What exactly is inflation, and are interest rates the only option for dealing with it?

Just when we thought it was safe to return to the supermarket aisle, it seems inflation has come back to bite us again. Worse, the Reserve Bank of Australia (RBA) predicts it will linger for longer than previously expected, adding to cost-of-living concerns.

So, what is inflation, and what causes it? Do we have to worry about inflation? And if so, what are the options for getting it back under control?

What is inflation and how is it measured?

Inflation is a sustained rise in the general level of prices for goods and services purchased by households.

In Australia, inflation is measured by the Consumer Price Index (CPI), which is calculated by the Australian Bureau of Statistics and published every month.

The CPI consists of a basket of goods and services consumed by the typical household. 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.

What causes inflation?

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.

Why worry about inflation?

Inflation is a concern because it erodes living standards. If your wages don’t keep up with inflation, your purchasing power will be diminished. It’s worse for people 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 it would be nice for prices to stay constant, 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.

What is the best way to manage inflation?

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.

But interest rates are a blunt instrument for managing inflation because they affect the whole economy and not just the source of inflation. And interest rates can’t deal with cost-push inflation either.

As a result, some commentators question the effectiveness of using interest rates as a tool for tackling inflation in Australia.

Instead, some are suggesting alternative options, such as:

• changing the rate of the Goods and Services Tax (GST)
• changing the rate of compulsory superannuation contributions.

Both suggestions might be effective in controlling total demand through changing the spending decisions of households. They would have little impact on businesses.

However, since both 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.

Is there anything the government can do?

Unfortunately, there is no easy fix for Australia’s current inflation problem. The federal government does have a role to play though. In the short term, it could implement policies such as tax hikes or curbing government spending, which seem to be on the agenda for the federal budget in May.

Longer-term, the key to fixing Australia’s inflation problem is by boosting productivity, 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.