Is this inflation or just a blip?

Many business owners are experiencing pent up demand, due to delayed expenditure carried over from last year and a renewed optimism from consumers. Extended lockdowns and harsh restrictions have been met with monetary and fiscal stimulus, which has boosted our economy. Share markets are back above pre-crisis levels, house prices are at all-time highs and business profitability is up (with the exception of some sectors, notably entertainment and hospitality). This shows the power of coordinated stimulus measures from central banks and governments.

With this in mind, will the Reserve Bank of Australia (RBA) stick to their guns and delay official interest rate increases until 2024?

If we do see sustained inflation, the RBA may have to increase interest rates sooner than anticipated, flagging a big reset for asset prices. A change in the risk free rate, from which many asset managers build their valuation models, will have flow on effects if the Reserve Bank is forced to increase interest rates from the current 0.1%. The test will not only be if they increase rates, but also how they apply the brakes and communicate this to the market.

The real question is whether this is real inflation or just transitory. Are we seeing a permanent change in behaviour that will continue into the future beyond COVID-19, or are demand and the associated supply chain bottlenecks a result of the inability to spend as we normally would to travel and move about in the community? Are we merely seeing the short-term redirection of funds to home renovations, new car purchases, restaurants and local getaways?

The main factor to watch closely will be wages growth. Sustained inflation cannot persist without economy wide wages growth. Pre-COVID-19 we saw a decade long decline in wages growth due to a range of factors, including systematic action by businesses to cut labour costs, excess capacity in the labour market, technology disruptors, de-unionisation and enterprise bargaining agreements, and one of the largest contributing factors, low public sector award increases.

The current balance of supply and demand in the labour market is being affected by the closure of our international borders, but this will remain short-term as we hope to reopen our borders. The shift in spending outlined above will do little to drive wages growth, so we are unlikely to see the RBA forced to react and increase official interest rates in the short term. The RBA is far more likely to use other monetary policy measures to strike the right balance depending on what economic conditions warrant, such as recalibration of the Bank's bond purchases in either direction.

In any case, it will be interesting to watch this unfold and will play a critical role in how individuals position investments to navigate these uncertain times.

If you have any questions about the impact of inflation on your investments, or if you would like to discuss your personal financial situation, please contact your local BDO adviser today.

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