The rise of inflation explained

Inflation is a complicated economic concept, and it can be very confusing! In this article, we'll explore what inflation is, why inflation has become an issue in Australia and why the RBA keeps increasing the cash rate.

Hopefully, this information will help you understand what's going on and make some decisions for your financial future.

What is inflation?

The economic meaning of inflation is “a general increase in prices and fall in the purchasing value of money”. This means that inflation is the rate at which the general level of prices for goods and services rises and our money’s purchasing power falls. In simple terms, inflation increases your living expenses, or – the phrase we have all been hearing a lot – your cost of living.

The most common measure of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of certain everyday items that are typically purchased by households. It’s not just groceries that are included; the costs of clothing, housing and transport are all analysed. Between January and December 2022, inflation rose by 7.8% in Australia, and this is the reason we’ve been hearing it mentioned so much, and why we’ve seen interest rates increase too.

It's worth noting that some level of inflation is considered healthy for an economy, as it can indicate growth, but high inflation can be problematic as it can make it difficult for people to plan for the future, and lead to economic instability.

Why has inflation risen?

During the COVID-19 pandemic, we saw prices increase because production across many industries dropped but demand increased. We also weren’t spending money like we had been before the pandemic, and many people who could continue to work through the pandemic found that they were able to save more. Governments around the world also introduced stimulus packages.

Since the pandemic, people have begun to spend the money that they accumulated and demand for products and services has increased even more. Additionally, supply-chain disruptions have caused some goods and services to become even more expensive.

These supply chain disruptions have not only been caused by the pandemic. Natural disasters here in Australia have hit the farming and food industries hard, and the invasion of Ukraine has caused disruption to several global economies. Prices have jumped up across many of the CPI categories. For example, if petrol is more expensive, then it costs more to harvest crops and transport food from the farm to the supermarket.

The natural offset to inflation is higher wages, but if these aren't increasing in line - or higher - than inflation, then the affordability of goods and services gets squeezed. Here in Australia, salaries have not been increasing inline with inflation, and this is also driving up the cost of living.

Why is increasing rates a good solution?

Central banks around the world, including the Reserve Bank of Australia (RBA), attempt to limit inflation – and avoid deflation – to keep the economy running smoothly. They will try to find a balance that keeps inflation in check while also allowing a country’s economy to grow, because increasing cash rates too much can have negative effects on the economy as well.

The RBA’s monetary policy tool to combat inflation (increasing interest rates) makes it more expensive for individuals and businesses to borrow money, and it discourages people from spending. As a result, the demand for goods and services drops and when demand decreases, the pressure on prices to rise also decreases. This leads to goods and services dropping in price.

Additionally, higher interest rates can also make it more attractive for people to save money rather than spend it. Banks may increase the interest rates on their lending products, but they also usually offer higher interest rates on saving accounts and term deposits. This also helps curb spending and inflation, encouraging saving instead.

What else should I know?

Inflation doesn’t just make things more expensive – it also creates uncertainty. It’s more difficult for people to predict the cost of living in the future, and as prices and rates rise, budgets and spending habits need to be adjusted. It also means you may have less money to put into your savings, because you’re using it to cover your living expenses.

Experts are predicting that inflation will begin to track downwards this year, and by 2024 should reach the target rate of between 2-3%. Despite a drop, we may not see prices decrease as much as we would like. In fact, prices may continue to rise but it will happen much more slowly, meaning we don’t notice it quiet so much when reviewing our weekly or monthly spending.

What can I do to help my finances?

There are things you can do that will help you into the uncertain future. Hopefully you’ve already been doing a few of them, but if not, here’s where to start:

1. Make a budget: Know how much you have coming in, how much money you need to live, and what you have left.
2. Reduce your expenses: Maybe you need to start taking public transport or can save money on your mobile and internet bills. Review your spending and cut-back where you can.
3. Be a smart spender: Shop specials at the supermarket, look for rewards and discounts codes and try to limit your ‘want’ purchases.
4. Save, save, save: No matter if it’s only a small amount each month, get saving what you can. Thanks to great interest rates, your savings will soon begin to grow. Make it even easier for yourself by saving automatically with our Pay&Save

If you’re worried about your finances and are struggling with the rising cost of living, we can help. Find out more about your options when facing financial hardship or call our team on 1300 591 276.