Inflation refers to the general increase in the price of goods over time. If prices were to decrease it would be called deflation. Consensus amongst economists is that inflation is better than deflation but only while it remains within accepted parameters. The Reserve Bank of Australia (RBA) has a long stated policy aim of maintaining inflation between 2% and 3%.

Inflation is generally synonymous with strong economic growth. If an economy is growing faster than its current capacity, you can expect inflation to rise. Interest rates are the primary monetary policy tool used by the RBA to address inflation. An increase in interest rates will slow the economy and therefore inflation should also slow.

Investment markets will respond to the expectation of future interest rates because this is the key variable used to price the value of any future cashflow in today’s dollars. In mathematical terms the value of any future income stream will be higher if you discount using a lower interest rate and lower if you discount using a higher interest rate.

It pays to remember that markets don’t like surprises. We have seen higher than expected inflation numbers and as a direct consequence we have seen increased volatility as markets recalibrate company valuations.

For as long as the expectations of future interest rates remain uncertain you should expect market volatility. The RBA meet 11 times a year and at the end of each meeting they will provide analysis and thoughts around the question of interest rate expectations. Dr Lowe has been leading these meetings since September 2016 and is yet to see economic conditions that warrant a rise in interest rates.

The current monetary settings were put in place in response to the pandemic as it broke in March 2020. Inflation at that time was in the negatives and unemployment spiked to 7.2% and was forecast to exceed 12%. It was truly a scary time and governments and central banks globally responded with historically large stimulus packages.

When the RBA put its emergency settings in place in 2020 it also went to great lengths to give confidence that it would not remove these settings until at least 2024. This was presumably to give consumers and investors the confidence to gently recover from the shock of the global pandemic. History has shown that the guarantee of cheap money has had unintended consequences.

Inflation is now at decade highs, house loans are at decade highs, house prices have grown over 20% in some areas, unemployment is at 4.2% and falling. The economy is running well beyond current capacity.

However, as late as October 2021 the RBA had continued with forecasts that inflation will not reach a point that requires the cash rate to be increased until 2024. The market had not supported this forecast with the bond yields rising materially in the past six months. The RBA has recently replaced this courageous long-range prediction with the notice that they will only raise rates when actual inflation is sustainably within the 2 to 3 percent target range.

Gone are the days of adjusting the interest rate lever due to predictions of future economic activity. This has been replaced with the RBA waiting until they can see real “sustainable” evidence of changes to economic activity. In a speech in November 2021 Dr Lowe stated that “…it is hard to precisely define what ‘sustainably in the target range’ means”. 

Statistically, inflation data has a lag to it. The data we see today is really some months old. The fact the Dr Lowe has never yet raised rates as the Governor of the RBA is simple trivia. There seems to be little doubt that Dr Lowe will raise rates in his career. The risk is that now the RBA is waiting until they have actual evidence of inflation, they will contribute to volatility rather than smooth volatility.

Whilst a glib interpretation, it is like us turning on the heater in November because we were cold in July. Decisions have historically been made to nudge economic conditions towards stability which is why it is sensible to put the jumper on to prevent you getting cold rather than because the data is showing that you were cold some time ago. The use of outdated data is likely to expand the highs and lows of monetary policy decisions.

When you are giving some thought to inflation and how it might impact your portfolio also consider that market expectations of inflation are more likely to have stabilised before the media or the RBA can see the actual inflation data to confirm it has occurred. 

A final upside about inflation and its associated rise in interest rates is that this is not bad for all asset classes. The returns from bonds and cash improve as interest rates stabilise at higher levels. This will be a real plus for portfolios as it provides increased returns from defensive assets into the future.