A 40-year high in inflation, rising interest rates, talk of our property markets crashing, and our economy falling into recession.

Then there’s Russia’s war with Ukraine.

A spike in energy prices, a skyrocketing jump in the price of oil; supply chain problems.

Excessive government spending; exploding government debt.

A huge increase in the nation’s money supply.

All these factors and others are contributing to increased inflation.

But am I worried? Not really.

And you shouldn’t be either.

And I’m going to explain why in a moment.

2022 the year of inflation

I think when we look back on 2022 will be seen as the year of inflation.

Granted, it started in 2021 because of the massive disruption that Covid caused in the world.

But inflation is on everyone’s radar now.

And it’s continuously in the media, isn’t it?

I’d like to say I haven’t seen so much rubbish written in the media before, but I’d be lying.

I read the same kind of misinformation when we experienced the GFC back in 2008.

At that time all the commentary was about economic Armageddon and crashing property markets.

And many of the same doomsday experts gave us dire warnings when Coronavirus caused the original lockdowns in 2020 but, once again, government and central bank policies helped us avoid terrible bankruptcies, double-digit unemployment, and the 20% house price falls that were predicted then.

This is easily forgotten at present as many Australians are worrying about interest rates rising and property prices falling.

The property pessimists are telling us that inflation and interest rates are the reasons why the property market will perform poorly over the next few years.

I’m confused!

I’ve invested through inflationary times before and inflation is a property owners’ friend – as long as you own the right type of property.

I know how good it can be for those who are in the right assets, particularly property.

Now I’m not saying the property market won’t correct.

It will – it already has started in certain sectors, but there’s no reason to suggest the property market will crash.

The problem is we haven’t seen inflation in the developed world for decades.

It’s extremely uncomfortable if you’re facing higher prices for everything every single month, especially since wage growth has yet to materialise.

And the continual commentary about the current economic problems makes it even worse.

Things like:

  • Inflation is still getting higher
  • Stocks are down
  • Property values are going to crash
  • This is looking like stagflation: There’s high inflation and low economic growth.
  • Maybe we’re going to have a recession.

Now in a moment, I’m going to explain to you exactly what inflation means, what causes inflation, is inflation good or bad and what I’m planning to do, but before I do, if you’re worried about all this my message to you is:  look at the big picture.

When we’re faced with economic problems (or any problem), there are two ways to view things:

  • The up-close perspective: Looking at inflation, interest rates, debt, consumer spending, joblessness, and so forth.
  • The broader big picture perspective: Looking at long-term trends and historical patterns.

You can get tunnel vision during periods of high stress.

So I always suggest taking a step back for a broader view.

What happened in the past can teach us about what’s happening now.

Our property market and the economy move in cycles.

There have always been periods of high growth and low growth.

As the platitude goes: “History doesn’t repeat; it rhymes.

Economy

For example, when our economy gets stimulated (like it was in 2020-21) people get more excited, take more risks, and start to consume more.

This period of high growth often causes inflation.

Then, things slow down again later.

It goes up and down.

But we never spend time in the middle.

Our economy and the share markets and our property markets are at the extremes.

Despite the screaming headlines you see in the media or those so-called “gurus” telling us the sky is falling, recessions and slowdowns are normal.

But despite these cycles, our “big picture” research at Metropole shows that Australia’s property markets have increased by 540.1% over the last 42 years – that’s an average compound annual rate of growth of 7.62%, with some States obviously performing better than others.

Chart01

When you invest for the long term, the market fluctuations don’t harm you, especially if you own quality assets.

Things only become problematic when you make bad investment decisions such as owning secondary assets or over-borrowing and taking unnecessary risks, or panic selling when the market is down.

So what is inflation?

There are many definitions, but I like this one:

“Inflation is a persistent substantial rise in the general level of prices related to an increase in the volume of money resulting in the loss of the value of currency.”

Broadly, inflation is caused by an imbalance in supply and demand, yet very few people understand the importance of the underlying factor of the volume of money.

You see…there are a lot of factors that affect the prices of certain items in the short term, and there are some factors that affect the price of a large number of items in the long term –   things such as supply chain issues caused by the war in Ukraine or the lock down in China.

But the only thing that affects the price of everything all the time and over a long period of time is the volume of money.

Inflation2

Just to make things clear…a level of inflation is normal.

We don’t have to fear that inflation exists, and in fact, it is healthy for the economy.

The issue is when the amount of inflation is inappropriate.

Hyperinflation can be extremely harmful to consumers- if the cost of living rises considerably more than salaries, the standard of living goes down.

On the other hand, deflation is also undesirable – no one sees wants to see the value of their assets go down.

What Causes Inflation?

 When we look at the cost of items in the short term, every individual product will have its own reason for becoming more expensive.

This is often related to supply and demand, such as droughts increasing the cost of strawberries.

Or conversely a bumper crop or if demand falls due to a health scare the price of strawberries might fall.

It’s also possible for there to be a change in a single factor that affects a large swag of goods simultaneously, such as:

  • An increase in the price of oil causing transportation to become more expensive, or
  • Supply chain issues in a country like China

But at a macro level, inflation is caused by factors like pressures on either the supply or demand side of the economy.

  1. Cost-Push Inflation

Cost-push inflation occurs when prices increase due to increases in production costs, such as raw materials and wages.

The demand for goods is unchanged while the supply of goods declines due to the higher costs of production.

  1. Demand-Pull Inflation

Demand-pull inflation is caused by strong consumer demand for products or services.

This is something we’ve been recently experiencing as consumer confidence tends to be high when property values rise, when unemployment is low and when wages are rising and this leads to more spending.

Look what’s happened to inflation over the last 70 years

 Looking at Australia’s CPI over the past 70 years shows how Australia has experienced long periods of high inflation, disinflation, and more recently, low and stable inflation.

