Dealing with Inflation in Australia
By Thomas Kidd
Australians have really been feeling the cost-of-living pressure lately. Inflation began to take off shortly after the COVID pandemic began, reaching its peak at 7.8% in the December 2022 quarter, a level that hasn’t been seen for over 30 years [1]. What is the cause of this high inflation, and what can you do to protect yourself against the rising cost-of-living?
Inflation in Australia
There are three main contributors to the high rate of inflation over the past few years [2]:
COVID Pandemic. Lockdowns during the pandemic caused major disruptions both in the manufacture and trade of goods. This decrease in supply is cited as one of the major causes of price increases.
War in Ukraine. As a result of the Russian invasion of Ukraine, trade lines between Russia and the western world were cut off. Russia is a major producer of gas, oil, and minerals that are used for producing electronics, causing significant price increases in these areas.
Domestic Issues. Aside from the issues listed above, Australia experienced poor weather over this period, which had an impact on the supply of agricultural products. The demand for goods remained strong due to the swift response in fiscal and monetary policies. This mismatch between supply and demand is a typical driver of high inflation.
How do we slow down inflation?
Fiscal and monetary policies can be used to combat inflation. The Reserve Bank aims to keep inflation at a target rate of about 2-3% - its main instrument for doing so is by changing interest rates1. By increasing interest rates, the RBA makes the cost of borrowing funds higher, which has two main roll on effects; mortgagees will have increased repayments, which reduces their capacity for discretionary spending; and businesses will be disincentivized from taking on debt to expand their growth.
There are concerns that there is a mismatch between these effects and the cause of inflation. Reduced discretionary spending does not help address the high cost of essential goods, and slowing down business growth could be damaging when a lack of supply is part of the problem. What else can we do? Fiscal policy is where the government can work to align its goals with the RBA to curb inflation. In its most recent budget, the federal government announced several initiatives to address the issue [3] including:
Energy prices. This includes direct payments to assist with energy bills as well as investment in energy efficiency upgrades that will reduce costs going forward.
Medical expenses. Bulk billing incentives and concessions on long-term medicines will reduce costs in this sector.
Housing. Expanded investment in construction will aim to reduce costs by increasing the supply of homes.
How can investments protect you against inflation?
There are two main ways investments are used to overcome the effects of inflation:
Growth assets
Because the cost of living is expected to increase over time, investments need to grow to maintain their purchasing power. Assets such as shares and property are used in an investment portfolio to provide long-term returns that, hopefully, will outstrip the pace of inflation and grow your wealth in real terms. The key phrase here is “long-term”; these assets can experience high degrees of volatility in the short-term and typically are recommended to be held for 5 years or more. Periods of high inflation can lead to especially volatile market conditions, with changing interest rates and consumer habits, so it’s important to keep in mind the sequencing risks that come with these assets as well.
Hedging Instruments
Some investments experience returns that correlate with the rate of inflation, such that when inflation increases, so too do their value. An allocation towards these types of investments can help a portfolio maintain its purchasing power during these difficult periods. This quality can appear in many different assets but is typically associated with tangible assets such as commodities and real estate. However, these investments can have widely varying rates of correlation, volatility and return expectations; a well-balanced portfolio will include a diverse range of assets, including hedging instruments, that can weather all types of market conditions.
References
[1] Reserve Bank of Australia: https://www.rba.gov.au/inflation-overview.html
[2] Reserve Bank of Australia: https://www.rba.gov.au/publications/smp/2023/feb/box-c-supply-and-demand-drivers-of-inflation-in-australia.html
[3] Budget 2023-24: https://budget.gov.au/
Thomas Kidd in an authorised representative of Alliance Wealth Pty Ltd. (AR: 001292328)