Inflation – What it really means and why it is so important. As something you can’t live with and also can’t live without – inflation is a major economic factor that so few people really understand. Here’s what inflation really means and why it is so important for our economic recovery post COVID-19:
What is inflation?
Firstly, it is important to truly understand what inflation. Actually is and what it means before we go any further into the intricacies behind it. Inflation quite simply, as host Andrew Baxter defines it, is what prices increase by over time. Ultimately – it is the statistical measure of the change in prices over a given time period. Measured simply by what we call ‘CPI’. The consumer price index (CPI) is the simple measure of inflation yet poses a number of challenges regarding its accuracy and relevancy as we are about to explore. CPI merely measures a basket of what households spend their money on to provide a statistical measure of their price increase over time – usually annually. So, the question arises – what actually goes in that basket?
Is CPI misleading?
To kick off with an example – at the moment we sit here in Australia with an absolutely rampant property market. As an owner of a property in Australia, the cost of buying that property is not actually included in the CPI figure given its classified as a real asset. However, the rent to live in it is. As a major disconnect, what we start to see is the cost of living and buying start to rise albeit not be reflected in the CPI calculation.
Right now, here in Australia, our CPI figure sits at roughly just 0.9% yet we’ve seen the cost of private healthcare rise by 8-9% in the last year and fuel prices continue. To remain expensive at browser despite oil prices sitting. At relatively low levels, just to name a few. Ultimately, as host, Andrew Baxter says, if you asked any Joe Bag of Donuts. On the street if it feels more expensive to live than last year and by how much – we guarantee you’d get a figure greater than 0.9%. Ultimately it comes down to CPI versus the real cost of living. Which we believe to be very different amounts.
Why inflation is better than deflation
At present, the RBA has a target inflation rate for Australia between 2 and 3%. If prices are rising by 2-3% each year, isn’t this a bad thing? Wouldn’t it be better if things were getting cheaper? Well, you need your prices to be increasing as it shows that your economy is strong and there is a demand for goods. To have these two things you need low unemployment and decent wage growth – all healthy signs of a prosperous economy.
If we take the opposite where prices are decreasing, known as ‘deflation’, this essentially means there is no incentive for consumers to buy anything. If the cost of that new fridge or laptop is going to be cheaper next week or next month – why would you buy it today? This is a disaster economically as it slows down sales, slows turnover in business and halts overall economic consumption which in turn reduces a country’s GDP. The moral of the story – we want prices going up, just not too quickly.
How inflation affects the stock market
Inflation and the stock market are inextricably linked by virtue of the bond market. What this comes down to are yields. Yields are essentially the % income (or return) received on an asset – the amount of rent received on an investment property or the dividend amount received on owning shares for example. When we see inflationary pressures rise (as we have recently in the US), we see bond yields increase also.
When bond yields increase, so to do their attractiveness given there is more income on the table for lower risk (bonds are lower risk assets vs. holding shares) – what this means is that everyone sells their shares and uses the money to buy bonds instead. This is called a ‘rotation’ and is something that causes havoc in the stock market when inflationary pressures rise.
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How to make some money trading inflation
As the government and central banks keep pouring fuel on the fire through fiscal stimulus and quantitative easing amidst the economic recovery from COVID-19, no doubt are we going to see inflationary pressures rise. The question arises, how do you trade and profit from this?
Finding the right kind of stocks that benefit from higher inflation is tough so where host Andrew Baxter recommends playing are in ETFs like TBT or GOVT. Both of these diversified ETF’s increase in value as either bond yields and/or inflationary pressures rise – a perfect portfolio hedge outside of gold or actually buying bonds. To learn more, reach out to Australian Investment Education.
