8 days ago · 6 min read
There is so much talk of rates and inflation right now, but as with most topics in finance, the discussion turns complex and leaves most people scratching their heads.
So what does it all mean? Why should you care? Let’s break it down…
First, a few definitions.
Inflation is a general increase in prices of a basket of selected goods and services. It serves as an indicator of the change in “purchasing power” of a currency over time (i.e. what your money can buy).
The Consumer Price Index (CPI) is the most widely used measure of inflation. Most central banks around the world aim for an increase of 2% in prices per year. That way, consumers don’t notice the changes in prices too much. If it’s higher than the target range for a sustained period of time, it can cause serious economic problems.
Why? Prices are rising but incomes are not. So consumers cannot afford the same amount of goods or services they could before.
The latest inflation data shows prices rose 0.8% in September alone, and 3% year-on-year (yoy).
The effects can be easily felt when you make a daily purchase, such as buying yourself a cup of coffee in the morning. Today, you should expect to pay up to $1 more for a daily cuppa.
Not only coffee, but we are also seeing price climbs across a “basket” of goods and services such as transportation (up 3.2%), childcare (up 9.9%). Food and fuel prices (7.1%) also go up a lot.
And it’s not just an Australian phenomenon.
Major economies around the world are also suffering from price rises caused by inflationary pressures. The past week saw inflation increases in the UK (4.2% yoy) and Canada (4.5% yoy) and US (6.2% yoy).
There are a few root causes for this. The first cause is the disruption to global supply chains due to the pandemic, resulting in steep rises in freight and shipping costs.
Secondly, businesses are dealing with labour shortages. Employers are in a mad scramble for extra hands while workers are walking away from jobs, demanding better pay and flexible working arrangements.
Thirdly, just when it has become difficult to transport goods and production has slowed, demand has shot up making things more expensive. The surge in demand is so powerful that supply is struggling to keep up.
This surging demand is thanks, in part, to big government stimulus policies. Australia poured $291 billion into Covid-relief package as of May 2021. So people’s bank accounts have been filled. Households have been very keen to spend the money that they’ve saved up during the pandemic.
As we all know, inflation erodes the value of cash. When there is more money in supply chasing the same amount of goods and services, prices have to increase. Simple supply and demand.
Money depreciates in value when it’s in abundance. Savers are punished as their money has become less valuable in its ability to purchase goods. Asset holders, on the other hand, rejoice as the value of their assets appreciates.
That is why maintaining a steady inflation rate is important. Central banks have the power to keep it in check. They have the ability to control this with a modest increase in rates to slow the rise in prices. People will become keener to save because returns from savings are higher and less willing to spend. Economy slows. Inflation decreases (see image below).
Is this current elevated inflation just a temporary blip or could it spiral out of control? For now, runaway inflation seems unlikely, especially in Australia. The government is gradually winding down stimulus. Banks increasing interest rates on various products could also dampen demand.
Governments around the world believe it has a temporary nature and expect everything to eventually fizzle out over the coming quarter. There is a lot of uncertainty and forecasts aren’t always right but it is likely that the growth in demand will soften over time as market conditions normalise.
The housing market has enjoyed a busy year ending August 2021. Corelogic estimates the highest annual sales since 2004 of 598,000 house and unit sales across Australia. That’s 31% above the decade average and 24% higher than the 20-year average.
Here’s how it pans out.
During the pandemic, vendors knowing they have plenty of buyers, increase their prices. Buyers, previously unwilling to pay these prices, realise they can flip and sell the house at a higher price, so increase their bids. Plus, easy access to credit, government schemes, and record-low mortgage rates have obviously played a role.
Everyone is tempted to get in on the fun. The property market has become a lucrative business where everyone goes crazy over profit potential. Buyers and sellers have been flipping houses at higher and higher prices, turning profits as they do. Wealth accumulates. The young and poor are forced to rent or keep moving further away from the cities where they work.
Now saunters in the Reserve Bank: “This market is incredible, bustling and vibrant. I am no longer needed”. What happens next?
The flood of institutional money and stimulus efforts ceased. Interest rates hike up amid signs of an improving economy. Suddenly, the monthly repayments on that mortgage seem a bit high.
Without a buyer at any price, sellers frantically try to sell. That explains the increasing stock in the market at the moment. But buyers are going silent, prices could plummet and a price correction could occur.
Property prices are expected to lower as much as 20% if interest rates rise to 1%. However, it’s not going to be a crash, but simply a price correction. Houses should return closer to their true value.