Understanding the Challenge
Many Australians struggle with the increasing cost of living. Inflation, which causes a gradual decrease in the value of our dollar, can erode our financial stability, making it more challenging to reach our economic objectives. However, it is essential to comprehend how inflation operates in Australia and its implications for our finances before getting anxious.
Inflation in Australia
The Reserve Bank of Australia (RBA) targets a 2-3% average inflation rate to maintain economic growth and price stability. However, inflation can fluctuate and impact various aspects of financial planning.
Erosion of Savings and Investments
Imagine diligently saving for your dream vacation. However, inflation can eat away at the value of your savings, which means that the target amount you have saved up may not be able to buy you the same experience you had initially planned for. The same goes for your retirement savings, which can lose purchasing power over time, especially with rising prices.
Investment Returns
Investments are not always immune to inflation. For instance, if you invest in an ASX stock that promises a 7% annual return, but the inflation rate is 5%, your actual or real return would only be 2%. This is because the 5% inflation rate would eat up 5% of your 7% return, leaving you with a 2% real return. This means that your investment would need to keep pace with the rising prices due to inflation.
Debt
Inflation can have both positive and negative effects on debt. On the one hand, outstanding debt feels heavier when your income remains stagnant. However, the value of the debt itself decreases with inflation, making it easier to repay in real terms. The potential downside of a fixed monthly payment is that it may become more difficult to afford as your income decreases.
Tax Brackets
The tax brackets in Australia do not usually take inflation into account. This means that as your income increases nominally, you might be placed in a higher tax bracket, even if your purchasing power has yet to improve. As a result, you will have to pay a higher percentage of your income to the Australian Taxation Office (ATO).
Key Takeaways
Understanding inflation’s impact on financial planning is crucial in Australia as it erodes savings, impacts returns, and influences debt and tax.
Read part two, where we will discuss various strategies to combat the threat of inflation.
