- The Australian inflation rate peaked in the December quarter but has been slower to decline than some global peers. While interest rate rises are helping to reduce inflation (especially as discretionary consumer spending slows), rises in domestic energy prices, a tight rental market and a lagged pick up in wages have contributed to higher than expected inflation outcomes.
- The main policy available in the RBA’s toolkit to manage inflation is interest rates, which is a blunt tool because of its unequal impact on households with debt.
- The burden of interest rate increases falls on households with mortgage debt. Businesses and investors are also impacted but the deductibility of interest provides some offset.
- Some countries in Europe have opted to use price controls for essential items to reduce inflation, with mixed results. Price controls tend to add distortions to the market and rent controls are not helpful while housing supply is limited (like in Australia).
- But the government still has a role to play in helping the RBA achieve its 2-3% inflation target through keeping fiscal policy neutral/contractionary if inflation is high, ensuring a well-functioning energy market, maintaining sustainable wage increases, regulating businesses to discourage price gouging and monopolistic behaviour and calibrating appropriate migration targets to match housing supply.
Australian inflation is very high. Consumer prices were up by 7% over the year to March, around a 33-year high but this was a decline from a cyclical peak of 7.8% in December 2022. The Reserve Bank of Australia (RBA) has been focusing on reducing inflation through the main policy tool available in the central bank’s toolkit – interest rates. The cash rate has risen from 0.1% in April 2022 to 4.1% in June – a 4% lift in just over a year. But, the impact on inflation so far has been lower than expected. As a result, we are often asked whether interest rates are actually having an impact on inflation or whether there are better tools available to policymakers, especially as interest rate hikes are having an unequal impact across household groups. We go through some of these issues in this article.
Are interest rate hikes working to reduce inflation?
Interest rate hikes have led to a slowing in consumer demand which is helping to reduce inflation. Discretionary spending fell in the March quarter and the volumes of retail spending was negative over the December-March quarter. Without the lift in interest rates, inflation may have increased further and consumer and market-based medium-long term inflation expectations could have kept rising well above the RBA’s 2-3% inflation target.
Some might say that rate hikes should have worked faster or better by now to reduce inflation. The problem has been that there have been numerous supply driven elements of the inflation story that have been less sensitive to interest rate changes. COVID driven supply chain disruptions led to big increases in shipping costs, commodity prices like energy, metals and agriculture increased significantly in 2021-22 (mostly from supply disruptions), domestic energy supply issues led to an Australian energy crisis and multiple domestic floods led to higher food prices. While these issues may not be directly influenced by the level of change in interest rates, it is the responsibility of the RBA to ensure that supply driven price changes do not leak into consumer prices. A lot of these supply related issues are now resolved but it takes time for it to be reflected in the final inflation figures.
Evidence of excessive price gouging by businesses is not obvious. Profit margins have expanded (increasing from 10% in 2020 to a recent high of ~16%) but have generally moved in proportion to the rise in inflation (see the chart below) and are now declining. The profit share (ex mining) of GDP has also been fairly stable. And slowing consumer discretionary spending means that continued profit margin expansion will be unlikely.
Source: Bloomberg, AMP
The peak of Australian inflation (in December 2022) also occurred later compared to some global peers which means that the slowing in inflation appears like it’s taking longer. US inflation peaked at 9.1% in June 2022 and in the Eurozone at 10.6% in October 2022 (see the next chart).
Source: Macrobond, AMP
Australia’s energy crisis occurred later relative to the Northern hemisphere, because of a raft of our own domestic issues like supply challenges with coal, a poor national plan for the energy transition and higher global prices. This meant that both the US and Europe were more impacted by an energy price surge in early 2022 from the war in Ukraine and the winter weather.
Australia’s rental market also tightened significantly over the past year as net migration rebounded to record highs after the pandemic, pushing vacancy rates to ultra low levels in the capital cities and lifted rents, although recent vacancy rates across the capital cities have ticked up and newly advertised rental growth is slowing.
Australia’s wage setting system also seems to have more “inertia”, with the minimum wage decision occurring once a year and many other wages like awards also based off this annual decision or driven by changes to headline inflation, which only peaked in December 2022.
