What inflation means and how to stay alert, not alarmed

Impending inflation rise is all over the news and we really want to know what inflation means for the quality of our daily life.

Most people hate the idea of inflation.

And that’s because they worry that if the price of the things they buy increases, they won’t be able to afford to buy as much.

Which is a valid concern.

So, let’s dive a little deeper into inflation and answer questions about what inflation means. If it’s good or bad, what’s happening with inflation right now and why, and what it might mean for you.

What is inflation?

Inflation is a rise in the overall level of prices for the goods and services that people buy. It’s not one thing becoming more expensive, but a whole range of things.

It’s usually measured by the Consumer Price Index (CPI). The CPI is basically the change in price of a basket of goods that the average consumer might buy. It includes things like fuel, food, housing and healthcare. Last year, over the twelve months from December 2020 to the December 2021 quarter, the CPI rose 3.5 per cent. The cost of housing and fuel were the main drivers of this increase.

Explainer: What drives the price of petrol?

Is inflation good or bad?

That’s a tricky question to answer.

Let me start with a scenario. Imagine you wake up tomorrow morning and the monetary value of everything had unexpectedly increased by 10 per cent. Every price for every product or service is 10 per cent higher. Interest rates are 10 per cent higher. Your salary is 10 per cent higher.

At first, you’re probably alarmed. And then you realise that because your salary has increased on par with prices, this inflation has no impact on your standard of living. And this scenario, according to the economists, is the case over most periods.

Now, consider a case where your earnings are not keeping up with the rate of inflation. For example, the prices of goods and services increase by 10 per cent, but your salary only rises by 5 per cent. Or you rely on a fixed income that is not indexed to inflation, or if you are holding a lot of cash.

In general, it seems to be that a low level of inflation (in the range of 2 to 3 per cent per annum) can be a good thing for the economy as it encourages people to buy sooner. For example, let’s say you are thinking of buying a new car. If the price is likely to be hundreds of dollars more expensive next year, why not buy it now?

What’s happening with inflation?

Inflation is different in different countries. At the time of writing in mid-March, in Australia, headline inflation is 3.5 per cent (see above), in Europe and the UK around 5 per cent and in the US 7.9 per cent year-on-year.

While it’s impossible to predict what might happen with inflation in future, it seems that the general expectation is that it is unlikely to become unsustainable ( in Australia that is, above 3 per cent for core inflation). And looking at the other key factor (Australia’s wages growth), Dr Shane Oliver, chief economist at AMP, says this is expected to be around 3 per cent this year.

 Why is inflation rising?

According to Oliver, the main factors driving the rise include:

• A surge in demand for physical goods rather than services – thanks to COVID restrictions, stimulus payments and pent-up consumer demand.
• A shortage in the supply of goods which struggled to keep up with demand.
• A rise in some prices as economies re-opened from restrictions.

What inflation means for you

Inflation has different effects for different people.

1. Borrowers

For borrowers, be ready for higher mortgage repayments.

This is because interest rates are set to rise. We can expect to see a small increase in the Reserve Bank’s official cash rate from the current level of 0.10 per cent to 0.25 per cent or even 0.50 per cent by the end of this year. This is likely to flow through to variable mortgage rates.

How borrowers can prepare for rising interest rates

2. Home buyers

For potential home buyers, housing price gains could slow.

With rising interest rates on mortgages, there may be a slowing in home price as higher rates restrict the amount new buyers can borrow.

3. Investors

For investors, investment market returns may be constrained.

Rising inflation could result in lower returns from key investments, like bonds and cash.

4. Everyone

For everyone, be conscious about how you’re spending your money.

When we see measures of inflation like the CPI, it’s important to remember that this is a broad basket of goods and services. It doesn’t need to reflect what you buy. So, it’s worth being conscious about the items you’re spending your money on. Buy less of the items that have increased in price.

Be alert, not alarmed

It seems that the most likely scenario is for a slow and steady rise in inflation to a level that is more normal than the exceptionally low levels we have experienced in the past decade. So, as they say, be alert not alarmed.