Will you be impacted?

It’s been a long time since there has been so much uncertainty surrounding the domestic economy and with that, the share market and investing generally, as there is, looking to the year ahead and the potential impact of higher inflation.

The sudden eruption of domestic inflation, largely caused by the war in Europe and pandemic supply chain issues making it harder to import and make goods, has dragged the country back to the bad old days of the seventies and eighties.

This is when a spiral of high prices spurred regular explosions in wage growth, which in turn created further price increases, which lead to higher wages. A situation only really brought to heel by the Hawke/Keating governments Wages Accord and the decision to introduce compulsory super contributions rather than direct wage increases for several years.

Australia faces this dilemma again with a new Labour Federal Government enacting Industrial Relations laws that are focused on prompting real wage growth after almost a decade of persistent negative or low wage growth.

Will this prompt inflationary pressures again within the economy and if it does, what is so bad about inflation anyway?

Most economists look upon inflation as a cancer in a modern economy. It is insidious in terms of its direct impact on an economy, but it is also hard to combat because once it takes hold, it can be brought under control in one area of the economy, only to break out in another area.

Inflation acts like a cancer in that it erodes the true value of assets, artificially puffing up their value. A house which might sell for $500,000 in normal times might find that inflation puffs up its value to say $550,000 simple because of expectations that in an inflationary environment it will cost more.

The question of course is what’s so bad with that. If you own property, then you will probably welcome a course of inflation to boost values, however inflation distorts and ultimately undermines the true value of assets.

It means people are more likely to put their money into non-productive assets such as property, which in turn only serves to inflate property prices, while starving investment in active assets that actually do or make things like businesses, which in turn enrich the economy.

It means for example if you owned a successful business and the premises that you operate that business from, during a period of high inflation you would be tempted to sell the premises at an inflated high price and close the business, where higher wages are eroding your profits.

If this cancer is allowed to spread through the economy, I think we can all see that it would lead to a very fragile economy that would become vulnerable to booms and busts as prices inflate and then burst and fail to produce the goods and services needed by the local population.

Inflation also makes life tough for those living on fixed incomes such as pensions and income from investments. While most Government pensions such as the age pension are automatically adjusted for inflation, there is a lag affect which means they never really catch up and so slowly buy less and less.

The same with income derived from investments. Inflation distorts markets and generally makes it harder for businesses to operate and this usually proves a drag on investment returns. This might appear small at the beginning, but it slowly snowballs its way to significantly lower returns.

There are some early signs that consumer confidence has weakened due to the significant jump in the cost of living for most Australian households and this should slow the rate of inflation. Much will depend on international events and much bite higher domestic interest rates will have.