Inflation and interest rates: where are they heading?

The topic of rising inflation and its potential impact on interest rates has been dominating the financial press over the past few weeks. The bond markets expect that higher inflation readings will force central banks to raise interest rates.
It’s my opinion that higher inflation is likely to be temporary. And it’s also useful to remember that “markets” (and popular opinion) are not always right. Bond markets priced in higher inflation in February 2021 but eventually normalised after a few months.
A quick economics lesson: why does inflation lead to higher interest rates?Inflation is a measure of rising costs. Inflation is measures by the ABS using a basket of goods and services. High inflation is bad for an economy because it erodes purchasing power, increases uncertainty and can have a negative impact the value of a country’s currency.
A key role of the RBA is to manage inflation so that it remains inside its targeted 2% to 3% band. It does that by changing the cash interest rate (currently 0.10%). Increasing interest rates, reduces spending (because the business and private sector must direct more money towards interest costs) and therefore reduces demand for goods and services which cools price increases.
Therefore, if markets expect that high inflation will persist, they price in that interest rates will increase, which negatively impacts the value of existing bonds, particularly if the coupon (interest rate) is fixed. This has been happening since August 2021 i.e. bond value have been falling.
What’s causing higher inflation?As announced by the ABS last week, Australia’s inflation is 3% for the year ended September 2021, which is at the top end of the RBA’s target band. It was slightly less than expected (3.1%) and lower than last quarters annualised reading of 3.8%.
This time last year, inflation was less than 1%, so what has happened since then? The chart below sets out how prices have changes over the past year. Five categories have risen by more than 2% over the past year being transport, furnishings, health, alcohol and tobacco and recreation.
See chart here.
1. Tran

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