Hopes that we had seen the peak of inflation in March were dashed again as Australia’s inflation rate reaches 6.1% – the fastest annual increase in 21 years.
This latest data will inevitably lead to further interest rate rises in the coming months. Share markets around the world are reacting to the rising inflation numbers and Reserve Banks are trying to pull their only leaver to stop to slow the inflation numbers. You may question why increasing rates when inflation is rising is a sound strategy. Surely the last thing we need when prices for all of our goods are increasing is to cop a further hit through the increase to our mortgage rates.
This might sound surprising but rising inflation over the long term is good. It shows the economy is growing. However, if inflation rises too high or too fast this causes goods to be expensive. What we regularly hear on the news is that the Reserve Bank has a target inflation rate of 2 – 3% per annum. We are striving for a Goldilocks economy which is not too hot or too cold but just right. Although there is some debate among economists as to the exact characteristics of a Goldilocks economy, it is safe to say there should be a balance between growth, employment, and inflation. Currently, as we are hearing, the inflation rate is running at a much higher rate.
So how do we bring inflation under control? Really the only way the Reserve Bank has to reduce inflation in their bag of tricks is to increase the base interest rate for the cost of borrowing for Banks. We anticipate the Reserve Bank will raise rates a number of times leading up to Christmas. This pushes Banks to raise their own interest rates meaning that businesses and consumers find higher returns on savings and borrowing more expensive.
This is designed to slow the spending in the economy as more money is held in bank accounts and less is spent. If less is spent then the demand for goods theoretically drops. The lower the demand for goods should make them cheaper and hence lower the inflation rate.
This is but one simple view and you need to remember there are a lot of other economic factors at play at the moment such as the ongoing Ukraine conflict and Covid issues which continue to impact supply chains around the world. As these issues become clearer we can expect to see inflation start to stabilise and the shocks to the share market will reduce. We saw how the latest statement from the Fed Reserve Governor received a positive response on share markets because there was the slightest hint that there could be a softening in the outlook dependent on the data. Needless to say, there are still some anxious times for investors ahead.