Few Investors Really Understand Inflation. Here’s What It Means

Inflation remains one of the more important investment inputs investors need to get their heads around. It truly influences what you should own if you’re aiming to outperform. 

Australia’s headline inflation rate eased to 3.5% in the year to July. The RBA’s preferred underlying measure, the trimmed mean, held steady at 3.6% for a third consecutive month. Wages grew at a slightly slower 3.2% over the year to the June quarter, while the cash rate sits at 4.35%. 

Headline data like this often gets lost in the noise of markets. Why do the forces underlying inflation matter so much?  

Inflation is not really a story about prices. It’s a story about spending. Once you see it that way, a lot of standard portfolio advice looks like unhelpful guesswork. 

Inflation is Spending Divided by Stuff 

The most useful definition of inflation is as a function of ongoing nominal spending relative to the output available to absorb it.  

Total dollar demand is on one side of the equation, while total real supply is on the other. 

It’s important to understand that nominal spending comes from only three places:  

1. Income: tethered to the workforce, so it tracks economic output.  
2. Asset sales: these plug a hole rather than provide durable demand.  
3. Borrowing: bounded only by the willingness of lenders to lend and borrowers to borrow, so it can run far ahead of what an economy produces. That’s why credit cycles and inflation cycles tend to correlate with one another. 

Output is the slow-moving side of the inflation equation. Factories take years to build, and services are capped by the number of tradespeople and workers available.  

That asymmetry explains why demand is a stronger driver of inflation than supply, and why goods inflation tends to lead services inflation in both directions. 

Australian Inflation Unmasked 

Apply that lens to the recent local inflation data and the headlines are less reassuring.  

Inflation fell to 3.5% largely because of a base effect, as an unusually large 1.3% rise in July 2025 dropped out of the annual calculation. Prices still rose 1.0% during the month itself, and the trimmed mean rose 0.5%, its sharpest monthly gain in a year. 

Australian Trimmed Mean CPI 

The breakdown behind this aggregate data is more revealing.  

Goods inflation eased to 3.2%, while services ran at 3.7% and non-tradables, the domestically generated part of the basket, stayed above 4%. Housing was the largest contributor at 5.0%, while automotive fuel jumped 7.5% in the month as federal excise relief began to unwind. 

That means the minor inflation decline we saw was largely imported and administrative.  

The domestic component, where wages feed into service prices, has not cooled.  

That’s why the trimmed mean has sat at 3.6% for three straight months. 

That’s also why the RBA, after three hikes this year, held rates at 4.35% in August while saying it doesn’t expect inflation to return to its target midpoint until late 2027.  

Ominously, its August minutes show the Board debated tightening again before holding. 

A Key Shift: Nominal Growth Not the Attraction it Once Was 

There’s a part of the inflation debate that’s been wrongfooting plenty of sensible investors of late. Investors have long assumed that heavily indebted developed world governments want to maximise their nominal GDP growth at the expense of accepting higher inflation, since it’s the least painful way of navigating their ballooning debt levels. In other words, inflation allows governments to reduce the real value of their debts. 

Whether that’s still the case is debatable. 

The arithmetic makes intuitive sense. Take the US for example. The Congressional Budget Office projects US federal debt will rise from 101% of GDP this year to 120% by 2036, much higher than the 106% record set back in 1946.  

This is a costly trend. Net interest alone payable by the US Government now exceeds US$1 trillion a year.  

Circling back to inflation, nominal GDP is the denominator in every one of those ratios, so if the US government were to allow its economy to run slightly hot for a decade, it could effectively shrink its debt burden without legislating anything unpopular. 

However, US government policy has gone the other way. Several years of fighting inflation have, in practice, been a fight against nominal economic growth and the wages, margins and commodity price strength that eventuates when an economy runs hot.  

That’s not expected to change in the foreseeable future. The CBO's baseline assumes inflation returns to target by 2030, rather than a debt load that’s effectively inflated away in the interim.  

And Treasury’s management of the yield curve is serving to flatten the very slope that encourages banks to lend money into existence, which is where nominal growth originates.  

This all spells an anti-growth agenda that’s at odds with the past. 

This is not just being driven by a hatred of inflation and its impacts. Social justice and green objectives have also been in play. 

In the words of Robert D. Atkinson: ‘For over a century, the core of American political economy was growth. Occasionally—such as during the New Deal—justice gained more prominence. But until the turn of this century, growth dominated. 

However, since then, growth has been on its back foot in the EU and the United States. In Europe, justice and green are the overarching priorities. Likewise, much of the Anglo world—especially Canada and the UK—has largely abandoned growth as a goal or preference in favour of equity and green.’ 

Of course, Australia isn’t the US. But the Australian Government arguably has a similar fixation on reducing inflation at the expense of nominal economic growth.  

Moreover, we import the consequences of US Government strategies through globally-connected bond yields, currency markets and the price of everything bought offshore. 

Investment Implications 

So, we’re arguably facing a world in which developed market governments, including in Australia, continue unsuccessfully trying to tame inflation at the expense of nominal economic growth. 

There are three main implications for investors: 

1. Upward pressure on asset values 

Owners of risk assets with pricing power are positioned to win. 

Growth that accrues to asset owners instead of wage earners is a narrower and more fragile economic base. It also effectively forces investors to chase asset values higher. 

The issue is that a term deposit paying 5% is really earning only 1.4% in real terms before tax, and close to nothing after the top marginal tax rate has been paid.  

In other words, cash isn’t really safe. It’s expensive in terms of opportunity cost. 

Hence, investors who don’t want to erode the value of their wealth will be increasingly forced up the risk curve. 

For example, owning global funds and ETFs is an effective means of hedging against higher-for-longer inflation. 

2. Commodities are a perfect hedge 

Commodities are effectively a subcomponent of inflation and thus one of the more effective hedges against it. Ensuring you have an allocation to commodities funds and ETFs may well be prudent given the trends at play. 

3. Contractual inflation protection beats hope 

This backdrop is also likely to favour assets with contractual escalators, which pass inflation through by agreement rather than aspiration.  

For example, listed and unlisted infrastructure often carries CPI-linked revenue, and some property structures do too.  

On the credit side, floating rate exposure resets with rates while fixed rate bonds don’t. That’s one reason why private credit has attracted so much Australian money and why many income strategies have outperformed. 

Tying It All Together 

In short, inflation is the relationship between how much is being spent and how much is being produced, driven mostly by credit.  

In a world in which inflation remains higher-for-longer despite opposing government action, it’s important to judge every investment return in real, after-tax terms. A nominal number that beats the cash rate but is negative after inflation isn’t a win.  

The investors who do well over the next decade are likely to be the ones who understand what inflation really is and prepare accordingly.  

Disclaimer: This article is prepared by Simon Turner. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.