Inflation is a key economic indicator that affects everyday Australians and investors alike. It describes a wider increase in the cost of goods and services over a period of time, reducing purchasing power within an economy. With most of the world enduring inflationary pressures recently, many investors want to better understand what causes it.
Here, we explore the causes of inflation in Australia, including global trends, monetary and fiscal policy, exchange rates and general consumer spending habits. Along with your own due diligence, these insights may help you better understand what is causing inflation in Australia and what you can do as an investor to navigate the economic landscape.
International factors
International factors often play a significant role in causing inflation in Australia, such as global conflict disrupting supply chains and subsequent price hikes. The Ukraine crisis, for example, has contributed to fluctuations in oil and gas prices, which has subsequently had knock-on effects on the cost of local goods and services.
The COVID-19 pandemic has also caused major supply-chain disruptions worldwide, leading to shortages of various goods and increasing prices. Additionally, ongoing trade tensions with major economic powers such as China have led to tariffs and trade restrictions, which have increased the cost of imports.
Exchange rates
Exchange rates can have an unexpected impact on inflation levels in Australia. A weaker Australian dollar may lead to higher inflation because it increases the cost of imports and reduces consumer purchasing power. When the exchange rate depreciates, the cost of imports rises – subsequently increasing the price of imported goods and services.
A weaker currency can also make it more expensive for businesses to access capital – especially from international sources – which means increased borrowing costs. On the other hand, a stronger Australian dollar can help lower inflation levels by reducing the cost of imports.
Monetary policy
Monetary policy is another factor that can contribute to inflation. The Reserve Bank of Australia (RBA) sets the official cash rate, which influences the cost of borrowing for both individuals and businesses. When the RBA reduces the official cash rate, it becomes cheaper to borrow money, which can stimulate consumer and business spending, leading to an increase in demand for goods and services.
However, when the RBA increases rates, borrowing money, such as home loans, becomes more expensive, which can reduce consumer and business spending and ultimately reduce inflation.
The RBA can also influence the cash supply by adjusting rates and using quantitative easing measures, which affect the amount of money circulating in the economy and have flow-on effects on inflation.
Fiscal policy
An additional contributor to inflation in Australia is fiscal policy. Government spending generally has a direct impact on inflation by stimulating demand for goods and services, which can result in higher prices. For instance, increased government spending on infrastructure projects can boost jobs and lead to higher income levels, which often results in higher consumer spending and inflation. When government spending reduces, however, it often means lower demand for goods and services, putting downward pressure on inflation.
Tax policies can also influence inflation by affecting the disposable incomes of everyday Australians. When taxes increase, consumers – including investors – have less disposable income, reducing spending. But when taxes decrease, consumers and investors have more disposable income, which can lead to increased spending and, therefore, higher inflation levels.
Local economic factors
While global activities have a key role to play in the levels of inflation in Australia, investors also need to pay attention to local economic factors, particularly cost-push inflation and demand-pull inflation.
Cost-push inflation
This is driven by higher production costs, which means higher prices for goods and services. Rising wages, higher taxes and bigger energy bills are all examples of cost-push inflation. When wages rise, business production costs increase, which means higher product prices. Similarly, businesses may pass on the difference to consumers when taxes increase.
Demand-pull inflation
This relates to increased demand for goods and services, which can result in higher prices. When the government increases spending on infrastructure projects or other programs, for example, it usually means more jobs and, therefore, higher demand for goods and services, leading to higher prices. And when consumers have more disposable income, they tend to increase their spending, leading to higher demand and higher prices.
What does inflation mean for investors?
Inflation always has an impact on the stock market and can affect investors in a variety of ways. That is why having a firm understanding of the relationship between inflation and your portfolio is crucial.
When inflation occurs, central banks, such as the RBA, often increase cash rates to keep it under control. This results in higher interest rates, increasing borrowing costs for individuals and businesses. As this may lead to lower profits and reduced earnings growth, company stocks may underperform in a high-inflation environment. However, some sectors, such as energy, may benefit from higher inflation as companies can pass any increased expenses on to their customers.
How can you manage your portfolio during periods of inflation?
The circumstances and goals of each investor may vary, but investment strategies for periods of inflation may assist in managing the effects on your portfolio. While there is no one-size-fits-all strategy for managing your portfolio in the face of inflation, some investors choose to invest in longer-term securities such as Treasury Indexed Bonds, which may offer protection against inflation. You can also diversify your portfolio by selecting stocks and industries less sensitive to inflation and interest-rate changes.
Doing your own research and adjusting your investment strategy according to your long-term goals is essential. Ultimately, understanding the impact that inflation, interest rates and monetary policy can have on the market is crucial to making more informed investment decisions and protecting your portfolio against inflationary disruptions.
eToro AUS Capital Limited AFSL 491139. eToro is a multi-asset investment platform. The value of your investments may go up or down. Capital at risk. See PDS and TMD
This communication is general information and education purposes only and should not be taken as financial product advice, a personal recommendation, or an offer of, or solicitation to buy or sell, any financial product. It has been prepared without taking your objectives, financial situation or needs into account. Any references to past performance and future indications are not, and should not be taken as, a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this publication.