Is the Australian Economy Heading Into a Deflationary Spiral?

The International Monetary Fund (IMF) has announced a set of recommendations for Australia to help perk up the nation’s economy. They’re projecting growth of 2.8% for the Aussie economy this year. They also said that lower interest rates and a weaker Aussie dollar were helping to sustain growth, but more could be done.

The IMF thinks we should continue cutting interest rates to prevent inflation from slowing too quickly. If inflation were to slow down, it could lead to concerns of deflation. And that’s not something you want to see if you have asset investments. Let me explain why.

How inflation affects wage growth and jobs

There used to be a time when inflation was seen as bad news for the Australian economy. With more cash floating around in the system, its value eroded over time. Goods that once cost AU$5 needed a price hike to keep up with all the excess currency.

You’ve probably noticed creeping inflation while shopping at your local supermarket. That’s because if you’re like most people you have a price in mind for what you think things should cost, based on your previous experience.

And you feel the effects of inflation even more when wages are stagnant. In any economy in which wages aren’t growing to keep up with inflation, goods cost more in real terms. The Australian Bureau of Statistics (ABS) reported in February that wages grew by 2.5% in 2014, which is the lowest rate in two decades. The RBA’s inflation targets are between 2-3%, making the current 1.7% inflation rate too low in their eyes. That means the RBA will be keen to create more inflation through interest rate cuts.

With the IMF recommending further cuts to the interest rate, that could spell trouble for consumers. The price of goods will rise, but your wages won’t keep pace.

Why economists want to prevent deflation in the economy

These days, economists have a tendency to believe that some inflation is a good thing. Many developed economies have an inflation target rate of around 2%.

The reason why inflation is seen as favourable is because it helps to prevent deflation. Deflation is simply the process of falling prices. Or you could take it to mean that your money buys more with less. While that sounds like good news for people like you and me, many economists disagree.

They argue that if you believe that prices are going to fall, you’ll put off buying goods now. And if everyone else does the same thing, growth will plummet because no one would be buying anything. This would lead to falling wages and massive job losses.

It would also lead to real debt levels rising. That’s because deflation increases both the value of money and debt. This makes it difficult for consumers and businesses to pay off debts, as more disposable income goes towards meeting repayments. And you can see how this creates a cycle that hurts jobs and wages.

In practice, every country needs to be judged on its own merits. Japan, which has been in a deflationary cycle since the early 1990s, has over US$10 trillion in public debt. But its unemployment rate sits at 3.6%. That’s not bad for an economy built on exports, and with no resources of its own.

What deflation means for investments

As an investor, the price of your assets is linked to inflation. In the same way that groceries cost more with higher inflation, your assets tend to appreciate with more money in the economy for everyone to spend. That sends investors flocking to hard assets like real estate, and you begin to see the effects through big increases in house prices.

And just as grocery prices fall during deflation, property values follow. You probably don’t want to see that happen if you have a portfolio in any asset class, not just real estate.

Consumers would put off buying assets in hope of future declines in values, hurting demand in the process. And with flat wages, the IMF is right in saying that the RBA will need to cut interest rates further. But even that may not be enough for the RBA to prevent a recession this year.

Mat Spasic
Contributor, Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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