Inflation and rates could remain higher for longer… what to do…

Inflation reduced from 7.8% in the December quarter to 7.0% in the March quarter, which was good news, of course.

Many economists believe that inflation (CPI) will continue to decline over the coming months.

However, history tells us that when inflation has exceeded 8% (like in the US last year), it has taken over a decade to return to ‘normal’.

Therefore, inflation and possibly interest rates may remain higher for longer.

If that happens, what financial decisions should you make to accommodate this risk?

Why the inflation rate may tumble this year

The reason that the inflation rate will fall over the next year is that higher inflationary quarters will be removed from the annual calculation and replaced with a lower quarterly reading.

For example, when calculating the annual rate for the year ended March 2023, the March 2022 quarter (2.1%) was replaced with March 2023 (1.4%) – which is why the annual rate declined from 7.8% to 7.0% p.a., as depicted in the table below.

If the June 2023 inflation reading is below 1.8% (to be released on 27 July 2023) which is likely, the annualised rate will fall again.

For the annual rate to fall below the RBA’s target (of 2% to 3%), the quarterly rate needs to drop below 0.75% for four consecutive quarters and remain below this level.

But history tells us that 70% of the time, inflation spikes to a higher level

It is tempting to adopt a viewpoint when we want it to be true.

For example, many people might believe that inflation will fall back in line relatively quickly because that’s what they want to happen.

Of course, life doesn’t always play out how we want it to.

To avoid this temptation, I think it’s always good to let history be your guide.

That is, how has inflation behaved in the past?

A reputable US firm, Research Affiliates has done some work on this (here). It looked at how inflation has behaved since 1970 i.e., over 50 years of data.

I found its insights very thought-provoking:

• When inflation rose above 4%, it tended to be non-transitory which means it took a lot longer to return to normal.
• When inflation rose above 8% (as it did in the US and most of Europe last year), 70% of the time, inflation subsequently rose to above 10%. That means that 70% of the time, and fall in inflation (as we are experiencing now) was only temporary.
• Perhaps the most compelling insight was how sticky inflation can be. When inflation rose above 8% (as it did), the median time it took to fall below 3% was 11 years!

Whilst we might want to believe that inflation won’t be sticky this time, this data does invite us to consider the likelihood of inflation, and therefore interest rates, remaining higher for longer than we expect.

Of course, it is possible that inflation will fall back into the RBA’s target band over the next couple of years.

After all, that has happened 30% of the time. But it probably shouldn’t be your most-likely scenario.

What may cause inflationary to be sticky?

The RBA has hiked rates by 4% over the past 11 months.

Most people would think that would be enough to bring inflation under control.

Of course, there’s a lag effect because it takes the banks two to three months to pass the higher interest rates onto borrowers (i.e., they don’t automatically recalculate the minimum repayments on P&I loans after every interest rate change).

Also, fixed-rate borrowers avoid the impact of higher rates until their fixed terms expire – there are plenty of Australians in this category.

Therefore, it’s true that it’s impossible for the RBA (or anyone) to measure the impact of current rate settings.

My guess is that the RBA feels it’s better to risk pushing rates too high, than not enough, especially considering Research Affiliates’ insights – no one wants high inflation for 11 years!

There are some things that are outside of the RBA’s and Australians' control that will likely add to inflationary pressures:

• The price/wage spiral will further fuel inflation. You would have seen that the Fair Work Commission increased the minimum wage by almost 6%, which few would argue against, but such an increase will almost certainly be inflationary. Fund manager, Coolabah Capital analysed recent GDP data and found that labour costs have been the largest contributor to inflation.
• Rents are rising fast. Rent accounts for almost 7% of CPI. Interest rates will push rents and the cost of housing higher (the overall category is 23% of CPI).
• Energy costs (gas and electricity) are expected to rise significantly over the next 12+ months.
• I suspect that many businesses haven’t passed cost increases onto customers yet. Most businesses tend to hold back on passing on higher costs for as long as possible. However, they must raise prices eventually, especially if inflation persists.

Interest rates could continue to climb higher

If inflation remains stubbornly high, it is possible that the RBA will have to push rates higher and hold them at elevated levels for longer.

• Also read:Sydney housing market update | May 2024
• Also read:Melbourne housing market update | May 2024
• Also read:Latest property price forecasts for 2024 revealed. What’s ahead in our housing markets in the next year or two?
• Also read:CoreLogic National housing market update | May 2024
• Also read:Melbourne property market forecast for 2024

ANZ and CBA increased their forecast peak cash rate to 4.35% this week, meaning that the RBA will have to hike one more time.

Coolabah Capital’s chief macro strategist, Kieran Davies’ modelling suggested that the RBA will have to increase the cash rate to between 4.6% and 5.6% to get inflation under control.

This forecast is much higher than any other mainstream economists’ estimates.

What if the RBA hikes rates too far?

There is certainly a cohort in Australia that would be feeling the full impact of higher interest rates, such as lower-income families and highly indebted households.

However, there’s also a cohort of Australians whose spending patterns remain largely unchanged.

This cohort includes higher-income-earning families which have large savings buffers.

That’s the problem with monetary policy (i.e., interest rates).

It is a blunt instrument.

Unfortunately, many Australians will suffer to get inflation under control.

Annual inflation is currently 7%, according to the ABS, but the reality is that a lot of household expenses have increased by a lot more than 7%.

A trip to the supermarket confirms that.

The saving grace is that as soon as the RBA is confident that it has inflation under control, it will be able to provide immediate relief to households by cutting rates again.

The government will also be able to use fiscal policy (spending) to stimulate the economy, if necessary.

Therefore, if Australia does slide into a recession, it is likely to be a very short and shallow one (same in the US too).

The problem will be if inflation persists.

Higher interest rates will cause stagflation, being high inflation at the same time as falling GDP.

What asset classes to invest in if inflation remains high

As stated above, it is possible that inflation will fall quickly in the coming year or two, but history says it’s unlikely.

Therefore, the natural question is how should you invest to protect yourself from a higher inflationary environment.

The chart below is from a presentation by Rob Arnott from Research Affiliates.

It sets out which asset classes outperformed (since 1970) when higher inflation surprised the market (the left-hand side of the chart).

Some key takeaways are:

• Commodities perform the best. However, arguably, Australian investors already have enough exposure to commodities via the Australian index (e.g., about 24% of the index is invested in the basic material sector). If not, VanEck has a good resource ETF (MVR), but I’d avoid adding too much exposure to commodities.
• REITs are a good inflation hedge because property prices accelerate in a higher inflationary environment. I prefer to not invest in Australian REITs because they have too much exposure to retail property and global REITs provide more diversification. I like REIT and Vanguard International Property Securities Index Fund.
• Inflation-linked bonds (referred to as TIPS in the above chart) protect you from a positive surprise in inflation, such as ILB.
• Reduce equities exposure. Equities tend not to do well in a high inflationary environment. US equities tend to perform better but I’m not sure that will be true this time around given the index is dominated by tech companies trading on high multiples. Value has outperformed growth by a large margin in high inflationary times, so I’d recommend tilting the portfolio this way, rather than reducing exposure.

What should you do

Of course, the commentary and ideas above are general in nature and should not be considered as advice.

Everyone’s situation is different.

However, generally, I would advise against making big changes just because you are concerned about inflation.

Often, it is better to stick with a diverse asset allocation but change the way (methodology) you invest.

If nothing else, perhaps this blog highlights the complexity involved with portfolio construction and management (i.e., investing in shares and bonds) which is an important ingredient to minimise investment risk and maximise long-term returns.