While these factors all suggest that inflation in Australia could remain higher for longer for now, the good news is that our Pipeline Inflation Indicator still suggests significant downside to Australian inflation over the next six months and we expect headline consumer prices to be at the top end of the RBA’s target band by early 2024 (on a 6-month annualised basis).
Source: Bloomberg, AMP
Are interest rate hikes increasing inequality?
The impact of monetary policy works primarily through the lending channel because borrowing rates are priced off the cash rate. Households with a mortgage are the most impacted by interest rate changes. Businesses and individual investors are arguably less impacted because they can deduct the debt interest expenses. There are also other financial market channels that monetary policy works through, mostly through the exchange rate.
The high level of household debt now means that mortgage holders will bear the brunt of monetary policy changes. Renters can also be affected from higher interest rates if landlords are able to pass on the higher cost of debt servicing through higher rents. This is only usually an option in a tight rental market (which the current situation is allowing for).
In Australia, 37% of households have a mortgage (using data from 2019-20), 29% rent and 30% own their own outright. Detailed ABS data on housing costs shows that households with a mortgage spend close to 16% of their gross household income on “housing costs” (mortgage or rent and rate payments) as at 2019-20, owners without a mortgage spend 3% of their income on housing costs and the average renter spends close to 20% of their income on housing. And there are divergences across income quintiles (see the chart below) with the lowest income quintiles spending a very large share of income on housing costs.
Source: Bloomberg, AMP
Are there other options to combat high inflation?
The high degree of supply related factors that have increased inflation, the slow reduction in prices despite aggressive interest rate hikes and the high burden placed on households with a mortgage has led to questions about whether there are other options available to reduce the level of inflation.
The RBA has been tasked with the responsibility for the 2-3% inflation target but the only tool at its disposal is monetary policy. While the range of options within the toolkit has expanded beyond interest rates (including yield targets and quantitative easing) all of these measures ultimately influence the money supply and therefore the cost of borrowing.
The government has more tools at its disposal compared to the RBA through its spending and taxation decisions as well as regulation. However, these tools are slow moving and do not have as much of a direct impact on inflation. Some have argued that price controls need to be considered in Australia. Food price caps have recently been tried in Europe for some essential items, including in France, Croatia and Hungary with mixed impacts as measured inflation went down but there were reports of some food shortages.
Usually, economists do not advocate for price controls or caps because it’s a distortion in the market and leads to problems like supply shortages. However, the Federal government did impose energy price caps domestically, so it is already being utilised in some capacity. Talk of rent controls would likely add to supply constraints across Australia at a time when housing supply needs to lift.
But, the government does have a role to play in many components that impact inflation, such as by ensuring a well regulated electricity market, sustainable outcomes for minimum award and public sector wages which set the tone for the rest of the market, ensuring that fiscal policy (both state and federal) is appropriate for the state of the economy (we think the impact of the May Federal budget is more or less neutral but with the addition of some state cost of living benefits it could be marginally inflationary and the government could consider raising taxes to help get inflation down), regulation of retailers to ensure adequate competition and ensuring adequate housing for the migration targets.
Implications for investors
For investors, the good news is that inflation is expected to decline through the rest of the year which should mean that central banks are close to the top of their tightening cycles. This is generally positive for sharemarkets however, the further interest rates increase, the higher the risk of recession which is a risk for sharemarkets. The RBA’s recent hawkish stance means that further increases to the cash rate are likely in Australia. We expect another two interest rate increases from here, taking the cash rate to 4.6% which risks a recession in the next 12 months because of the heightened sensitivity of households to interest rate hikes in Australia.
If you receive the Age Pension, recent changes to means testing for retirees could put more money in your pocket. These changes impact the assessment of certain lifetime income streams that began on or after 1 July 2019 (including any that you take up now).
Lifetime income streams
There are two main types of lifetime income streams:
- Lifetime superannuation pensions, which are purchased from a super fund; and
- Lifetime annuities, which are purchased from a life company with either your super or savings.
Once purchased, the payments from these income streams will last for the rest of your life.
