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Inflation, the market is saying this time is different…

Inflation as you all know has been riding high.

But what you really care about is where are we going from here. I don’t have a crystal ball, but the market is saying its going down in the near term. The market, based on five-year inflation break-evens (which shows the average inflation rate over the next five years, where nominal bonds and inflation linked bonds earn the same returns), has market pricing implying inflation will relatively quickly fall to policy bank target ranges (that is 2%-3%).

We expect that inflation will steady and likely fall given the roll-down effect as last year’s high inflation prints roll out of rolling 12 month headline figures - but are we returning to the RBA benchmark target of 2-3% any time soon? This benchmark has been hammered into us for time and memorial - well at least since Burnie Fraser was head of the RBA (and I was in my high school economics class) before he moved into his glamour “finfluencer” days for Industry Super.

A recent study by Arnott, R. and Shakernia, O. 2022 title History Lessons: How “Transitory” is Inflation? looked at the behaviour of inflation after it rises above certain thresholds and how long it lingers – and the results are not good! What they found is that inflation takes far longer to recede than most realise.

The study analysed all cases where inflation surged above 4% in 14 OECD countries from 1970 to 2022. The paper didn’t look at causes for why inflation was elevated, nor did they evaluate policy response effectiveness – simply once past a given threshold – how long did it take for inflation to fall. They looked at inflationary surges through the lenses of 2% intervals – there were 52 instances where inflation went above 4%, of which six went above 20%.

Arnott and Shakernia (2022) observed a pattern that when inflation went above the 4% threshold, in 32 out of 52 instances, inflation reversed and never reached the next threshold of 6%. In these instances, the median time for a return to 2% was 2.5 years. But once it passed through 6%, inflation tended to be sticky and the medium time to return to 2% was 10 years!!

In terms of bringing inflation back to 3% (upper end of the RBA target band) and perhaps a level most people could accept, the results are still not great. If inflation went past 4%, but never hit 6%, the study found that median timeframe to return to 3% was 18 months. However once inflation went past 6% (where Australia is today), the median timeframe to return to 3% was 7.5 years.

The US hit 8.5% back in June 2022 and has halved inflation in a year – according to the study this is a ‘best quintile’ outcome relative to history. Hopefully Australia can be as lucky, certainly Wednesday’s inflation print is in the ‘right direction’.

We’ve had successive interest rate increases for the last 18 months (the fastest rate in history) – and there are certainly signs in the economy that this is starting to take effect (e.g. consumer discretionary spending). Arnott, R and Shakernia do address the impact of policy rate increases in their paper citing a study by Havranek and Ruskan (2013) of 198 instances of policy rate hikes of 1% of more in developed countries – with the effect being that for every 1% increase in the policy rate, there was a 2-4 year lag for 1% decrease in inflation.

For infrastructure investors (debt or equity) inflation is central to our valuation/pricing models – we need to take a long-term view, from what Infradebt generally observes, most market participants assume a long-term inflation rate of 2.5% - far below where we find ourselves today . To the extent projects have CPI linked revenues, higher inflation relative to forecast will benefit projects (operating costs will be higher, but as infrastructure projects have high operating margins, the impact is more than offset through higher revenues). However, higher inflation also implies higher interest rates, which means higher borrowing costs and higher equity discount rates. If we look to inflation break-evens (see earlier chart above), the market is effectively calling for a recession – this would be the key mechanism that would get inflation back down quickly. However, if this recession doesn’t materialise or isn’t as severe/prolonged as the market expects, this will mean that policy rates will remain elevated (compared to recent history) for longer and this will/should feed through into valuations.


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