Inflation explained: How does it impact Australians?

4 December 2020
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.

It goes without saying the COVID-19 pandemic has had a dramatic impact on economies globally, and Australia did not escape unscathed. The lockdown measures affected the supply and demand of certain goods which saw fluctuations in their prices. For us, one of the biggest impacts has been a drop in inflation.

This article covers:

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 was $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 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 relative costs, such as telephone bills.

These are the categories and their respective breakdowns:

Category Weighting
Housing 22.30%
Food and non-alcoholic beverages 16.80%
Recreation and culture 12.60%
Transport 11.60%
Furnishings, household equipment and services  9.10%
Alcohol and tobacco 7.10%
Health 5.30%
Insurance and financial services 5.10%
Clothing and Footwear, Education and Communication (combined) 10.10%
Total 100.00%

Source: Trading Economics, accessed 2/12/2020.

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.

If the ABS are the ‘score keepers’ 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 to bring inflation back to the target. If inflation is likely to remain too low, the Board would typically lower the cash rate.

What is the current rate of inflation?

The current target rate for inflation is between 2-3%. According to the RBA, low and stable inflation reduces economic uncertainty, helps people make investment and savings decisions and is the basis for sustainable, strong economic growth.

The current inflation level of 0.7% as of September 2020 is significantly undershooting our target; however, this has risen since June 2020 (-0.3 per cent), likely resulting from the reduction or reversal of lockdown measures across many states, as well as the lifting of free childcare and increase in automotive fuel. The ease of restrictions likely resulted in an increase in consumer purchasing behaviour, stimulating more supply and demand for certain goods and thereby contributing to the CPI rise.

All Groups CPI, Quarterly Change

CPI quarterly change graph

Source: Australian Bureau of Statistics, Consumer Price Index Australia, September 2020.

Even before COVID-19, Australia was not hitting the target inflation rate of between 2- 3%. However, once COVID-19 hit, our inflation took an event greater hit, and there was a consequential impact on the economy. We are now bouncing back; however, our most recent quarter is not quite at target back in line with levels pre-pandemic.

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 increase the likelihood of 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 spending. This means they 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 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 price 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.

Aerial view of Moranbah, Queensland. Source: Marc Witte (Shutterstock).

For example, during Queensland’s resource boom, 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.

How does inflation impact the RBA lowering or raising the cash rate?

Inflation is one of the biggest factors in the RBA’s decision to lower or raise the cash rate. The RBA uses the CPI figure as a way of judging economic activity. The cash rate is used to slow down or stimulate economic activity. The cash rate is the interest rate every bank has to pay on the money it borrows, namely from unsecured overnight loans between banks. Banks will process transfers between each other overnight and the cash rate impacts the interest banks pay on these transactions. This interaction can impact consumers, as the associated costs can be passed down from the bank to consumers in interest.

If the inflation rate is high, the RBA will typically increase the cash rate to slow down (but not halt) activity. This, in turn, may lead lenders to increase interest rates on products such as home loans. Lenders may also increase the interest rate for savings accounts.

When the inflation rate goes down, the RBA will typically do the opposite: stimulating economic activity by reducing the cash rate. When the cash rate is low, interest rates charged by lenders will typically fall. If you have a mortgage, you may be able to pay less interest each month on your loan. However, if you have money in a savings account, you may earn less interest.

What is the future outlook for inflation in Australia?

If you compare the quarterly inflation figures of the last two quarters (0.7% September 2020 and -0.3% June 2020), to the four quarters pre-COVID (1.6% to 2.2%) this indicates something economically significant has changed. This is undoubtedly due to the COVID-19 pandemic causing an economic downturn, not only locally but also globally.

It is hard to say what will happen with inflation in Australia, particularly as our nation continues to weather the COVID-19 storm. Industry forecasts suggests inflation will remain below 2% over the next couple of years; however, the Melbourne Institute Inflation Expectations survey indicates consumers expect the inflation rate to be at 3.60% in 12 months time, with a potential increase to 3.90% in 2022.

What I am confident in is that the RBA has backed themselves into a corner with interest rates. If the world and our economy are unlikely to return back to how things were pre-COVID-19, I struggle to understand what the RBA could do to stimulate the economy, without the benefit of being able to cut interest rates. I am optimistic that our nation will take a turn for the better and we’ll soon start to resemble a sense of normality. This will mean people are going to be spending more, and we’ll stimulate tourism and put inflation back to levels pre-COVID-19, but with interest rates remaining at these lows for at least the next two or three years.

This article was reviewed by our Sub Editor Jacqueline Belesky and Senior Finance Journalist Shay Waraker before it was published as part of our fact-checking process.

Brendan Mills Headshot

About Brendan Mills

Brendan Mills is the owner and director of CFO Dynamics, a financial management and strategies firm. Brendan holds a Bachelor of Business and is a CPA with experience across a range of industries including professional services, building & construction, mining services, wholesale, manufacturing, medical, business to business and trade industries. He is also the author of the e-book ‘Confessions of an Accountant’. You can find Brendan on LinkedIn.

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