Your rate of Age Pension is calculated using both an income test and an assets test. Not surprisingly, the test resulting in the lowest rate will apply.
Lifetime income streams are different to many other types of investments, such as bank accounts, account based pensions and investment properties, where generally 100% of the asset is assessable.
Certain lifetime annuities receive more favourable treatment from the assets test.
Under the social security assets test, generally 60% of the purchase price of certain lifetime annuities will count as an asset through to age 84, or for a minimum of five years.
From then on, only 30% of the purchase price counts as an asset. Under the social security income test, 60% of any payment you receive from this type of income stream is assessable as income for social security purposes.
Don’t miss out on the Age Pension if you don’t have to
Those most likely to benefit from these changes are retirees who receive a part Age Pension because of the assets tests and who have purchased a lifetime income stream on or after 1 July 2019.
If you were getting a reduced Age Pension because of the assets test, then investing in a different type of structure on or after 1 July 2019 – like a lifetime income stream – could change your Age Pension outcomes.
In addition to benefiting from a lifetime income stream, they could actually get an increase in Age Pension as well.
Find out if you’re eligible for more Age Pension
It’s important to speak with a financial adviser about your personal circumstances before making any financial decisions. In some cases, the difference can be significant.
While every situation is unique, take the example of a retiree who was able to boost their initial annual Age Pension entitlement from around $14,500 to $19,000 by investing part of their savings in a lifetime annuity.
That extra $4,500 worth of Age Pension could make a significant difference to their retirement income and how long their retirement assets last. It’s not necessarily a dollar or two here and there. It could mean thousands a year in increased Age Pension for a retiree – simply from how they choose to structure their assets.
Lifetime annuities as a source of income
Using the income generated from a lifetime annuity to complement other sources of income (such as the Age Pension) is a common approach for retirees. Its generally seen that a lifetime annuity complements other sources of income in retirement. It’s rare to see 100% of anyone’s income coming from one source.
Making the means test work for you
Here’s how using part of your savings to purchase an eligible annuity as your lifetime income stream might look: Working with your financial adviser, you’d calculate your total spending requirements once you retire, including both essential and discretionary spending.
Then you work out where that number sits relative to the maximum rate of Age Pension. Let’s take a couple who are eligible for the maximum rate of Age Pension – about $36,000. If they can get by on $36,000, they might not need another layer of income. But if they worked out that their essential spending was more than $36,000 – say it’s $40,000 – then they could buy $4,000 worth of additional income a year to get them up to $40,000 through a lifetime annuity to cover their basic living costs for life.
Because an annuity can offer either a fixed or inflation linked payment, you have the peace of mind of knowing your income will be stable for the rest of your life – no matter how long that is. This is particularly valuable when you want certainty of income without some of the risks associated with other types of market-linked investments.
Essentially, it’s allocating resources to buy a very secure lifetime income stream, that sits on top of the maximum rate of Age Pension you are eligible for. So, no matter what happens, you can always afford what you need throughout your retirement.
Important notes: Age Pension benefits described above will not apply to all individuals. Age Pension outcomes depend on an individual (or couple’s) personal circumstances and may change over time. While lifetime income streams may immediately benefit some Age Pension eligible retirees who are assessed under the assets test, in later years, if assessed under the income test, any ongoing Age Pension benefits may be reduced. For market-linked lifetime annuities, only the first year’s monthly income amount is guaranteed. After the first year, monthly payments will move up or down annually adjusting to the changes in your chosen market-linked indexation payment option. In periods of strong market performance, any Age Pension benefits may reduce to reflect the higher income received. Consult your financial adviser about potential impacts on your personal circumstances and whether a lifetime income is right for you.
Wills aren’t just for later in life and you should really have one when you start earning. And as money and family matters can be complex, it makes sense to get help.
Who needs a will anyway?
A will is something you might think you only need once you’re a millionaire or close to retirement but it’s important to get your will – and your whole estate plan – organised as soon as you start earning money of your own.
Why? Because when you’re on the payroll, your super savings will soon start adding up and without sorting out an estate plan, you can’t be sure your assets will be passed on to the right people when you die, including your super savings.
