Episode Details

I think we need to be prepared for the possibility that the next couple of years might be a bumpy ride in terms of the economy, financial markets, interest rates and so forth. The media thrives on higher levels of uncertainty, so be prepared for plenty of doomsday predictions and lots of negativity. The silver lining is that negative sentiment almost always creates attractive long term investment opportunities, but you must be on the lookout for them.

Inflation is not demand driven

It has been well documented that the cost of living has been rising in Australia and around the world. Australia’s inflation rate is currently 5.1% p.a. (as measured by CPI), but anyone that’s been to the supermarket lately knows that prices of many products has risen by a lot more than this. Inflation is a problem in many other countries too – NZ inflation is 6.9%, UK is 9.0% and US is 8.3%.

Inflation occurs because demand for goods and services exceeds supply. Inflation can be demand driven (i.e., when demand is above normal, but supply remains at normal levels) or supply driven (i.e., supply is below normal).

I certainly acknowledge that some sectors have experienced levels of consumer demand that are well above normal levels, particularly during lockdowns. However, at this stage, I think inflation is mainly driven by supply chain shortages. Therefore, to cool inflation, demand must be reduced to below normal levels. Unfortunately, that means financial pain for some people because household budgets need to be strained to the point that people buy fewer goods and services than they would otherwise need to buy. That will be achieved either by higher prices (market forces) or higher interest rates (RBA), or both. Cooling supply driven inflation is generally painful, especially when wages aren’t rising nearly as fast as prices.

But interest rates must return to normal ASAP almost regardless of inflation

One year ago, I wrote that interest rate expectations can change very quickly, and we shouldn’t get seduced into thinking they won’t rise. Last year many commentators were suggesting that interest rates might not rise for many, many years. Today, the same commentators are predicting multiple increases in the coming months.

The reality is that interest rates were at emergency settings (zero) for a very good reason – Australia was in lockdown! But that is no longer the case and interest rates must return to more normal levels as soon as the economy can afford it. If interest rates were left at zero for too long, there would be severe negative long-term consequences.

The big question that economists are currently wrestling with is what do normal interest rates look like? It is likely that the neutral interest rate