THE INFLATION GENIE

Inflation is a hot topic. Can the Reserve Bank get the inflation genie back into the bottle quickly? Or is inflation potentially going to stay high for an extended period? In either case, what is the future path of interest rates?

The answers to these questions are very relevant in a tough transport and logistics industry, where decisions have to be made concerning contracts, pricing inputs, the cost of debt and business planning. Running a transport operation in normal times is challenging, and high inflation not only adds cost pressures, but also economic unpredictability. Members of Generation Z and millennials (ie anyone under 30 years old) will never have experienced high inflation. In that context, it can be hard to understand why central banks are being so aggressive, raising interest rates to eye-watering levels and threatening to push economies around the world into recession. How is that pain worth it?

Inflation is a familiar foe to those us who lived through the 1970s and 1980s. While the judgement around how much pain should be inflicted on the economy is one for the technocrats, my generation can attest to the fact that inflation is also incredibly painful, and highly destructive. To use an analogy, imagine a mouse running in a mouse wheel. While the pace is slow the device provides stimulation and exercise. It can be a good thing. But a mouse that gets excited might run a bit too fast. As the wheel spins faster the mouse gets stressed and lifts the pace. Of course, the wheel spins faster. Now suffering something of a panic attack the mouse runs full speed until it finally collapses. Exhausted. Perhaps injured. Maybe even dies of a heart attack. And all for nothing. No matter how fast the mouse runs, it never gets anywhere.

Now imagine the same effect on your transport operation. Business running costs are going up by say 7 per cent due to input costs such as rental space, people, contractors, capital equipment, and fuel. What do you do? With such high increases in costs, you cannot absorb all of them, leaving only the option of having to pass them onto your client. In turn, your clients are faced with higher input costs and must pass these onto their customers. And on it goes.

Are there any winners? There are winners and losers in every game. If you have borrowed money and fixed the interest rate, it might be helpful as high inflation reduces the value of debt. But for the vast majority of us it’s an endless cycle that, left unchecked, destroys businesses, economies and sometimes countries. That’s why central bankers are wringing their hands right now, doing whatever it takes to bring inflation under control. We can already see that in higher interest rates, with more rate hikes likely to come. How does TWUSUPER manage inflation risk? We know that members depend on their super for a comfortable retirement. What seems like a large nest egg today might not be enough if investment returns prove to be less than inflation. Assets that in other circumstances are seen as safe now become deadly. For example, funds invested in cash earning 3 per cent might sound like a much better deal than the 0.3 per cent pa they were earning last year. But with inflation running at 7 per cent this translates to a real return of -4 per cent. The loss might not be so obvious as losses in the share market, but they are just as painful when the time comes to draw down on savings. The insidious nature of inflation demands that superannuation funds focus on generating positive real (after inflation) returns. For example, TWUSUPER’s Balanced option has an objective to return at least 3 per cent pa more than inflation after tax and costs. When inflation is running at 2 per cent that might seem a soft target. But at 7 per cent it means the option must provide an after tax and costs return of at least 10 per cent. How we deal with this is in the preparation that happens years earlier. Investing to manage inflation risk long before it becomes obvious. In our case we adopted inflation targeting as part of our investment beliefs. This led us to favour asset classes that are typically resilient in the face of inflation such as property and infrastructure. It also has made us wary of fixed interest investments that have suffered from a double whammy of high inflation and rising interest rates. Better to lock in fixed interest investments later after inflation has peaked. We don’t have a crystal ball that can tell us if the current bout of rising interest rates will be enough to put the inflation genie back in its bottle, or how long it will take. Disrupted supply chains, war in the Ukraine and the lingering effects of the COVID pandemic make the job much harder. But at the end of the day the pain required to get it under control is almost certainly worth it. Either way, we need to be ready.