The effect of rising inflation
Written and accurate as at: May 03, 2022 Current Stats & Facts
The word ‘inflation’ doesn’t only dominate business news headlines but also finds its way into general news reports.
So, what is inflation, and how does it affect you?
Inflation signifies an increased cost for goods and services, meaning you pay more for every purchase you make.
Does the US influence Australia’s inflation rate?
It is not a surprise that countries in today’s world are more connected than ever before. Therefore, a rise in US inflation rates will also impact the Australian economy and other countries.
However, the degree and timing of its impact will vary. For example, a rise in labour costs in the US may have a limited effect on Australians; however, an increase in the price of iPhones or Nike shoes in the US will reflect their price in Australia.
What will be the impact of rising US inflation on Australia’s economy?
Interest rate movements made by the US Federal Reserve Bank (the Fed) are closely monitored by central banks worldwide, including the Reserve Bank of Australia (RBA). Many developed economies, including the US and Australia, have reduced interest rates to boost their economies in recent times. With rates nearing all-time lows, there is an expectation that rates will increase due to the strong performance of those economies. Quite often, when the Fed increases its interest rate, Australia is quick to follow suit.
The cost of borrowing funds (home loans, business loans, personal loans etc.) will increase, leading to a rise in the inflation rate, making goods and services more expensive. Rising inflation rates can also negatively impact the Australian dollar, where one AUD buys less USD than it may have done previously.
This also affects tourists who may have to convert money before travelling and can negatively affect individuals’ capacity to save money significantly if their incomes do not rise by the same rate as inflation.
What will be the effect on investors?
Investors may wonder whether stock returns will suffer if inflation keeps rising. Data suggests that Inflation isn’t necessarily bad news for stocks. A look at equity performance in the past three decades does not show any reliable connection between high (or low) inflation periods and Australian stock returns. Since 1991, one-year returns on stocks have fluctuated widely. Yet the weakest returns can occur when inflation is low, and 24 of the past 31 years saw positive returns even after adjusting for the impact of inflation.
History shows that stocks tend to outpace inflation over time—a valuable reminder for investors concerned that today’s rising prices will make it harder to reach their long-term financial goals.
Over the period charted, the ASX 300 posted an average annualised return of 7.65% after adjusting for inflation.
Source: Dimensional
However, a rise in inflation may affect investment markets negatively due to higher interest rates, volatility in the economy and uncertain share prices.
For mum and dad investors, rising interest rates mean paying more interest on their home loans, which reduces their disposable income and, in turn, reduces their capacity to invest. Growth in share prices can be volatile, taking them longer to build wealth.
For retirees, an increase in the price of goods and services at a time of share market volatility can lead to selling more of their investment assets (potentially at a loss or reduced profit). Also, there could be uncertainty in dividend income, which many retirees rely upon. Retiree investors will have fewer years to recover from a drop in their portfolios than younger investors.
Five points to consider during a rise in inflation.
- First, it is essential to analyse your cash flow situation to understand where your money goes.
- Consider fixing at least part of your home loan to limit your exposure to rising interest rates.
- Reconsider new personal loans, such as car loans. Do you need to take on new debt when interest rates are likely to increase?
- For the risk-taking investor, it can be tempting to invest more money into shares when prices are falling, but always consider averaging your position to avoid market timing risk.
- For investment purposes, consider having exposure to well-established companies' "blue-chip stocks" vs riskier stocks. Investors often find comfort knowing their funds are exposed to good quality companies with solid balance sheets.