The double-edged sword of inflation

 

We are experiencing record inflation (3.5% in Australia) (7.9% in the US and similar in Europe) resulting from the pandemic, global unrest, supply issues, record low-interest rates, and the printing of money worldwide.

 

In Western Australia last year, inflation was 5.7% whilst wage growth was only 2%.

 

Inflation above what is considered healthy for an economy (2%) is a double-edged sword. Central banks can reign it in with interest rate hikes, but the result of going too high with interest rates brings you out of the fire and into the furnace.

 

Let’s consider what happens when we raise interest rates. It costs more to borrow money, so we borrow less and spend less. Demand goes down and the inflation drops. 

 

Sounds great but, it’s like putting a stop sign in front of the economy. Job growth sinks because business stops investing, unemployment goes up and wage growth disappears. It becomes a downward spiral because now consumers are spending less because their disposable income has dropped and so businesses are hit once again. It’s like plugging the dam and setting the town on fire at the same time.