Inflation’s return no cause for alarm: Tim Hext

Inflation will rise over the next five years as Australia transitions out of COVID, but investors shouldn’t be alarmed by the prospect of rising prices. Pendal’s Tim Hext explains why 

• Inflation to return to RBA target over next decade
• Rising prices no cause for investor concern
• On-demand webinar: The two big issues shaping Fixed Income 

FALLING underemployment driving higher wages will be the key driver of inflationary pressures over the next few years as the economy moves back towards capacity.

That’s the view of Pendal portfolio manager Tim Hext, who recently addressed a Pendal on-demand webinar on the outlook for fixed income. 

An underemployed person is as someone who is employed now, but would like additional hours (and is available for more work). 

Importantly, businesses are in a strong position to pass on wage rises as price increases, Hext says.

Unlike previous recessions, many households are exiting the Covid downturn with higher incomes, he says. 

A forecast underemployment rate of 6 per cent in 2023 – alongside an official unemployment rate at 4 per cent or lower – means a full employment economy. This points towards 3 to 4 per cent growth in wages. 

This means services inflation — which accounts for two-thirds of the consumer price index — is expected to rise to 3 to 4 per cent, while goods inflation will likely rise to 1 per cent. 

“And voila, the RBA is hitting their two-and-a-half target,” says Hext. 

“Crucially though, we are still going to have negative real interest rates. Cash rates will be below inflation and bond rates will also be below inflation. 

The implication for investors? 

“Whether you have 2 per cent, 2.5 per cent or 3 per cent inflation — it is low,” says Hext.  

“Provided inflation is seen as low and inflation expectations remain low, it is supportive for risk markets. 

“That’s why I’m alert to inflation but not alarmed.” 

Inflation – a history 

Hext says investors should look at the history of inflation in Australia in three distinct stages to better understand the outlook: pre-global financial crisis, post-GFC and the post-COVID era. 

Pre-GFC, the Reserve Bank of Australia consistently hit its inflation target in a two-decade period characterised by the emergence of China as an economic force, lifting commodity prices and keeping manufactured import prices low. 

After the GFC, Australia entered a second phase when inflation sank below the target. Partly, this was the end of the Chinese-driven mining investment boom and the GFC-inflicted damage to business investment. 

But a more powerful and unheralded driver was strict fiscal policy as governments tried to balance budgets and pay off the GFC debt. 

Hext calls that time the “three 1 per cents”.

“We had inflation 1 per cent below target, we had GDP 1 per cent below capacity and unemployment 1 per cent above full employment.

“And we seemed happy with that. “We were happy to go along in that sludge and fiscal policy was used hardly at all to try and address it.” 

We are entering a third phase

Now, Australia is entering a third phase triggered by the pandemic.  

“It is a huge reset and it is why we are entering stage three of inflation targeting which will last for at least 10 years. 

“We will see inflation a fair bit higher than we have seen in the last 10 years.” 

Hext says the most important reason for this is the return of fiscal dominance where governments are willing to run large deficits in the vicinity of 5 per cent GSP without concerns about high debt. 

“We are actually genuinely striving to run a full capacity economy,” he says. 

Another feature is the move towards a low carbon economy as governments take on the challenge of addressing climate change and start to shoulder the costs of reducing carbon for the long-term benefit of society. 

The transition to a sustainable economy will see shifts in energy sources from oil and gas to green and renewables, lifting costs.