve no doubt seen the images of people with wheelbarrows of cash heading out buy a loaf of bread. Similar things have happened in Zimbabwe and in several South American countries. These are extreme cases but they illustrate why policy makers recognise high inflation is such a threat and are prepared to take strong measures to ensure it doesn’t take a hold. Inflation makes your money worth less, that is, what it can buy is reduced. Those hit hardest are those with savings. A lump of money sitting in the bank which once would have been enough to purchase a new car, now only covers the cost of a second hand vehicle with 100,000 kilometres on the clock.

Inflation devalues the currency of the country in which it is occurring. Most countries today are not fully self-sufficient, relying on imports of food or materials or manufactured goods. If your currency is devalued as a result of inflation, then buying these imports will become more and more expensive, potentially reaching the point where they become unaffordable entirely.

To help protect against this risk most countries have a central bank with a mandate given to them by their government that specifically provides an inflation target. Here in Australia our central bank is the Reserve Bank of Australia and their target is to have inflation running at between 2% and 3% per year. The equivalent in the United States is the Federal Reserve, and their target is 1 to 2%.

There are a few different inflation numbers put out by the Australian Bureau of Statistics. The RBA’s preferred measure is “underlying inflation”. Currently here in Australia underlying inflation is 3.7%, so beyond the RBS’s preferred band. This is unusual. For a very long time inflation has been below the 2% bottom range. This is why the Reserve Bank has cut rates so low and been able to leave them low for an extended period of time. With inflation now bursting through the upper band however, low rates will quickly become a thing of the past.

So why has inflation become a problem now? In response to the outbreak of COVID around the world central banks pumped money into their economies to provide something of a cushion. They did this by cutting interest rates to help borrowers. They also injected cash into the economy through buying government bonds, the seller of those bonds receiving cash that then needed to be deployed somewhere else. The entire purpose of these activities was to prevent prices falling, to keep people spending, which keeps people employed, which prevents a recession. And pleasingly, it worked. Whilst Australia did briefly go into recession territory, generally speaking we got through the global pandemic well with good support provided to businesses and workers.

But we are on the other side of that now, and now there is too much money chasing a limited supply of goods and services. We’re seeing it in all sorts of places. There aren’t enough hospitality staff because backpackers haven’t been able to come into Australia as they normally would, and many people who used to working in hospitality have moved into other careers. This means cafes and restaurants need to pay more to attract and retain staff, and that means they need to put up prices to their customers if they are to remain viable. If you’ve tried to buy a car in the last 6 to 12 months you will know all about it. No longer is there any haggling with the salesperson. You get what’s available, pay the ticket price, and you will be grateful if you don’t have to wait six months.

Most of our manufactured goods are imported, and COVID saw massive disruptions to these global supply chains as shipping ground to a halt. Factories across Asia were forced to close and indeed in China there are more closures happening right now. Whether it’s final finished goods, or simply components such as semiconductors that are needed for so many other manufactured goods, all this disruption has ensured that demand is outstripping supply, pushing prices up. And as we established at the beginning of this episode, prices going up, well that is the definition of inflation.

This inflation hasn’t arrived on our doorstep completely by surprise. Last year prices were seen going up around the world, but there was much debate as to whether this was just a short-term phenomenon that would correct itself once COVID related bottlenecks were freed up. It still does feel likely that some of the current inflationary pressure will ease up given time. But there’s far less certainty that it will happen quickly. And the challenge with inflation is that it tends to be a bit of a spiral. If prices go up, then employees need pay rises so they can continue to afford the goods and services. If the employer grants them a pay rise, then the employer needs to go back and put their prices up again to recover the extra wages expense that they have now incurred. Which then circles back to the employees needing another pay rise and on and on we go.

Even worse is when you have expectations built-in that inflation will be at a high level for a long period of time. Imagine you run a business that builds Freeways. When you quote, you know the work is going to take several years to deliver. When you work out your pricing you need to determine how much you’ll be paying in material and wages. Now if you have an expectation that inflation is going to be at a persistently high level, then you will factor that into your pricing, meaning your customer, in this case likely state or federal government, will pay a higher price than would have been the case were it reasonable to assume minimal inflation. In this way inflation can get “baked in” to the economy, and once that happens it’s very difficult to unwind.

The risk of inflation getting embedded into peoples psyche was a key reason for central banks around the world having specific inflation targets. The thinking was that if everybody knew central banks were working to keep inflation within these particular ranges, then that gave you a reference point around which you could plan. And it’s worked very very well. Indeed right now is really the first test of this approach. In all the developed countries around the world inflation is currently above their central banks preferred range. Now as mentioned, for a long time it was below their range, so it’s not like a period outside the target range is necessarily I disaster, but the question mark at the moment is what will central banks need to do to pull inflation back down and get things back to what they consider to be a comfortable level.

The primary instrument central banks have for winding back inflation is raising interest rates. By forcing households and businesses to pay higher rates of interest on their debt, money is sucked out of the economy. Consumption reduces, businesses have less ability to pay employees higher wages, and the heat comes out of the economy, slowing down price rises and therefore inflation. But slowing down the economy, without bringing it to a complete halt is about as easy as the Titanic trying to steer around an iceberg. Investment markets worry that in bringing inflation down, central banks will create a recession, causing unemployment to rise and businesses to fail. Now clearly, no central bank is setting out to achieve this, and it is interesting that so many financial market participants seem to have such little faith in the competency of their central banks to slow things down without slamming on the brakes. But nevertheless it is easy to see that there is a risk of a hard landing, and this is why we’re seeing such volatility on share markets.

So faced with the current scenario of prices rising, and the likelihood of interest rates rising, what are the sensible actions for you to take? Well for one, if you have debt, determine what your repayments will be if interest rates are a couple of percent higher than they are today, and determine how you will afford those new higher repayments. If you’re an employee, pay close attention around pay review time and make sure that you not only get a pay rise this year, but the rate of rise is at least equal to the rate of inflation. If you are a business owner or self-employed, ensure you are putting up your prices to match the increased costs of your inputs, otherwise you will find that you’re working harder than ever but getting rewarded less and less. And of course if you have significant savings in the bank beyond normal short-term and emergency funding needs, think about whether those monies should be invested, because the purchasing power of those savings is getting eaten away by inflation. Remember, those with significant savings are the ones that get hurt the most in a rising inflationary world.

Well, that’s it for this week, I hope this helps you make sense of what’s going on right now.

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