We interrupt your regular home loan-related posts to bring you an important update all the way from the US of A. There’s been a very interesting development around inflation. Okay interesting is probably a strong word. Wait. Don’t close the browser yet. This is absolutely something you should care about.
If you haven’t already, you’ll want to click that little menu icon in the top left hand corner of the screen and scroll to the Economics category. When you’re there, have a read of the Economics 101 post for the low-down on inflation. Inflation is both a good thing and a bad thing in the sense that a little bit of it is good and a lot of it is… well quite frankly, terrifying. Here’s why. One reason prices move up over time is that there’s more demand for the same basket of goods today than there was yesterday. The fancy economists call this “demand-pull inflation”. This could for example be because people can more-readily afford those things – which means that either more people are in jobs or that people are being paid more than they were previously being paid. Sounds pretty positive right? And it is. A little bit of inflation (2-3% according to the RBA) is generally-speaking a good thing.
Where do things start to go south? Believe it or not there is a such thing as an economy growing too quickly. Particularly if it leads to too much inflation. As a result of unprecedented monetary stimulus (cheap credit brought about by changes in a central bank’s policy) and fiscal stimulus (the government handing money to people and businesses to remain employed and continue to do business), there has been a bucket load of renewed demand which has the potential to push up everyday prices. Things aren’t looking too good on the supply side of the equation either in the sense that global lockdowns have led to a shortage of raw materials and manufactured goods which also has the potential to push up everyday prices.
Every month the US reports changes in consumer prices over the preceding 12 months. Well the US recently released some pretty scary findings about changes in consumer prices over the 12 months to April 2021. The report found a 4.2% increase in consumer prices between April 2020 and April 2021. To give you a sense of how significant a bump that is, changes were 2.6% from March 2020 through March 2021 and had hovered around 1-1.5% for each of the 8 months before March.
The reason this 4.2% figure was particularly concerning is that economic analysts had reached a consensus forecast of around 3.6%. I appreciate the difference doesn’t sound like much but in the world of economics, this was a bit of a blunder. It’s far too soon to tell whether inflation is actually coming but the bad thing about rapidly-rising prices is that it significantly decreases your purchasing power. This is particularly bad in circumstances such as now where wage growth in western countries is generally quite low. If you’re not earning more to help offset inflation, your purchasing power is rapidly weakening. For example, if something costs $95 today, it will cost just under $100 in one year’s time with an inflation rate of 5%. This phenomenon disproportionately impacts poorer people who tend to keep money in the bank or under the mattress. The middle class and wealthy tend to invest and some of those investments are in inflation-hedged assets (fancy term for protecting one’s backside from inflation). Central banks cannot let inflation run loose – they will step in to control it if their hands are forced.
Transitory vs sustained inflation
Central banks insist that the current inflation trend is transitory. This means inflation is here for a short time to reflect businesses rapidly opening up again and consumers leaving the comfort of their homes once more. But that we shouldn’t be expecting longer-term sustained inflation. Their argument is a good one. They believe:
- The data is skewed because we’re comparing two very different time periods. The most concerning data was April consumer prices but if you’re comparing April 2020 data to April 2021 data, you should be thinking about how demand was unnaturally low due to businesses being forced shut and people being locked away in their homes vs demand being unnaturally high now as if the entire world is trying to play catch-up.
- All the stimulus that central banks and governments provided (which should theoretically lead to inflation) was just making up for lost economic output due to lost productivity and lockdowns across almost every sector. In other words, here’s how much money the economy should have generated during 2020, here’s how little it actually generated due to the inability to do business, and all we’re doing with all this stimulus is picking up the shortfall.
- Take a close look at what it is in the basket of goods that has jumped the most in price over this period and question how consumers will react to those price hikes. Let’s be honest – if something you want to purchase has risen dramatically in price then you’ll just temporarily put off that purchase until demand cools, if that something is unnecessary (airline tickets, rental cars, birks). Therefore we should expect to see things level out relatively quickly. So far, the data is showing that most of the big price hikes are being seen in goods and services that are generally deemed unnecessary or discretionary.
Central banks have however noted that they will act if inflation proves to be sustained. This is the opposite of transitory. It means inflation is here to stay unless we do something about it. That something means contractionary monetary policy to cool down the economy. Central banks will deploy measures that will seek to make borrowing more expensive (yes interest rates can also go up believe it or not).
“Y’all heard it here first” – bond traders
To recap, a bond is a loan. The government can issue bonds just the same as companies. We call these treasury bonds. A treasury bond’s yield is the interest rate the government will pay to any investor willing to buy and hold its bond (ie lend $ to the gov). In late February/early March bond yields started skyrocketing as bond traders started to speculate that inflation is on its way. This is why I referred to the bond market as the “all-seeing eye” in our last article, Home loan products: Variable vs fixed rates. They haven’t necessarily been proven right just yet because we’re yet to learn whether inflation will be transitory or sustained but we can’t say we weren’t warned. If like me you’re on the edge of your seat and you would like to keep an eye on how the situation develops, you can track monthly US reports on consumer prices or generally track the movement of bond yields. Or you could do both. I will do both.