Inflation, Interest Rates and You
It’s important to measure how much you make on your investments but it’s much more important to know how much you keep after inflation.
So why have interest rates sky-rocketed?
There are two general types of inflation.
What is the current situation in Australia?
What are the effects of inflation?
Does anyone benefit from high inflation?
What are the Long–term effects of inflation?
Firstly, what is inflation? Inflation is the rate that prices increase over a specific period in time.
Inflation is like a hidden force that affects the purchasing power of money. For example, when your favourite chocolate bar costs more each year – that’s inflation at work. It’s crucial to understand that inflation erodes the value of money over time. As prices rise, the same amount of money buys fewer goods and services.
The problem is that Australian families who are paying more for their weekly grocery bill also have to pay more for their mortgage.
- So why have interest rates sky-rocketed?
To slow the economy and reduce inflation, policymakers at the Reserve Bank want to reduce household spending. They do this by increasing interest rates. When interest rates rise, we spend less on goods and services. This reduction in spending, in turn, reduces demand and therefore reduces inflation. This is called Monetary Policy.
It is worth noting that the socio-economic burden of controlling inflation falls mainly on young families because they have the largest mortgages. This is how younger couples with large mortgages are saving Australia. And it’s not fair!
Simultaneously, the older and wealthier section of the Australian population who have no mortgage suffer little negative impact.
Economists measure inflation as an increase in the Consumer Price Index (CPI). The CPI is a measure of the general increase in prices. In a healthy, growing economy a CPI rate of around 2% – 3% per annum is considered appropriate. This is the target inflation rate of the Reserve Bank. To find out more about the CPI click here.
- There are two general types of inflation.
They are demand-pull inflation and cost-push inflation.
Demand-pull inflation occurs when there is an increase in demand but with no similar increase in the production of goods and services. Prices therefore increase. We see this occurring in Australia due to the rapid surge in immigration giving rise to increased demand. The term “population-driven inflation” has recently appeared in the Australian press.
This increase in immigration was preceded by increased money supply as the government pumped money into the economy via job-keeper payments, business assistance packages and household supplementary funding to overcome the negative economic impact of the Covid pandemic.
Cost-push inflation (sometimes called “Wage-push inflation”) occurs when the costs of producing goods and services rises. This increase is currently due to increases in the cost of electricity and fuel. This rise in inflation was coupled with bottlenecks in logistics networks. Together, these increases in cost have been added to the price of goods and services. Simultaneously, the cost of borrowing for businesses has also increased.
- What is the current situation in Australia?
Price increases have occurred simultaneously with a fall in real household income. Compared to the remainder of the developed world Australian households have experienced a comparatively larger drop in real income. And on top of this, the cost of borrowing for a home loan has increased dramatically.
Australian consumers are bearing increases in the cost of rental properties, fuel, electricity, food, and in particular, much higher interest rates on their mortgage. For more information and to calculate the effects of inflation in Australia over time click here.
The effects of inflation become obvious when the cost of goods today are compared with their cost in past years. For example:
- In October 2020 a litre of unleaded petrol cost $1.22 three years later an average of $2.00+
- In 2000 a coffee cost less than $3.00
- What are the effects of inflation?
High inflation has five prevalent outcomes. They are:
- Higher interest rates
- Loss of purchasing power
- Higher prices
- Slower economic growth
- The potential for a future recession if the anti-inflationary measures (rates set by RBA) prove to be excessive.
- Does anyone benefit from high inflation?
To increase the value of your investments you need to earn at a rate that is higher than the rate of inflation. This is the real return of your investment.
Increases in interest rates by the Reserve Bank have resulted in higher earning rates for investors who hold bank deposits such as term deposits and interest-bearing bank accounts. But if the rate of inflation is higher than the interest rate offered by the term deposit or interest-bearing account, the real rate of return is negative. That means that the investor is actually going backwards.
We are currently experiencing inflation of 5.4% and banks are offering term deposits around 4.5%. So those investors who are currently earning 4.5% in a term deposit are seeing those earnings eroded by an inflation rate of 5.4%. These investors have a real rate of return of -0.9% per annum.
Let’s look at an example.
| Investor 1 invests $1,000 in a term deposit offering 4.5% with a CPI of 5.4% (current inflation rate) | |
| Investor 2 invests $1,000 in a term deposit offering 3.5% with a CPI of 2.5% (target inflation rate) | |
| QUESTION: | Who is getting the highest real return? |
| ANSWER: | Investor 2 is better off by 1.9% per annum. |
| WHY: | Investor 1 has a negative real rate of return (-0.9%) while investor 2 has a positive real rate of return (1.0%) |
- What are the Long–term effects of inflation?
One long-term effect of inflation can benefit borrowers. This occurs when the borrower repays the lender (bank) with money that, after a passage of time, is worth less than when it was borrowed. We all know the stories of our grandparents who purchased a house in the 1960’s or 1970’s. It could now be paid for, in full, for less than the price of a 2nd hand car. But that latent benefit for current borrowers is a long time in the future.
If inflation is left uncontrolled it will cause economic chaos. Unfortunately, there are numerous examples globally where inflation is very high. In Venezuela the current inflation rate is 317%. That means that an item purchased today for $10 will cost more than $9500 in 5 years’ time. Prices are rising so fast that many stores do not put prices on items that they have for sale. In Argentina the current inflation rate is 143% per annum, Zimbabwe is 77% per annum, while in Turkey it is 61% per annum.
Inflation is the enemy of the Reserve Bank. Policymakers will doubtless remain determined to ensure that inflation is quickly brought under control. Therefore any further spike in inflation such as that Australia experienced in 2022 is now largely reduced. There is growing agreement among Chief Economists that the appetite for further interest rate increases has diminished.
Fiscal Policy is use of government spending and taxation to influence economic conditions such as inflation. Importantly, over the past two years of interest rate increases, the Federal Government has elected not to participate in any actions to mitigate those interest rate increases. Instead it supported the blunt instrument of Monetary Policy and the subsequent rapid increase in interest rates.
💬 Have questions? Email me directly or book your free Discovery Call to start a conversation about your goals.
🎓 Ready for a transformation? Check out my Money Makeover Course and take the first step toward financial freedom today!
