How low inflation affects your finances and why it’s dangerous

Politicians, economists and the Reserve Bank have conditioned us over the years into the evils of high inflation. But just as evil is ultra-low inflation and that’s what we’re facing now.

Politicians, economists and the Reserve Bank have conditioned us over the years into the evils of high inflation. But just as evil is ultra-low inflation and that’s what we’re facing now.

It’s hurting families and businesses alike … and it looks as though we are going to have to get used to it.

High inflation undermines the value of our money. Low inflation undermines the amount of money we have to spend.

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That’s why economists were so concerned with the recent 1.3 per cent annual increase in the consumer price index … the lowest in 55 years. It is indicating that inflation is stuck at these low levels and could be for some time to come.

The “Goldilocks” level for inflation (not too hot and not too cold) is 2-3 per cent a year. Either side is a problem.

Ultra-low inflation must be fixed. Illustration: John Tiedemann

What is confounding the experts is that low unemployment and good jobs growth should be leading to strong wages growth which then fuels strong consumer spending leading to higher prices and higher/healthier inflation. But that is not happening.

So how does long term low inflation affect your household finances?

Wage rises will be even tougher to get

If inflation is low, your boss is under pressure to keep any prices rises low which means their profits are squeezed. So to maintain profit margins the boss has to keep a lid on, or cut costs, to maintain profit growth.

Your wage is part of those costs. Companies are forced to become more efficient by re-engineering their business with new technology or simply cutting traditional costs.

Low wage growth means less to spend at the shops

The ripple effect of low wage growth is that Australians don’t increase their spending at the shops or on big ticket purchases. That’s why retail spending is weak and why so many major stores and fashion labels have been closing.

Yes, online shopping has been putting pressure on those retailers who don’t have a digital strategy, but by far the biggest impact is simply that consumers don’t have the extra dollars to spend.

As a result consumers are delaying, for example, trading up to a new car which is why sales are slumping.

The housing downturn will be accentuated

As we constantly remind people, the property market is all about demand and supply. If supply is greater than demand then property prices generally go down. If demand is greater than supply then prices more likely rise … it’s that simple.

The supply side is the number of new properties being built and the old properties being put up for sale. The demand side is the number of people looking to buy those properties.

If wage growth is low, because of low inflation, people are more inclined to not move or buy a new property because they don’t have the cash to afford it. So demand suffers and values fall.

The Reserve Bank of Australia uses interest rate moves to control inflation.

The economy stays in a rut

By now you’ll be getting a sense of the horrible ripple effect of low inflation. It can become a vicious cycle.

Low inflation leads to lower profits, leads to low wage growth, leads to less money to spend, leads to lower prices, lower profits …. And it goes around.

The economy then starts to stagnate which means bosses are afraid to invest and consumers afraid to spend.

Because we are a great trading nation, Australia has a bit of a circuit breaker with our exports. On that front things are looking pretty rosy.

As a country we’re racking up record trade surpluses (exporting a lot more than we’re importing) particularly to China. Exports to China are up 24 per cent over the last 12 months and account for 34 per cent of our total exports. China is by far our biggest customer.

If exporters are making good profits from selling outside of Australia hopefully they pass that windfall on through wage increases for their employees who will go out and spend.

That’s why we don’t want US President Donald Trump mucking that up by dragging us into a trade war. The domestic economy is bad enough without taking away our export boom.

Banks become tighter with their money

We know everyone’s overriding sentiment toward the banks is “who cares about them.” And we completely understand.

But the reality is that we should care because the banks provide us with the credit to buy goods and services, which help the profits of the businesses that provide them and who hopefully will then agree to wage rises for their staff who go out and spend … there’s that circle again.

Banks make their profits from the interest gap between what they pay savers for their money and then what they charge borrowers on their loans. When inflation is low, interest rates are low and that gap is small. So bank profits are squeezed.

When bank profits are under pressure, banks go into their shell, start cutting staff (which they’re doing) and become stingier with their lending (which they’re doing as well).

When credit gets harder, consumers and bosses can’t get access to funds to spend and invest.

Slipping into deflation has to be avoided at all costs

The other risk of low inflation is slipping into deflation, when the cost of living is actually falling. That becomes a nightmare.

Falling prices means bosses start slashing wages so there’s even less money being spent. And deflation means the value of your debt increases at a time when there are less dollars available to pay it off.

Deflation is too horrible to consider, which is why the authorities are so focused on boosting inflation and wages.