I conduct a ‘risk profile’ with every client and this helps guide the overall asset allocation for their portfolio. One of my questions is on inflation, and it is always met with indifference. This is because inflation hasn’t really been a problem in Australia for decades.
Inflation may soon become a problem though.
Generally, supply and demand is fluid. Demand can increase when prices drop and vice versa. Supply can increase when prices (and profitability), are higher, and vice versa.
Below is a simple supply and demand curve illustrating what happens when supply reduces from Supply 1 to Supply 2, yet the demand curve remains the same. Prices must increase, and the intersection of the lines illustrate this.
Today we hear that Italy is closing their factories. The other day that numerous car manufacturers were closing plants. Buying a new car, or designer handbag, probably isn’t top of mind for people at the moment – conserving cash is. However if these manufacturers are closing operations, the fridge, iPad, clothing, computer etc manufacturers will probably also follow suit, or already have. And whilst demand may reduce as people conserve cash, there will still be demand. Just no supply.
This will be a supply shock and I believe may lead to significant inflation as consumers pay more for goods on limited supply. The Reserve Bank would normally counter inflationary pressures by increasing interest rates. But they can’t really do that at the moment otherwise all the hundreds of thousands of people on reduced incomes (or no incomes) will default on their loans, as too will businesses. The actions of the Reserve Bank, by lowering interest rates, and quantitative easing (pumping money into the system) will increase inflationary pressures.
I don’t wish to add to the doom and gloom currently out there. But I believe inflation should become a more important consideration when deciding how to invest funds.
Lastly, rampant inflation – hyperinflation, can lead to famine, extreme social unrest and massive wealth destruction. Whilst hyperinflation generally occurs after a war has destroyed production facilities, at its core it is a result of a rapid increase in the money supply which is not supported by the growth in an economy. Factories closing around the world, and governments covering the incomes of people who are no longer working, is simply not sustainable.