Perhaps you’re on your fourth or fifth or even your 20th job by now and still don’t have an estate plan. It probably isn’t keeping you up at night but there could be other triggers and life stages that make your estate plan far more important:
- Buying a home – having a will makes it crystal clear what will happen to a home you own when you die. You may want to make sure loved ones can continue to live there or have this part of your wealth passed on to the right people.
- Having kids – your will isn’t just about money, it’s also about people. If you have children, a will can help to make sure they’re looked after and cared for by the people you have chosen if the worst were to happen.
- Getting married or moving in together – sharing your life with a partner often means sharing wealth too. Whether you’re married to your significant other or not, it’s important to make sure they’re looked after if you die, along with anyone else you want your wealth to go to.
- Separation and divorce – when relationships end, money matters can get tricky. No matter how simple and amicable things are, an estate plan is an important way to make sure wealth and assets are passed to the people you choose, particularly if there are new partners and/or children involved.
- Your parents die – when your parents die with a proper estate plan, transferring their wealth is going to be easier to manage. If they don’t have one, you and any siblings can get caught up in a long and expensive process of sorting everything out. It’s a big reminder of why a good estate plan is so important to the ones you love.
Making a will
A will is a very important legal document. It covers what you want to happen to your assets – like cash in the bank, shares, investments or properties you own and any personal items.
In your will, you’ll need to include who you want to be your executor. This is the person (or it can be an organisation) who will carry out the instructions in your will. This person is making a big commitment of their time as well as taking responsibility for distributing assets, communicating with everyone and carrying out your wishes according to your will. They’re also going to be the one dealing with any issues that come up if there are disputes about your will.
What happens if you don’t have a will?
When someone dies without a will, it’s called intestacy. The intestacy laws of the relevant state or territory will determine how assets are divided and who they go to.
Getting this sorted will usually involve a fair bit of work with lawyers who’ll often be working based on an hourly rate. There’s potential for these legal costs to add up over time and it can sometimes take years to resolve things, particularly for complex estates and family situations.
This is why it will probably cost a lot more to sort things out if you die without a will than it costs to put a will in place now. Basically, making your will now is cheaper and less stressful for your loved ones than dying without one and it gives you the chance to have a say in what happens to your money when you’re gone.
The dangers of DIY
There are plenty of DIY wills available – from hard copy kits to online forms – but they’re not for everyone. If your situation is simple – no partner, no kids, limited wealth and assets – then a good online service might be enough for you to come up with your own estate planning documents but for a lot of family situations and estates, online and DIY wills just aren’t going to cut it. A dynamic form, no matter how well it’s put together, can’t help you understand the tax implications of how your money is shared out, for example.
A DIY solution can also get tricky when it comes to executing your will. You’ll probably get detailed instructions for how to do this but if they’re not followed to the letter, your will might not be legally binding. This may leave your loved ones in the same situation as if you didn’t have a will at all.
Your will is just part of the plan
Your will isn’t the only part of your estate plan you need to get organised. Your super isn’t always passed to your loved ones through your will so you’ll need to make a separate arrangement for this – it’s called a beneficiary nomination. If you have life insurance in your super account you’ll also need to make arrangements for nominating beneficiaries with your provider.
Another part of your estate plan to think about organising is your enduring power of attorney. This is where you choose someone to act on your behalf and make certain choices if, for example, you’re unable to do this for yourself. If you have an accident or fall ill, your attorney can look after your financial affairs and get things done for you.
You can also arrange a separate medical power of attorney to make choices on your behalf about your medical and lifestyle needs if you are unable to make these decisions for yourself. This document goes by different names depending on which state or territory you’re in.
It’s clear that choosing an attorney in your power of attorney is a serious business. You need someone you can trust to make decisions with your best interests at heart. They’ll also need to have the time and know how to follow up on things like getting your bills paid, signing papers or maybe even arranging to sell assets on your behalf.
Save time and money by getting help
Getting a will or estate plan done properly isn’t as expensive or difficult as you might think. Particularly if you get your super fund to help you out. They often have resources online and some funds offer estate planning services to members too.
If you need help with your estate plan, contact us and we will help you start your estate planning journey.