Inflation by gdf57j

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									Business Focus Reference Sheet




 FINANCE
    SERIES
                                                            Inflation
                                                            By Andrew Kent

                                                            There is currently a great deal of media      to purchase another house after
                                                            attention being given to inflation. The       some time has elapsed will mean
                                                            rhetoric surrounding inflation ensures        that the proceeds of the sale are not
                                                            that nobody doubts inflation is a bad         enough to buy an equivalent house.
                                                            thing, and yet most people have little        So in relation to housing, they have
                                                            idea why it is so feared. So what is so       experienced a fall in purchasing power
                                                            bad about inflation?                          and a reduction in the relative value
                                                                                                          of their money in the housing market.
                                                            First it is important to understand what      General inflation makes this scenario
                                                            inflation actually is. Inflation is defined   true across the whole economy. And
                                                            as a rise in the general level of prices      once general inflation is in place, it
“Inflation is defined as a rise in                          which results in a fall in purchasing         tends to accelerate.
the general level of prices which                           power and a decline in the value of
                                                            money. It is measured by monitoring           High levels of inflation actually have
results in a fall in purchasing
                                                            the prices of a collection of commonly        such a profound impact on businesses
power and a decline in the value                            purchased items. In Australia one             that they require a different accounting
of money.”                                                  of the better known collections is            treatment. Take a simple wholesale
                                                            the consumer price index (CPI). An            business; if it is using standard
                                                            increase in the cost of this group            accounting practices during a period
                                                            of items represents an increase in            of high inflation, it is possible to
                                                            inflation.                                    book a profitable transaction whilst
                                                                                                          generating a loss on the sale This
                                                            Economics is based on balancing               is because the value of money has
                                                            supply and demand. If prices for              declined so that the cost of the goods
                                                            individual items rise, it is usually          sold needs to be adjusted in line with
                                                            because the demand for these items            the equivalent replacement cost at the
                                                            has increased relative to the supply of       time of sale if it is to be an accurate
                                                            these items. This could be due to a           reflection of the transaction. At the
                                                            decrease in the availability of an item,      same time, during a period of high
                                                            (e.g., bananas after a cyclone), or an        inflation, individuals experience a
                                                            increase in the demand for the item           general fall in purchasing power and
                                                            because more people are prepared              subsequently a reduction in living
                                                            to pay for it (e.g., world demand for         standards for everyone.
                                                            oil). If the increase is confined to
                                                            single items, it might be regarded as         How to respond to inflation?
                                                            an adjustment in the relative values
                                                            people are placing on things. If the          Australia, like many western countries,
                                                            increase is across a broad range of           regards the management of inflation
                                                            items, then it is considered to be            to be so important that, like the legal
                                                            inflationary.                                 system, it is removed from the office
                                                                                                          of government. Under the Australian
                                                            The impact of inflation                       system, a bipartisan target range of
                                                                                                          inflation is set and the Reserve Bank
                                                            A local example of product inflation          is empowered to keep the inflation rate
                                                            in recent years is Australian housing         between the target range (currently
                                                            prices. A person selling a house is           between 2 and 3 percent). The main
                                                            likely to make a significant profit on        weapon they have been given to fight
                                                            paper compared to the price they paid         inflation is control over the official
                                                            for the house. However, an attempt            interest rates.



Bendigo and Adelaide Bank Ltd ABN 11 068 049 178, AFSL 237879, The Bendigo Center, Bendigo Vic 3550.
Copies of this and related Business Focus Reference Sheets are available from the Branch Manager or
Business Banking Manager at your nearest Bendigo Bank Branch, and from our website.
www.bendigobank.com.au/business
                                                                                                                     page 1 of 3
Business Focus Reference Sheet

