What is inflation?

Inflation is the rate at which prices for goods and services rise, and, consequently, the purchasing power of cash falls. Central banks, like the Reserve Bank of Australia (RBA), attempt to limit inflation by raising the cash rate which, in turn, helps keep the economy running smoothly. 

Several kinds of inflation can occur for different reasons.

Demand-pull inflation 

Demand-pull inflation happens when the demand for goods and services outweighs the supply, causing prices to rise. It has been described as ‘too much money chasing too few goods’.

Cost-push inflation

Cost-push inflation occurs when there’s an increase in the cost of producing goods or services, like higher prices for raw materials, or higher wages. The producers then pass these costs on to consumers, causing prices to rise. 

Built-in inflation 

Built-in inflation, also known as wage-price inflation, can happen when workers demand stronger wages to keep up with the rising cost of living. 

Like with cost-push inflation, employers pass the higher labour costs on to consumers through higher prices. These higher prices cause those consumers to demand higher wages, which causes their employers to pass on the higher labour costs to consumers, and so on. This is known as a wage-price spiral. 

Hyperinflation

Hyperinflation is an extremely high and fast inflation rate, which can be caused by an increase in the supply of money that isn’t supported by a growing economy. 

It erodes the real value of a currency quickly, as the price of all goods and services increases. It creates a vicious circle that requires a central bank to print ever-increasing amounts of money, further damaging a currency’s value. 

Stagflation 

Stagflation is characterised by high inflation, slow economic growth, and high unemployment. It’s a dilemma for central banks because the same actions that are supposed to lower inflation can lead to more unemployment, exacerbating the issue.  

Deflation 

Deflation is the opposite of inflation, meaning the prices of goods and services fall and the purchasing power of cash rises.

Inflation is caused by runaway prices. Prices may rise due to supply constraints (demand-pull inflation), production cost increases (cost-push inflation), increasing labour costs (built-in inflation), slowing economic growth (hyperinflation), or a combination of slow growth in the economy and high unemployment (stagflation). 

The causes of inflation can be varied and there can be multiple types of inflation at play. 

Typically, inflation is the result of vendors raising prices, either due to an increase in demand, or a decrease in supply.

If people want the same product, their demand drives up the price. On the flip side, anything that affects the supply chain, such as transport, storage, labour, or material costs, can create a shortage, which makes a product limited and thus more valuable.

In Australia, we measure inflation using the Consumer Price Index (CPI). The CPI looks at price changes over time for a fixed ‘basket’ of goods and services, like groceries, transport, and healthcare.

Inflation is measured primarily in two ways: headline inflation and trimmed mean inflation. 

Headline inflation is the overall change in the price of goods and services, whereas the trimmed mean is considered underlying inflation. 

Trimmed mean inflation is what central banks, like the RBA, use because it cuts out ‘economic noise’, like seasonal price changes or short-lived trends.

There are a few reasons why inflation has been so high in the last two years, but the primary culprits are corporate profiteering, supply chain disruptions due to global conflict and the COVID-19 pandemic, and, to a lesser extent, high demand. 

For example, the Russian invasion of Ukraine hurt the supply of petroleum, gas, and grain crops to Europe, which made food production, storage, and transportation more expensive. This created a ripple effect that eventually reached supply chains in Australia.

When inflation gets bad, managing the rise in prices of essential goods and services can get tricky. However, creating a budget and focusing on growing your savings account can help you to manage your money more effectively. 

You can also try out these ten ways to handle the rising cost of living, or download one of these budget apps. 

Once you accumulate a nest egg, you can compare high-interest savings accounts to take advantage of rising interest rates – which is one of the few silver linings of inflation. 

Inflation and interest rates on financial products like home loans, savings accounts, and term deposits are closely linked.

In times of high inflation, interest rates tend to rise. If inflation is too low, interest rates will come down. This happens because the Reserve Bank of Australia (RBA) changes its monetary policy.

The RBA’s job is to watch the economy and smooth the highs and lows of the business cycle. If anything gets too extreme, the RBA adjusts its monetary policy to protect the welfare of Australians.

The RBA does this by setting official interest rates, also called the cash rate. Banks and lenders use the cash rate as a benchmark for their interest rates. If the cash rate rises, so do rates on mortgages and deposits. If the cash rate falls, the reverse happens.

The cash rate lets the RBA control the amount of cash in the economy. If rates rise, personal loans and mortgages become expensive to borrow, so people stop taking them out, instead parking their cash in savings accounts. If rates fall, loans become cheap and deposits less attractive, so people spend their cash and give the economy extra juice. 

Right now, the RBA is trying to slow down inflation. The graph below shows how variable interest home loans have risen with every RBA decision.

Inflation is gradually slowing down in 2024, which we can tell by looking at the quarterly CPI releases from the ABS. 

In the December quarter of 2023, headline inflation was at 4.1% annually. The latest quarter, March 2024, recorded headline inflation of 3.6% annually.

The RBA wants to see the inflation rate return to its ‘target range’ of 2-3% annual inflation. So, we’re getting there. 

While inflation might not be coming down as quickly as the RBA wants, it’s certainly a lot better than it was back in March 2023, when the annual inflation rate was 7%.