The CPI reflects the impact on the Australian economy of global influences, such as oil price shocks, as well as domestic effects, such as policies that impact the labour market and wages growth.

Chart02

What about inflation now in 2022?

Today’s high rate of inflation was caused, in part, by factors related to the coronavirus pandemic.

During the difficult years of 2020 and 2021 when large parts of Australia were locked down, the government crafted a number of stimulus measures to prevent us from falling into recession, prevent the high levels of unemployment that some predicted, and prevent the real estate Armageddon that others predicted.

It did this in part by entering a program of Quantitive Easing – which basically reduced interest rates, increased the supply of money, and drove more lending to consumers and businesses.

During those times when we were sheltering in our Covid Cocoons, most Australians stashed their cash and built up a war chest in our bank accounts or offsets accounts.

On the one hand, we were unable to go out and spend our money and on the other hand, we were cautious, being uncertain of what was ahead.

Now that we’re back to a normal life Aussies are getting out and spending more and this is occurring at a time of limited supply for many goods, pushing up prices and therefore inflation.

So we have both a demand-pull and cost-push in play.

Until that novelty wears off or until prices rise to the level where it starts to really impact demand or consumption, it’s likely we’ll continue to see pretty high levels of inflation.

So in essence, inflation was caused by the government, and now they’re asking the RBA why they can’t get it under control?

Rba

And it’s likely we’re going to have significantly higher inflation for quite some time because of continuing problems with the Russian and Ukrainian war and supply chain issues related to the Chinese lockdown.

In fact, the Reserve Bank now expects headline inflation to reach 7%, and it’s not expected to peak until the fourth quarter of this year – 2022, in part because high energy and power prices won’t filter through to households till then.

It’s likely that after that the annual rate of inflation will start to decline.

The Reserve Bank is going to try to control inflation by raising interest rates and stifling demand.

The problem is, if it raises rates too fast or too high it will suppress demand too much and we could fall into a period of recession.

However, if it occurs this recession is likely to be short-lived as the Reserve Bank will lower interest rates again to grease the wheels of the economy.

Fortunately, Australia’s economy is in good condition at present, growing well and with strong job growth, low unemployment, strong exports, and a positive balance of trade.

Why raise interest rates?

Many Aussies are worried about rising interest rates.

They’re asking questions like

  • what do rising interest rates mean?
  • what is the reason for rising interest rates? And
  • does raising interest rates really help inflation?

Higher mortgage costs will mean the average consumer will have less money in their pocket to spend after forking out more on their monthly mortgage payments.

It’s a bit like getting a pay cut and this in turn should slow down spending and economic growth and therefore inflation.

Consumer confidence will play a big part – all the negative messages in the media and stories about property values falling will mean homeowners will feel less secure and curb their spending, once again decreasing economic activity and inflationary pressures.

And this decrease in economic activity will discourage businesses from raising their prices.

Of course, raising interest rates only tends to have an effect on the demand side of the inflation equation, not the supply side, and supply constraints from the geo political problems are likely to remain for some time.

Interest Rates2

Do rising interest rates mean falling house prices?

I know lots of investors are wondering what do higher interest rates mean for our housing markets.

Economist Stephen Koukoulos wrote an insightful piece in Yahoo Finance explaining it’s actually quite rare for rate-hiking cycles to coincide with falling house prices.

He explained that not counting the current interest rate cycle, there have been four instances in the past 30 years where the RBA has implemented an interest-rate-hiking cycle:

  • August 1994 to December 1994 – Cash rate up 275 basis points.

  • November 1999 to August 2000 – Cash rate up 250 basis points.

  • May 2002 to March 2008 – Cash rate up 300 basis points.

  • October 2009 to November 2010 – Cash rate up 175 basis points.

In each one of these four cycles, house prices were flat or higher – both one and two years after the first rate hike.

Five years after the first rate hike in each cycle, house prices were on average around 40 per cent higher.

Looking at house prices five years after the last hike in the cycle, they were always higher, with the average gain around 30 per cent.

It is also noteworthy that house prices recovered after the flat patch in the wake of the 2009-2010 cycle, to be 26.1 per cent higher five years after the last hike in that cycle.

May be an image of text that says "Rate hiking cycle House price change* House price change House price change* 1 year after last hike 2 years after last hike 5 years after last hike Oct 2009 Nov 2010 -4.1% -1.2% 26.1% f May 2002 Mar 2008 -4.6% 12.7% 13.5% Nov 1999 Aug 2000 14.0% 33.7% 64.3% Aug 1994 Dec 1994 0.3% 2.0% 26.0% Per cent change from time of first interest rate hike of the cycle. Using quarterly ABS data, slicing the new series to the old methodology at the September quarter, 2003"

So how worried should property investors be about inflation and rising interest rates?

We have now entered the next phase of the property cycle, one where the market is cooling, and prices are adjusting.

But this started at the beginning of the year after a once-in-a-generation property boom and was brought on by affordability issues, especially at the upper end of the Sydney and Melbourne property markets

And while property prices will correct in some locations, there will not be a property “crash” as some commentators are predicting.

For house prices to “crash”, we need to have forced sellers and nobody there to buy their properties so values free fall.

This is more likely to happen at a time of high unemployment, but currently, anybody who wants a job can get a job, and with wages rising it’s unlikely that we will see many distressed forced sellers.

Sure some recent buyers will find high mortgage costs a financial challenge, but there is likely to be little mortgage stress in Australia.

Those who recently purchased would have gone through stringent lending hurdles from the bank to ensure they could cope with rising interest rates.

And for those who have a mortgage, even when interest rates rise couple of percent, and they most likely will, they’ll only be around the level as they were prior to Covid when these homeowners and investors coped with their mortgages.




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