                                                            Thus increases in the cost of goods            battle, and tolerate some short term
                                                            triggers concern about inflation, to           pain. It is when individuals and
                                                            which the Reserve Bank responds by             businesses respond to inflation by
                                                            increasing interest rates, (which is also      seeking higher wages or increased
                                                            one of the items in the consumer price         prices for their goods and services that
                                                            index). To many people it seems a              inflation gains momentum. The more
                                                            strange response: things cost more,            widespread this practice becomes the
                                                            so the Reserve Bank, on behalf of the          more difficult it becomes to contain
                                                            Australian Government, makes it harder         inflation, and the harder the Reserve
                                                            for people to pay for them. But this           Bank needs to work to get it back
                                                            is precisely what they are trying to do.       under control. Given that they have
                                                            The idea is that if fewer people can           only one real weapon, official interest
                                                            afford things, then demand for things          rates, then higher inflation will result in
                                                            will reduce and this will flow on to a         higher interest rates.
                                                            reduction in the price of these items.
                                                                                                           The other weapon against inflation,
                                                            It is somewhat ironic that many people         although outsides the Reserve
                                                            fear the interest rate increases, which        Banks control, is fiscal policy. This
                                                            are the official response to inflation,        is the financial policy of the Federal
                                                            more than inflation itself. Prior to           Government, and unlike interest rates
                                                            raising interest rates, the Reserve            this can be directed at individual
                                                            Bank generally tries to dampen inflation       segments of the economy. For example
                                                            through public statements, which               increasing housing supply through
                                                            usually relate to certain aspects of the       the provision of low cost housing, or
                                                            economy being over-heated. These               reducing demand for luxury items by
                                                            public statements are considered to            increasing taxation or duties on these
                                                            be its other, more subtle, weapon              items. At a broader level changes to
                                                            against inflation. Unfortunately these         income tax rates can also impact on
                                                            statements largely go unheeded. In             inflation. By receiving more tax than
                                                            the last few years the Reserve Bank            they spend the Federal Government
                                                            has talked down the share market               effectively removes money from the
                                                            and the housing market, stating on             economy which reduces inflationary
                                                            various occasions that one or the other        pressure. It also has the advantage
                                                            or both were overpriced and due for            of creating savings for the future.
                                                            a correction. The share market has             The Federal Government’s current
                                                            since experienced a major correction,          commitment to reducing taxes has
                                                            and growth in the housing market has           the opposite effect, putting more
                                                            also slowed. However, the March CPI            money back into the economy and
                                                            figures were still significantly higher        subsequently increasing inflationary
                                                            than the target rate, indicating that the      pressure and reducing savings.
                                                            Reserve Bank has more work to do. The
                                                            international markets read this result         Different causes of inflation
                                                            as increasing the probability that the
                                                            Reserve Bank would lift interest rates         There are two major causes of
                                                            further and responded by buying more           inflation. One relates to consumable
                                                            Australian dollars, lifting the value of the   goods (such as bananas, wages and
                                                            dollar. This response only makes sense         oil); the other to assets (such as
                                                            while they think that the Reserve Bank         property and precious metals). General
                                                            will defeat the current inflationary threat.   inflation usually involves both, but
                                                            If it does not, then the relative value of     often at different rates.
                                                            the currency will decline as rapidly as
                                                            the inflation rate rises.                      Inflation in specific consumable goods,
                                                                                                           such as bananas or oil, as a result in
                                                            For the time being it would be prudent         changes in demand or supply, usually
                                                            for businesses to assume that the              resolves itself through changes in
                                                            Reserve Bank will win the inflation            consumer behavior, which reduces



Bendigo and Adelaide Bank Ltd ABN 11 068 049 178, AFSL 237879, The Bendigo Center, Bendigo Vic 3550.
Copies of this and related Business Focus Reference Sheets are available from the Branch Manager or
Business Banking Manager at your nearest Bendigo Bank Branch, and from our website.
www.bendigobank.com.au/business
                                                                                                                       page 2 of 3
Business Focus Reference Sheet

                                                                 the demand and brings the price to                                So why worry about inflation? Because
                                                                 a new equilibrium. Not everyone is                                inflation is bad news for everyone.
                                                                 prepared to pay $20 per kilogram for                              Let us hope that this current inflation
                                                                 bananas, and similarly, at a certain                              scare is short-lived and resolved with
                                                                 level, the price of oil will result in                            minimal pain.
                                                                 either additional production, or reduced
                                                                 consumption.

                                                                 Inflation that is caused by money
                                                                 seemingly being generated out of thin
                                                                 air is of greater concern. An example
                                                                 of this is rapidly increasing housing
                                                                 prices. A $500 increase in the average
                                                                 price of houses represents an increase
                                                                 in Australians’ collective personal net
                                                                 worth of around $1 Billion, without
                                                                 any additional value being generated
                                                                 in the economy. In recent years the
                                                                 increase per house is several hundred
                                                                 thousand dollars, which represents
                                                                 several trillion dollars of additional
                                                                 personal wealth. When some of
                                                                 this is liquidated and injected into
                                                                 the economy (spent on things other
                                                                 than houses), then it puts inflationary
                                                                 pressure on the rest of the economy.
                                                                 Correcting this sort of inflation is also
                                                                 more difficult and painful as it requires
                                                                 a correction in the underlying cause: in
                                                                 this case the housing prices. It is also
                                                                 a correction that needs to be managed
                                                                 carefully, because if it happens too
                                                                 quickly it can unravel other aspects of
                                                                 the economy and financial systems –
                                                                 as seen in the US sub-prime mortgage
                                                                 crisis.

                   Information to help you                       As outlined above, general inflation
FINANCE            grow your business
                   successfully.
                                                                 reduces profits. This has a flow-on
    SERIES                                                       effect in regard to profit-based assets
                   Some of the titles in this
                   series includes:                              (e.g., businesses and shares).

9 Business Credit Card                                           Subsequently, investors generally
                                                                 respond to inflation by moving
                                                                 their investments from profit-based
9 Merchant Facilities                                            assets to fixed assets, i.e., property
                                                                 and precious metals. However,
9 Cash Accounts                                                  when inflated property prices are
                                                                 an underlying cause they no longer
9 Equipment Finance                                              represent a safe hedge against                                    ACKNOWLEDGEMENTS
                                                                 inflation.                                                        Andrew Kent is CEO of Business Gear Change.




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the Bendigo Business Focus Reference Sheet.
Bendigo and Adelaide Bank Ltd ABN 11 068 049 178, AFSL 237879, The Bendigo Center, Bendigo Vic 3550.
Copies of this and related Business Focus Reference Sheets are available from the Branch Manager or
Business Banking Manager at your nearest Bendigo Bank Branch, and from our website.
www.bendigobank.com.au/business
                                                                                                                                                   page 3 of 3

								
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