O.K. there’s lots of talk about inflation – what is it? And what does it mean for those of us interested in property investment?
Inflation is defined as a general increase in prices and a decline in the purchasing power of money.
We’ve had periods of high inflation in Australia and as a result our currency is worth comparatively far less than it was.
$10,000 doesn’t go very far at all today, whereas in 1960 it would have bought you a reasonable house in Sydney and a new motor car!
What causes inflation?
Theoretically, as the world becomes a more developed and efficient place, you might expect prices to get cheaper. And sometimes we do see this, such as with certain types of new electronic goods.
Economists explain that inflation comes from both demand-pull and cost-push. Wars and natural disasters can cause inflation too. Gradually, over time, businesses and individuals tend to charge more for their services.
A key factor today is that it is actually stated monetary policy to target a range of inflation. Our central bank in Australia (the Reserve Bank, or the RBA) has a target range of inflation of 2-3%.
Why do we want moderate inflation?
High inflation can hinder economic growth for it introduces uncertainty. It discourages saving (as money loses value over time) and also discourages lending, for inflation introduces a risk premium by effectively redistributing wealth from creditors to borrowers.
In the US, the Federal Reserve also noted how high inflation can also cause individuals to spend more time worrying about hedging against inflation than actually engaging in more productive activity.
Why not deflation?
On the other hand, deflation – being the opposite of inflation – can be even more destructive, for when prices are expected to fall, individuals are disinclined to spend at today’s prices. Economic growth stalls then falls. Debtors can be left with assets worth less than they paid for them and a devastating downward spiral can ensue.
Strange though it may seem, it is also very difficult to cut wages in times of deflation.
Psychologically, employees simply don’t like it, even though a wage cut in times of deflation no less logical than a wage increase in inflationary times.
How is inflation measured?
There are a number of inflation gauges, but the one which is most commonly referred to by the Reserve Bank is that of the Australian Bureau of Statistics (ABS). Each quarter the ABS releases its Consumer Price Index, which measures inflation across a number of categories.
To ensure that the series is not too volatile (so that the data is not wildly skewed, by say, expensive bananas if a cyclone has wiped out the banana crop), in addition to the headline inflation figure, the ABS reports two underlying inflation measures known as the weighted median and the trimmed mean. These minimise the impact of outlying statistics.
As you can see above, headline inflation is currently benign at only 2.0%. However, this figure is dragged down by discounting in some sectors. More importantly, the most recent underlying inflation printed at 2.50% ((2.6+2.4)/2) – which is smack in the middle of the 2-3% target range.
The RBA considers the ABS inflation figures carefully when it sets its monetary policy, and the currently soft inflation and weak retail sales figures were a key factor in allowing the interest rate cut yesterday.
The problem with inflation for individuals
Inflation is an effective tax on net savers, and thus individuals need to have a more effective method of beating inflation than simply always relying upon a pay-rise.
The 3 main methods of beating inflation
The best inflation hedges tend to involve holding assets which have a growth component as well as an income component. Advanced investors might look to preference shares (preferred stocks) and convertible bonds as two such examples.
One method popularised by the writing of Robert Kiyosaki is to buy gold and silver bars or coins. Anyone who bought physical gold a decade ago would know that this can work.
Over the long term, this approach has the disadvantage of providing no income, and thus the dividends received by equities investors instantly award them an advantage. For most average investors, buying shares in companies which can outperform inflation is a proven inflation hedge.
Not all companies thrive in inflationary times, however. You need profit-making and dividend-paying companies, such as those with an effective monopoly or franchise, which can increase their revenues above inflation but also above the rate of increase in their costs.
A great way to do this is to look at a diversified LIC which invests in a portfolio of industrial stocks which pay strong dividends and tend to outperform the wider market.
The other way to beat inflation, of course, is through buying well-located real estate – though again it must be property that is in high demand.
There are two reasons why property investment is suitable as an inflation hedge.
1. Firstly, because if you take out a mortgage the loan is not impacted by inflation; rather the balance is fixed at the level at which you took it out, so it effectively becomes worth less.
2. Secondly, although the trend is by no means closely correlated, rents and property prices do tend to increase over time with inflation the growth in household incomes.
To capitalise on demographic and affordability trends over the long run, particularly consider two bedroom apartments in the major capital cities which can be a great investment.
Apartments are less impacted by poor affordability than houses in the capital cities and there are also many more two income households than there were two decades ago which can drive values higher.
These types of property are increasingly in high demand and consequently can make for outperforming investments.
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