What is inflation? Why is it so high? And what is the RBA's plan to bring it back down?

If you’re the person in your household who usually goes grocery shopping or fills the car, you don’t need a statistician to tell you that prices are going up.

Nonetheless, the latest official reading of rising consumer prices is out on Wednesday from the Australian Bureau of Statistics.

This is called the Consumer Price Index, or CPI.

“The way to measure inflation in Australia is to look at the different categories that consumers use to spend their money,” explains AMP senior economist Diana Mousina.

The numerator at ABS goes around all the capital cities and checks the latest prices for this “basket of goods,” with about 100,000 different individual prices collected every three months.

The statisticians then calculated how much had changed since the last survey three months earlier.

Each year, the ABS also checks what Australians typically spend the majority of their money on, and ‘weights’ the CPI accordingly, thus reflecting where the average household spends the majority of its money.

“The things that have the greatest weight in the Consumer Price Index are things like food, housing, utilities, education and health,” Ms Mousina said.

But CPI doesn’t cover everything we spend a lot of money on.

The CPI does not include the price of the existing house, because it is considered an asset, not a consumer good.(ABC News: Ian Cutmore)

“It doesn’t take into account the cost of the land or, therefore, the cost of the mortgage or how much you paid for the mortgage,” says Mousina.

“The reason the ABS doesn’t include the cost of land, which is the biggest component driving house prices, is because house prices are considered an asset, and consumer price data is meant to look at the day-to-day spending that consumers make on goods and services, not on assets.”

How high is inflation today?

The latest inflation figure, calculated for the first three months of the year, was 2.1 percent.

For the year to March, that means the price of a basket of goods rose 5.1 percent.

The quarterly figure out this week from the ABS is expected to be slightly lower, at 1.8 percent according to the median of economists polled by Reuters.

But the annual figure is likely to be much higher, around 6.2 percent, as much lower quarterly price gains than last year continue to come out of the data.

And many economists, including those at the Reserve Bank of Australia, expect price gains to get worse before things get better, with the CPI expected to hit 7 percent by the end of the year.

Price increases are already above that level abroad.

Inflation is at a 40-year high of 9.1 percent in the US and 8.2 percent in the UK.

Across the gutter in New Zealand, it was at 7.3 percent – a 32-year high.

However, price increases in the past were much steeper than they are now.

Back in the 1970s inflation also spiked around the world due to the oil shock which caused soaring prices.

But the biggest price increases in Australia were seen some 20 years earlier.

Inflation here was as high as 23.9 percent in December 1951.

It was also caused by a global event — the Korean War sparked a wool boom, with wool prices tripling almost overnight.

As the world’s largest wool producer, Australia is seeing a huge economic impact from rising national incomes, especially as global supplies of many goods are still struggling to recover from the massive disruptions of World War II.

The ABS has been tracking inflation since 1948 as it is considered one of the most important pieces of data for economic management.(Supplied: ABS)

Why is inflation so high?

You may have heard the expressions supply and demand.

Supply is how much of something is available and demand is how much of something is wanted.

Perhaps the most basic concept in economics is that prices will adjust based on supply and demand, and vice versa.

In other words, if people want to buy more of something than is available, then the price will go up to ration that good to people who are willing and able to pay the cost.

If prices stay high long enough, then the idea is that supply will eventually expand to meet demand, and/or demand will fall due to higher prices, until there is equilibrium again.

Diana Mousina said the COVID pandemic, and the policy response to it, caused a huge shock in demand, up for some and down for others.

AMP senior economist Diana Mousina said it was a combination of strong demand and supply disruptions that was driving prices.(ABC News: John Gunn)

“We’ve seen a huge increase in consumer demand over the last two years, especially for goods at a time when global travel is restricted,” he observed.

“The government gives a lot of money directly to consumers, giving, interest rates are cut, and consumers can’t spend money on their normal service activities.

“So they feel more cashed in and they have more cash in their bank account, and this is what causes an increase in the demand for extra goods.”

At the same time, first COVID, then war in Ukraine and, most recently, repeated waves of flooding across eastern Australia have combined to limit the production and distribution of many goods.

“We have supply chain problems all over the world, goods can’t get between countries fast enough to meet consumer demand,” said Mousina.

“That has caused some blockages in the supply chain, and it has allowed companies to raise the prices of these items.”

What will the Reserve Bank do about it?

Central banks can’t do much about supply, so they try to change demand, speed up or slow down the economy, by playing their levers, the main one being interest rates.

Until the second half of last year, most developed economy central banks had levers at, or near zero, even some below, such as the European Central Bank and the Bank of Japan (which are still in effect).

But, starting with the Bank of Korea and the Reserve Bank of New Zealand, interest rates began to rise, as policymakers realized that demand was not only surviving the pandemic, but soaring, and supply constraints were pushing prices up sharply.

The slow trickle of rate hikes turned into a flood this year, with the biggest central bank of them all, the US Federal Reserve, raising rates in March.

The Reserve Bank of Australia followed in May, and then backed it up with bigger rate hikes in June and July.

Even the European Central Bank is now finally getting interest rates back to zero, despite the Ukraine war threatening a recession on the continent.

And there is little sign but interest rate hikes will stop.

The RBA’s current target rate is 1.35 percent. The CBA expects it to hit 2.6 percent before the end of this year.

Economists ANZ and Westpac expect it to hit 3.35 percent either late this year or early next year.

That would be a 2 percentage point increase in interest rates, which is likely to be passed on in full to variable mortgage customers.

Mousina said the central bank raised interest rates so quickly because they didn’t want inflation to stay out of control for years, as it did during the 1970s and 80s.

“You have a period where inflation might go down a bit and then go up again,” he explained.

“But because policymakers are slow to deal with it, it keeps rising for a long time before you see these inflation rates, they’re out of control.

“There’s no way we’re going to go back to that situation, because the central bank is now targeting inflation, and they’re quite aggressive in lowering the rate of price growth, much more aggressively than I thought it was in the ’70s. “

But they also have to be careful.

If they hit demand too hard, too fast, then consumption could suddenly drop, risking a recession in which the economy shrinks for half a year or more.

That is one reason why the RBA is targeting a 2-3 percent price increase instead of zero.

“That is considered a moderate price increase that is sustainable in the long term for consumers,” said Mousina.

“When you get price growth of less than 2 percent, then there are risks or times where you can experience deflation [falling prices] … and deflation is not seen as a positive for consumer or business spending.”

That’s because, if you expect something to be cheaper tomorrow, you are unlikely to buy it today, which suppresses demand and can lead to a downward economic spiral.

In fact, the Reserve Bank spent the best part of a decade expecting prices to rise faster, so it doesn’t want to completely quell inflation.

“Not all inflation is bad,” explains Ms Mousina.

“If we get wage growth a little closer to the inflation rate, that’s good for consumers, because we haven’t had a lot of wage growth in Australia in recent years.

“High inflation is also good in terms of lowering debt, which we saw after the Second World War, very high inflation rates then lowered Australian government debt quite quickly.”

Given how indebted Australian households are, and the recent surge in government borrowing, some wage and tax inflation should help pay off the debt.

The Reserve Bank is in a difficult position as it needs to balance both sides to get inflation back within its 2-3 percent target.

Do goldilocks come to mind?

The interest rate must not be too low, or we spend too much. But if it’s too high, we don’t spend enough money.

So the question is, how much is right? No one really knows the answer.

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