Inflation has been one of the most widely discussed economic issues in recent years, affecting everything from grocery bills to mortgage repayments. While inflation is a normal feature of a growing economy, periods of higher inflation can create uncertainty for households and investors.
Understanding what inflation is, what drives it, and how policymakers respond can help investors make more informed decisions and remain confident in their long-term financial strategy.
Inflation refers to a sustained increase in the general level of prices for goods and services across the economy.
When inflation rises, the purchasing power of money falls, meaning the same amount of money buys fewer goods and services over time.
In Australia, inflation is measured primarily using the Consumer Price Index (CPI), published regularly by the Australian Bureau of Statistics (ABS).
The CPI tracks the price of a broad basket of goods and services purchased by households. Each month, the Bureau of Statistics calculates the price changes of items in the CPI basket from the previous month, and combines them to work out the inflation rate for the entire basket.
For example, if milk increased during the month by 2% and haircuts by 5%, then the overall inflation rate would include those two price rises based on the item’s weight in the CPI basket.
Each item’s weight in the CPI basket reflects the proportion of a household’s total spending on that item. For example, housing (21%) is the largest category, followed by food and non-alcoholic beverages (17%), recreation and culture (13%, including holiday travel) and transport (11%, including petrol). Communications (2%) is the smallest category.
Inflation results mainly from the interplay between demand and supply of goods and services in the economy. Other influences include the level of the Australian dollar, and household and business beliefs about the future path of inflation.
If demand outpaces supply, this excess demand puts upward pressure on prices. This is known as “demand-pull” inflation and is the cause of Australia’s current inflation problem. Inflationary pressures ease when the opposite occurs, which is why inflation falls during recessions.
In contrast, “cost-push” inflation happens when it becomes harder or more expensive to produce goods and services, so supply falls relative to demand. This happened during and after the COVID pandemic, when shipping and other bottlenecks delayed the arrival of goods, causing inflation to spike.
Inflation is a concern because it erodes living standards and reduces purchasing power over time if your wages don’t keep up with inflation. This problem is exacerbated for those on low or fixed incomes such as pensioners.
This causes people to devote time and resources to coping with rising prices rather than developing new products or services that create real value.
Inflation also penalises savers by reducing the value of their savings, while benefiting borrowers who repay debts with money worth less than when they borrowed it.
If left unchecked, inflation can be very costly to get back under control, as Turkey’s experience with inflation above 30% shows.
If inflation causes problems, why not aim for zero inflation? While stable prices may seem desirable, achieving zero inflation is not ideal either.
For starters, the CPI as a measure of inflation is imprecise. It has some biases, meaning a small positive number is probably close to zero anyway. Some modest inflation is needed and is a sign of a growing economy.
The RBA is responsible for dealing with inflation. It does so by raising or lowering the official cash rate, which changes the interest rates we all pay. That flows through to borrowing costs across the economy for households and businesses, and thus influences demand.
Interest rates influence the entire economy rather than targeting specific sectors, which is why policymakers sometimes describe them as a broad or “blunt” policy tool.
However, they remain the most flexible and effective mechanism for managing inflation in modern economies.
As a result, some commentators question the effectiveness of using interest rates as a tool for tackling inflation in Australia.
Governments and policymakers have other tools that can influence inflation,including:
Tax and superannuation changes might be effective in controlling total demand through changing the spending decisions of households, however they would have little impact on businesses.
However, since both these options would require changes to legislation, the process would require political agreement and could take years to pass. In contrast, changes in interest rates start flowing through to the economy in a matter of days.
More importantly, these alternative options only affect demand and consequently inflation via household spending or the “cash-flow” channel.
In comparison, interest rates affect demand through two other channels, which research by the RBA suggests are more important. These include the wealth channel (mainly house prices) and the exchange rate. Both channels would be lost under the alternative options.
Unfortunately, there is no easy fix for Australia’s current inflation problem. Governments however can influence inflation through fiscal policy decisions, including taxation and spending adjustments, which typically operate more gradually than changes in interest rates..
Long-term, the key to fixing Australia’s inflation problem is by boosting productivity, that is, increasing the amount of goods and services produced for each unit of labour and capital, which has stalled in recent years. Here, the government could implement policies to bolster the supply-side of the economy via deregulation, invest in education and infrastructure, and encourage business growth to boost production capacity.
This would lift the economy’s “speed limit” so it can grow faster without stoking inflation. But this will take time.
If you have any questionsand would like to discuss how current economic conditions make affect your investment or financial plan, we encourage you to contact your financial adviser.
Source: Elements of the above have been taken from https://theconversation.com/what-exactly-is-inflation-and-are-interest-rates-the-only-option-for-dealing-with-it-275084
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