The impact of inflation on a recovering economy

Fears of rising inflation hit the headlines here and in the US recently, causing ripples across the financial markets. After more than a decade of low inflation and low-interest rates, inflation is the most significant risk investors face now that the global economy is starting to recover at a rate that's exceeding expectations.

The downside of positive news

The impact of positive economic data is that inflation may increase faster than expected. And if that happens, interest rates will start going up, which is far from ideal for a recovering economy. 

 Increasing interest rates

Over the last 30-40 years, interest rates have steadily declined, and today they're sitting at rates never experienced before. The knock-on effect is that if inflation rises, the low-interest rates we've enjoyed as a support buffer will no longer exist. 

Instead of having low-interest rates acting as a tailwind, driving consumer spending and pushing us towards economic recovery, rising interest rates become a strong headwind. That will slow down economic recovery by pushing up the cost of living. Even an increase of a fraction of a percentage point could have a devastating effect if it happens too quickly.

The impact of inflation on the financial markets

 Rising inflation is also bad news for most major investment asset classes, such as shares and bonds. They will inevitably suffer losses because interest rates are used as a basis to price or value many investments. And if interest rates increase, the real value of an asset drops accordingly.

There are three types of inflation. Each one will impact the economy and your financial situation in a very different way. 

 Monetary inflation

 If the number of bank deposits, term deposits and currency in the financial system increases, it can be partly because governments around the world are running budget deficits. Interestingly, the amount of money in the financial system has increased every year since 1960 in the US. What's more, the total amount has grown faster since the GFC and even more so over the course of the last year. 

Budget deficits happen when a country's expenses exceed its income. If a nation can't immediately increase revenue by raising taxes and cutting spending, it'll need to fund the deficit. Many do this by issuing government bonds at a rate of interest and level of security that make them a low-risk investment for the buyer. 

However, the large-scale deficits and government bonds that have been issued in recent times have been bought predominantly by the Central Bank. They have gone on to create new bank reserves to give the money to the government.

Economists generally agree that the consequence of this type of monetary inflation is price inflation. But that's usually the point behind it. If prices and wages go up, so does the government's income, and they need to increase revenue to repay the deficit.

Asset price inflation 

As a rule, the prices and valuations of financial assets, like shares, bonds, property, gold, fine art, and fine wine (unless you drink it), generally increase over time. Some assets have experienced significant increases over recent times, such as some shares and property.

When there's more money circulating in the economy, it can be used to buy assets. One recent example has been in the US, where government stimulus payments have been used to purchase shares. It's widely believed that this behaviour has increased the price of some shares in the markets to unrealistic levels. 

It's an interesting scenario because the government intended for stimulus payments to increase spending, which in turn would boost the economy. However, some people have invested the value of their payments in the financial markets in an attempt to get a return on their money. It's a tactic that could work for some. But of course, it might not.

Consumer price inflation 

The Consumer Price Index (CPI) is the category of inflation you'll be very familiar with. It measures the monthly price changes of everyday consumer goods across eight major categories, including food and beverages, housing, apparel, transport, education and communication, recreation, health care and other goods and services. 

Despite CPI being considered as the benchmark for measuring inflation, it's actually hard to measure the personal effect of CPI because no two households have the same expenses. What's more, many economists believe that the official CPI rate is lower than the actual inflation rate. Still, it's a valuable tool for measuring how an economy is faring, and it's used to calculate the cost of living for social security payments and wage increases.

How inflation will affect your financial future

As a real-life example of the personal impact of inflation, let's assume you're spending $60,000 per year on regular household living costs. If inflation averages 2% per year in 20 years, this same $60,000 will become almost $90,000. And if it averages 3%, it will become approximately $108,000.

This is why it's essential to factor in inflation when you're saving for retirement. You have to aim to generate a return that exceeds inflation. Those of you in retirement may argue that you'll gradually spend less over the years, which is generally true. However, there are often several years immediately following retirement, when your spending can be similar or higher than it was when you were working.

Where's inflation at right now?

We've already experienced monetary inflation and asset price inflation. But we're yet to see an increase in CPI despite considerable effort to push it up over the last decade. While governments and central banks' responses over the previous year have been necessary to prevent substantial economic problems, their actions are yet to spark inflation. However, some economists feel inflation is likely in the short term, and most agree that it's inevitable in the long term.

What can we expect in the coming months?

The other ingredient needed to drive CPI upwards is for wages to increase. If wage earners have more money to spend and spend it, rather than save it, demand increases, which in turn raises prices and leads to a rise in inflation.

In Australia, we're seeing unemployment fall, and eventually, this will happen in other countries once their economies reopen. Nonetheless, a drop in unemployment is unlikely to push up wages enough to impact inflation in the short-term. There are still long-term trends working against this, including ageing populations, technological advancements and falling wages due to declining unionisation.

What can we expect over the next few years?

 If we believe what central banks in Australia, the US and elsewhere tell us, the year ahead and probably the next few years are unlikely to see sustained strong inflation. In fact, their economic planning is based firmly on this being the case. 

All the same, there's likely to be periods when the financial markets' expectations around inflation differ from the central banks' view and interest rates may increase sharply. 

This is nothing new. We're in a typical boom and bust cycle where markets slowly move upwards, then suffer a sharp fall before recovering again. What's most important is that no matter where the economy is at right now, you should always factor in rising inflation when it comes to planning your financial future. 

by Gary Lucas.

Thanks to Lyn Alden for her research, which was used as source material for this blog.