What is Inflation and How Does it Impact Interest Rates?

If you are like most investors, inflation is probably a concept you are aware of, but do not really understand. You may have heard it mentioned on the news and have a rough understanding of what the rate currently is. You may even have a broad view of how it works, but not how it impacts you or your portfolio.

However, while inflation may not be a key investment concept, it is something every savvy investor needs to be across. In particular, you should have some understanding of how inflation rates affect the availability and cost of finance. Here we explore the intricacies of this relationship and what it means for you, as a property investor.

How is inflation calculated?

Put simply, inflation is the change in the price of goods and services over time. As it reflects the balance of supply and demand, it is considered one of the best measures of economic performance. It is also a major driver of economic policy and the basis for a range of government and financial regulations.

In Australia, the inflation rate is reported quarterly and is largely informed by the Consumer Price Index (CPI). The CPI is calculated by the Australian Bureau of Statistics (ABS), based on the price of a set of common household purchases. Known as the “CPI basket”, this includes everything from housing and groceries to entertainment, education, transport, clothing, and healthcare costs.

To help make sure this calculation reflects the reality of most Australian households, each category of expenses is weighted differently. For example, as housing and food are most people’s primary expenses, they have the greatest impact on the overall equation. By contrast, phone bills and insurance premiums are given less weighting, as they are seen as less significant and essential.

While there are many factors that influence the inflation rate, here in Australia, there are three main drivers:

1. Cost of production: Most businesses base their pricing structure on the cost of making their products or providing their services. As such, if there is an increase in the base cost, this will usually be passed on to the consumer. This is often referred to as “cost-push inflation”.
2. Consumer demand: The balance between supply and demand is a driving force of both individual prices and broader economic performance. Generally speaking, if more consumers want a product or service than there are units available, the price will increase. This is usually known as “demand-pull inflation”.
3. Financial policy: Changes to government and financial regulations will also have an impact on the prices of key products and services. While most policies will be designed to control price increases, some will be designed to stimulate growth and economic activity. This is generally called “structural inflation”.

What is the target inflation rate?

While inflation is a normal part of a healthy economy, it needs to be managed quite carefully. If the rate gets too high, it can devalue the currency and create significant affordability issues for many households. Conversely, if it falls too low, it can impact consumer confidence and even lead to an increase in unemployment.

Acknowledging this, in the early 1990s, the Reserve Bank of Australia (RBA) adopted a target range for inflation. Currently set at 2% – 3%, this is considered the level of inflation required for economic stability and sustained growth. It is also seen as a realistic level of price growth that encourages employment without significantly impacting affordability.

As the RBA is responsible for setting monetary policy, the target also provides a framework for regulatory decisions. It allows them to monitor changes in the CPI and take action to keep inflation to an acceptable level. It also provides guidance on which are the best policy levers to pull, and when, to keep inflation under control.

What is the relationship between inflation and interest rates?

One of the main mechanisms the RBA uses to control inflation is the cash rate. This is the amount of interest financial institutions have to pay when they borrow money from each other. So, if the RBA chooses to raise the cash rate, finance becomes more expensive – and vice versa.

It is important to note here that, while the cash rate does not directly impact consumers, it has indirect impacts. Most significantly, financial institutions usually base their interest rates on the cash rate and will pass on any changes. This is particularly true when the cash rate increases, with interest rates usually rising shortly after.

Acknowledging this, if the inflation rate is trending upward, the RBA will generally choose to raise the cash rate. This makes it more expensive to borrow money, limiting the amount households have to spend and slowing the economy. Ideally, this is done proactively, in small increments; however, if inflation rises sharply, larger, more reactive increases may be required.

Conversely, if the inflation rate is trending downward, the RBA may decide to lower the cash rate. This allows lenders to offer more competitive interest rates and can help free up household budgets for more discretionary spending. Once again, this will usually be done proactively, in an attempt to keep the inflation rate within the target range.

A couple of other important things to know about the relationship between inflation and interest rates:

• The RBA Board meets the first Tuesday of every month (except January) to discuss changes to the cash rate. At this session, they review the latest data on the state of the economy, including the most recent inflation figures. Based on this, they then decide if any regulatory changes are required – like increasing or decreasing the cash rate.
• As the cash rate increases, most banks will increase both the interest charged on loans and paid on savings. This means that, if you have a large amount in savings, rising interest rates can actually be beneficial. However, this will usually be offset by increases in your mortgage payments and the rising cost of living.
• While they operate independently, movements in the US Federal Funds rate can influence changes to the Australian cash rate. This is because the RBA does not want to allow the gap between these two rates to get too big. If it does, it can drive down the value of the Australian Dollar which, in turn, drives up local inflation.

Want to discuss this further?

If you would like to learn more about inflation, interest rates, or anything else property related, contact Search Party Property. Our experienced team are experts in the investment process and can walk you through all of the key concepts. We can also work with you to set your investment goals and strategy, and find the perfect investment opportunities.