Inflation – friend or foe?

There is growing debate and discussion about the path of inflation in the medium term. However, the Reserve Bank continues to keep interest rates on hold as inflation pressures ease.

The combination of global government stimulus packages and the printing of money that has occurred since the 2007 global financial crisis have resulted in increases in money supply. This has historically triggered inflation but in our current economic environment it is being offset by significant falls in consumer demand.

There are a number of other factors that might affect inflation. An emissions trading scheme (ETS) will generally have some effect on general price levels, particularly energy.

Also, as the emerging economies of China and India become wealthier, their food and energy consumption is likely to increase dramatically. This will boost demand for those commodities, and could also lead to increased prices and higher inflation in Australia.

Why should we be concerned if inflation does rise?

The most worrying impact is that inflation erodes the value of savings held in assets such as cash due to the lump sum decreasing in real terms.

This means that retirees should take note of inflation movements as they generally live off accumulated assets and have a limited ability to build up more assets. Without careful planning, retiree incomes often cannot keep up with price rises, leading to a fall in living standards.

For some workers, the ability to ensure that their wage growth keeps up with inflation may be limited. Income earners should also be aware of ‘tax creep’, where salary increases that help to keep pace with inflation means movement into higher tax brackets.

For investors holding fixed income investments that pay a pre-determined return, inflation can also erode the value of that income.

On the other hand, for those investors holding significant amounts of debt, particularly fixed rate debt, inflation can be good news. The real value of those payments will fall, meaning the debt is easier to service. The value of the loan, too, will fall in real terms.

Growth assets, such as property and shares, which tend to keep up with inflation over the medium to long term, are ideal investments when inflation is on the rise.

Potential increases in inflation levels are something that should be considered in the design of your investment portfolio. If you believe inflation might impact your standard of living, talk to us about “inflation-proofing” your portfolio.

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Sources:
http://www.bos.frb.org “The Impact of Inflation” R Hellerstein Winter 1997
http://www.youngmoney.com “The Impact of Inflation” 31 May 2007
http://www.bloomberg.com “Australia’s RBA Sees Scope for Rate Cut as Inflation Eases; Currency Falls” 4 October 2011