Rising inflation risks

Rising inflation risks

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The Reserve Bank delivered some good news and some bad news for borrowers last week. The good news is that it looks like they are still maintaining a strong focus on driving as much economic growth as possible coming out of Covid-19 and intend raising interest rates only slowly. The bad news is that we’ve been here before and the outcome was interest rates rising for three and a half years and peaking higher than if the Reserve Bank had moved quickly.

That earlier period was from 2004 to 2007 when the official cash rate was increased from 5.0% to 8.25%. One-year fixed mortgage rates went from 6.2% to almost 10%. The Reserve Bank admitted some years after the tightening that they should have moved more quickly.

Our central bank is not perfect

The chances are that this time around they are not paying quite enough attention to the growing list of factors suggesting inflation will go higher and then stay relatively high for some time.

Consider for instance that at 4% the unemployment rate is now a lot lower than the Reserve Bank allowed for in their forecasts. The economy also grew by 2.8% in the June quarter and not the 0.6% which the Reserve Bank had estimated.

Inflation higher than expected

Inflation is sitting well above their expectations at 3.3% and set to soon exceed 4%. A record proportion of businesses have recently reported intentions of increasing their selling prices over the coming year, and we are seeing a continuing stream of rises in prices for transportation and construction materials.

There are data in hand showing businesses face the lowest level of difficulty finding new customers since 1974. Yet problems sourcing labour keep growing and wages growth has picked up much sooner than any of us were thinking.

For the moment, the common view afoot is that the official cash rate may only need to rise by 1.25% - 1.75% from its current 0.25% level. But the risk is that the increase needs to be closer to 2.5% given the range of factors revealing rising inflation and because of one special thing in particular.

There is a strong view that many of the factors causing inflation to rise here and overseas are temporary. This is true. But the period during which these temporary factors will be in operation looks like stretching out a lot longer than allowed for. This brings a rising risk of high inflation feeding into higher wage claims which feed then into higher increases in business selling prices.

The chances of those selling prices going up has been boosted by supply chain disruptions making it hard for consumers to shop online and find cheaper alternatives. Businesses have regained some of the pricing power lost to internet search engines some 10-15 years ago.

For borrowers the main implication of these various forces is that interest rates are headed higher, and at some stage when the Covid situation is more manageable, the Reserve Bank is likely to undertake a period of catch-up rate rises to get inflation expectations and eventually actual inflation back in check.

The incentive for borrowers remains to shift more of one’s interest rate resetting away from the one-year term towards three years or thereabouts.

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