Inflation explained: How does it impact Australians?

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Inflation is a major economic indicator of performance, and a key driver behind economic policy by the government and the Reserve Bank of Australia (RBA). Changes in the inflation rate can affect consumers and businesses.

You may be wondering how exactly inflation works, what drives it and what impact it has on day-to-day life for the average Australian. This article will answer some key questions on the topic, including what inflation is, how it’s measured, what rises and falls in inflation can mean for consumers, and what impact inflation has on the RBA cash rate.

What is inflation?

Inflation is the increase in price of the same item from one point in time to another. It is generally measured on a quarterly or annual basis. For the most part, prices tend to rise over time, but they can also fall, which is known as deflation.

To put inflation in context, if you were to buy an item for $100 today and the same item cost $103 on the same day next year, inflation for the year on that item would be 3%.

How is inflation measured in Australia?

A key indicator of inflation in Australia is the Consumer Price Increase (CPI), which is calculated by the Australian Bureau of Statistics (ABS) and published quarterly. The CPI measures the percentage change in the price of a variety of goods and services consumed by households.

The ABS considers how households spend their income, and weights different categories of goods and services against each other as part of a ‘CPI basket’. Housing and grocery costs often take a greater portion of an inflation calculation because they generally incur a greater cost to an average household than other expenses, such as telephone bills.

The categories of the CPI are:

Housing
Food and non-alcoholic beverages
Recreation and culture
Transport
Furnishings, household equipment and services
Alcohol and tobacco
Health
Insurance and financial services
Clothing and footwear
Education
Communication

What is the inflation target?

The inflation target provides a framework to keep the CPI between certain rates, helping support the RBA in strengthening price stability, full employment and the welfare of Australians. Currently, the target inflation rate is 2% to 3%.

If the ABS are the ‘scorekeepers’ of inflation, the RBA are the ‘goal setters’: setting the target rate for inflation and trying to influence it.

As one RBA example explains, if inflation is likely to be too high for too long, the Reserve Bank Board would typically increase the cash rate in an effort to bring inflation back to this target range. If inflation is likely to remain too low, the Board would typically lower the cash rate.

What does a drop or rise in inflation mean for consumers?

Inflation and deflation can have a variable impact on consumers, depending on your personal circumstances and other wider factors.

When inflation is low, there may be underlying economic uncertainty. A low inflation rate can correspond with high unemployment, because lower prices can indicate lower demand. With deflation, consumers tend to delay and lower their spending with the expectation that prices will fall further in the future. During these periods, consumers generally have lower confidence in the economic future, which is likely to diminish discretionary (i.e. non-essential) spending. This means people are more inclined to save than spend, which will lower economic growth. However, this may also be a good time to invest. The price paid for an investment may be lower after deflation, depending on timing and personal decision-making.

High inflation is often a result of strong economic growth. Consumers may see greater opportunities if demand is high, and supply needs to meet this demand. When the inflation rate is high, consumers can have reduced purchasing power, with the value of their earnings lowered. Consumers may seek wage increases to compensate for an increased inflation rate. This, in turn, can impact the ‘bottom line’ of businesses, potentially leading to price increases in goods or services, or to job losses. If the prices of goods and services rise faster than incomes, consumers may feel incentivised to make investment and purchasing decisions quickly, to avoid paying higher prices.

Personal circumstances matter, too. For example, if you are a working professional in a mining town, such as a teacher or doctor, you may be more affected by higher prices for accommodation, food, fuel and other items than a mining worker during a mining boom, due to differences in income. Similarly, if you are a renter and deflation affects house prices, you may be impacted less than the person who owns the property.

For example, during Queensland’s resource boom, median housing prices were 86.9% more expensive in the mining town of Moranbah than Queensland’s capital city of Brisbane. By 2019, prices were worth 62% less than in 2012, although recently reported figures suggest they may be on the rise again.