Inflation has remained higher for longer than predicted to the point where the phrase has become a mantra of the Reserve Bank of Australia (RBA) Board meetings. But, the question is, what to do about it when the only lever appears to be the blunt instrument of interest rates. The concern being that each interest rate increase risks tightening the economy until it breaks.
The Westpac MI leading Index suggests that the Australian economy will experience below trend growth well into 2024. The Index suggests GDP growth will slow to 1.2% over the year to the end of 2023 and hold around that weak pace in early 2024 with an annualised growth rate of 1.1% over the first half of the year. This is well below population growth, which will be running at around 2.3% over the year.
In a recent speech, RBA Governor Michelle Bullock said, “Inflation is past its peak and heading in the right direction, but it is likely to return to target a bit more slowly than we previously thought.” As a result, the 0.25% interest rate increase in October was considered appropriate to increase the speed at which inflation returns to target (2% to 3%). But the battle to control inflation is different to what it once was and is now increasingly homegrown and demand driven. While external pressures from global supply chain disruptions and other price rises created the initial surge in inflation around the world, Australia is now battling demand-driven inflation from three sources:
Prices have risen strongly for the majority of goods and services we consume. Inflation is broader than just the rising cost of fuel, electricity and rent.
Demand for services is stronger than supply – hairdressers and dentists, dining out, sporting and other recreational activities has increased. The cost of services has been impacted by increases in wage growth, business rents, insurance and energy.
Limited capacity – labour utilisation is high. Business is increasing prices in response to strong demand (unable to use labour to meet increasing demand).
For many goods and services, we’re currently paying well above average inflation of 3%. In the September quarter, fuel, electricity, audio visual equipment, rent, dining out and takeaway were all sitting at least 5% above the average inflation rate (and some well in excess of 5%).
While each RBA rate rise is generally met with alarm within the community, the RBA’s cash rate and rate increases have been more conservative than other central banks – 5.33% in the United States, 5.25% in the United Kingdom, and 5.5% in New Zealand. This conservative approach means that inflation will be higher for longer with Governor Bull stating that, “it took only three quarters for inflation to fall from 8% to 5.5% as the supply-side issues eased, and there is some more to go there. But we expect it to take another two years for inflation to fall that much again and move below 3%.”
So, have interest rates reached their peak? RBA modelling is predicated on further rate increases (one or maybe two over the coming quarters), and productivity growth recovering in the year ahead, to reach target inflation levels. But, this will depend on homegrown inflation coming to heel and there are many who believe we have reached the peak.
For investors, rising interest rates:
Increase the cost of debt. Individuals and business need to spend more servicing debt. However, while there is generally a lag of 6 months or so between an interest rate increase and its impact on the market, the property market is showing no signs of slowing down. The market has increased 8.1% from its low in January 2023. CoreLogic suggests that property prices are being impacted by an imbalance between supply and demand with listings 16.6% below the previous five-year average nationally.
Make low-risk defensive assets such as term deposits at interest rates of 5% plus look attractive. When interest rates were very low, safe stocks with dividend payments were more attractive.
Looking at the mix of your investments or debt levels? It’s important to get good advice. Talk to us before leaping in and making changes.