For the past 30 years, the Australian cash rate has declined, from 17.5% in the 1990s to 0.85% today. Record low interest rates have been great news for individuals wanting to borrow money – homeowners were able to pay less in mortgage and new homeowners were enticed into the housing market, banks were able to lend more and help businesses to boost their capital and the price of shares, bonds and assets as savers look for a higher rate of return.
However, new inflation data from the US has induced fears that the world is teetering on the brink of a global recession.
Thankfully, central banks and government treasury departments always have a plan to normalise inflation levels under these circumstances. It is expected that the RBA will finally raise its interest rates to normalise monetary conditions in Australia to return inflation to its ideal target level. But what factors have contributed to this sudden spike in inflation? How will it affect us in the short-term, and how will the government respond to bring things back to normal?
Why is inflation rising?
Generally, prices are always increasing overtime, hence why inflation is always positive. This is usually reflected in the Consumer Price Index (CPI) measured quarterly by the Australian Bureau of Statistics (ABS).
Underlying price pressures started to intensify midway through 2021 after almost six years of low inflation due to a combination of factors: a tight labour market stimulated by low interest rates and record-high government spending has led to a boost in household demand for goods and services, retailers being forced to pass on costs associated with supply-chain disruptions and higher shipping prices onto customers, and booming construction activity and inflation in building prices has been increasing the cost of building a new house to record-breaking rates.
The winners and losers of rising prices
A small amount of inflation is good for the economy. More demand means more spending which results in more aggregated demand. This in turn triggers more production to meet that demand. Moreover, inflation also enables debtors to repay their loans with money that is less valuable than the money they borrowed, hence encouraging borrowing and lending.
However, rapidly rising prices can be damaging. Inflation can erode the purchasing power of consumers if prices continue to increase at a rate faster than wage increases. When the real value of money is reduced, consumers will not be able to afford as many goods and services overtime.
Furthermore, the erosion of purchasing power may also lead to workers seeking larger wage increases to compensate for the effects of inflation. Ironically, this further increases inflation since firms will be compelled to pass the extra costs to the consumer.
A higher inflation rate can also influence when households make purchases or when businesses make investment decisions, thus distorting spending and investment decisions. The real return on investments will also be much lower, hence hurting growth stocks.
Inflation creates a lot of uncertainty for customers, banks and companies. Diminished economic growth and rising unemployment occurs as a result of the reluctance to invest. Hence, higher inflation is associated with long-term deterioration in economic prospects.
In spite of the many damaging effects of inflation, there are some who will benefit from these significant economic changes. Fixed-rate mortgages are home loans where the interest rate is locked in for a certain period of time or for the life of the loan, hence they won’t flow with inflation. During this period, both the interest rate and the required repayments will not change. These mortgage holders will essentially be paying back with devalued dollars. Homeownership is also considered as a hedge towards inflation because house prices generally appreciate over time.
Moreover, some investors can also expect to benefit from rising inflation and interest rates. The same factors which raise the price of goods also raise the values of companies, hence some shareholders can expect economic gains. The value of equities varies directly and proportionately with inflation. Companies will respond to increasing costs of inputs by raising the prices of their goods and services in order to protect themselves from inflation.
How will the government respond?
The RBA aims to keep inflation (CPI) between the ideal rate of 2-3% through various monetary policies. This target provides a framework for the central bank’s policy decisions and to achieve price stability, full employment, and prosperity and welfare of the population and ultimately ensure sustainable economic growth. If the inflation rate is too high, the RBA can be expected to tighten monetary policy by making policy decisions such as increasing the cash rate. If inflation is too low, the RBA will loosen monetary policy.
Typically, the central bank sets monetary policy only if the change in inflation can be expected to have an effect on the behaviour of households and businesses. The RBA tends to look through temporary changes in inflation without taking any policy actions if it will not significantly influence consumer and business behaviour. Hence, the RBA’s decision to increase the cash rate by 50 basis points in June 2022 reflects the RBA’s expectation that the rise in inflation will have a lasting effect on Australian business and household behaviour. The RBA board has released a statement highlighting their concerns regarding rising house prices and how they amplify household wealth and spending. Higher household savings rates in comparison to pre-covid levels signals strong household consumption growth and implies its contribution to rising inflation. Hence, in order to slow down economic activity and inflation, the RBA can be expected to further increase the cash rate when necessary to normalise monetary conditions in Australia and ensure that inflation returns to the ideal target over time.
Things will get worse before it gets better
Reserve Bank governor Philip Lowe has predicted that inflation in Australia will hit 7 per cent this year, but expected it to start declining by early 2023. Yet, it will take a couple of years for inflation to return to its normal rates. Interest rate increases are also to be expected as the RBA attempts to bring inflation down to its optimal levels. A couple of factors will contribute to the decline in inflation over time: a reduction in supply chain disruptions which were caused by the pandemic, the tightening of monetary policy and the possible eventual fall of some of the very high prices caused by inflation.
The Governor has also noted that a recession was not on the horizon for Australia, since the fundamentals were still strong and positive. Inflation will eventually return to normal, however the road to recovery will be difficult in the short-term.
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