Why is Inflation Important?
Inflation is important because it provides an indicator of the change in price of products and services in the economy. It is a defacto measurement of cost of living for a majority of population.
A low inflation rate is preferred over a high inflation because high or hyper inflation are indicator of economic mismanagement where supply and demand are out of sync leading to severe market dislocations. Just ask Venezuela and Zimbabwe.
Australia inflation rate has been stable over the last decade. Australian inflation rate is explicitly targeted by the RBA within its operation mandate. The range of acceptable inflation rate Australia is expected to have is between 2% to 3%.
For investors that are trading shares inflation can be important as it would affect the value of companies. Company values are calculated using a discount rate which account for the rate of inflation. Higher CPI rate means that the discount rate is increased accordingly. Given same amount of cashflow, a high inflation means the present value of future cashflow is diminished. This is a simplistic view on impact of inflation on equity markets.
There is also a dimension where some companies are more able to pass on inflation to its customers which would insulate a business from acceleration of inflation.
Essentially equities can be a hedge against inflation. However this only applies to companies with a strong market power like Telstra (ASX TLS), Woolworths (ASX WOW) and Wesfarmers (ASX WES). Not those that are in highly competitive industries.
What is the Current CPI?
The chart below shows the Australian inflation rate. Note the market convention is to quote the CPI rates on an annualized basis at each quarter.
We have included CPI which is known as the inflation rate as well as a Core CPI inflation rate. Core CPI removes a number of volatile items that are used in inflation rate calculation.
Keeping an eye on Core CPI Rates can be useful because while the current quarter CPI rate can jump around quarter by quarter. The core CPI provides a clear directional trend on where inflation is heading.
The most recent quarterly Australia inflation rate shows that the level of price growth in the economy is below historical average and at almost 5 year low.
Australian Inflation Rate
The wider implication of a higher than expected inflation rate means that the RBA would raise interest rates to cool the rate of increase in prices. Vice versa when inflation rates are low, it gives the bank more wiggle room in lowering interest rates to boost economic activity.
Therefore CPI rates would impact interest rates which would have implication on the value of Australian dollar vs Japanese Yen, US dlr and the Euro.
Define Inflation and Deflation
Inflation is measurement of the rate in which the price of goods and services are increasing. Deflation is when the change in price of goods and services are falling below zero. For example if LNG price which is lowering cost of utilities, then negative utility prices are deflationary.