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.
Types of inflation
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.
What causes inflation?
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.
How to measure inflation
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.
Why is inflation so high right now?
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.
How to protect yourself against inflation?
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.
The link between inflation and interest rates
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.
Is inflation slowing down in Australia?
Inflation is slowing down in 2025, according to the December quarter 2024 CPI.
The cost of living rose just 2.4% in the 12 months to December 2024, up 0.2% since the previous quarter.
While household costs such as alcohol and tobacco, and recreation and culture have contributed to a rise in inflation recently, housing, transport, automotive fuel, and electricity bill prices have helped to offset cost of living growth.
ABS head of price statistics, Michelle Marquardt, said:
"December quarter’s rise was the same as the 0.2 per cent increase in the September 2024 quarter. These rises were the lowest recorded since the June 2020 quarter when the CPI fell during the COVID-19 outbreak when childcare was free."
This is a good sign for Australian household finances. But, it remains to be seen whether the RBA is satisfied that inflation is within a sustainable target band of 2-3% per year.
Inflation FAQs
Is inflation the same as the CPI?
The primary method of measuring inflation in Australia is the Consumer Price Index (CPI), so the two ideas are often used interchangeably. If the CPI rises 7.0%, then headline inflation is 7.0%.
Are inflation and employment rates related?
Inflation and employment support each other, but they aren’t the same.
High employment can sustain inflation because everyone has enough income to meet rising prices; thus, price growth never slows.
Inflation slows or reverses if employment is too low because not everyone can afford higher prices.
Can inflation cause a recession?
Absolutely. If inflation gets too out of hand or goes on too long, it embeds in people’s expectations and becomes self-sustaining.
This hurts people’s savings and spending habits over time, which can eventually push the economy into a recession.
However, inflation doesn’t have to lead to a recession. Other factors, like high employment rates, can sometimes delay or offset a recession entirely because people have enough money to cope with rising prices.