What is the inflation rate?

Inflation rate is an increase in prices of goods and services. When inflation rises, prices go up  and the value of money goes down, every dollar you own buys you a smaller percentage of  goods and services - this is what is called the purchasing power. 

The value of money decreases over time as inflation rises. For example, in 1985 If you had  $75,200 this amount would buy you the average Melbourne house. However, in today’s  market conditions, the same amount would only buy you the approx. value of a 10% deposit  of an average Melbourne house which is roughly about $900,000. 

Inflation rate is measured by the Consumer Price Index and this is the most commonly used  measure followed by investors - CPI is defined as the cost of a number of goods and services  representative of the economy put together on what is called “market basket”. The cost the  market basket is compared over time and expressed as annual percentage change. 

There are three different causes for Inflation explained in simple terms: 

Demand pull inflation – increasing demand for goods and services which pushes the prices  up. If we look at two of our major property markets, population growth (demand) in  Melbourne and Sydney from overseas and interstate migrants have had a significant influence  on house prices due to limited supply of housing. 

Cost Push inflation – The production costs of goods and services goes up. Increase in  productions costs can include increase in taxes, wages and natural resources or materials used  for construction. Companies have to maintain profit margins and the increase in production  costs is passed on to the end consumer at a higher price to compensate for the increasing  costs. 

Monetary inflation – oversupply of money in the economy results in value of money going  down, pushing prices up and creating inflation. 

How does inflation affect house prices? 

Real estate markets are driven by a number of factors. House prices reflect the sensitivity of  those factors. Inflation rate is one of those factors which is has a direct relation to interest  rates.

Inflation and RBA cash rate – Australia 1970 to 2017 

The above graph shows the historical relationship between the RBA cash rate and inflation.  There is a very high correlation between these two-metrics tracking in similar directions and  currently at historic low levels, moving forward house price growth is expected to track in  line with these figures.  

Interest rates are adjusted by the Reserve Bank of Australia in order to meet its inflation  targets of 2% to 3%. When the RBA lowers interest rates, consumer spending increases, the  economy is stimulated, the price of borrowing money goes down, buying homes becomes  affordable increasing property prices and spurring inflation. If the opposite is implemented  and there are interest rates hikes, the RBA’s intention is to slow down the economy by  reducing spending. Higher interest rates make servicing loans costlier, people borrow less  money, spending is reduced and house prices go down –supply and demand dynamics of an  economy. 

Property prices tend to move in line with inflation and for that reason property is a great  hedge against inflation. Inflation is the cost of saving money and interest rates is the cost of  borrowing. For instance, an $800k loan on 30-year period at a fixed rate of 6% will cost  approx. $1000 a week. If inflation rises, the value of money is eroded. The purchasing power  of $1000 decreases however, the price of your property goes up hedging against inflation. In  addition, a real estate investor also has the capacity to receive rental income from property  which can also can increase in line with in inflation. 

Therefore, the ability to choose a property that grows in value at a faster rate than the cost of  holding it is important to generate maximum return on invested capital. In other words, the  key for investors to make money in real estate is to choose an asset that grows at a greater  rate than the rate inflation.

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