What is inflation, and why does it matter to your money?

What is inflation?

Inflation gets talked about a lot, especially when interest rates are rising. But what does it actually mean for your day-to-day finances? Inflation is how much prices increase over time, usually shown as a percentage. For example, if something cost $103 today, but it was just $100 last year, it’s experienced 3% inflation.

A healthy economy needs some level of inflation, but too much can wreak havoc on household budgets, businesses, and trade. And because inflation is closely tied to interest rates, a spike in one usually leads to a rise in the other, meaning your groceries and your mortgage could both get more expensive at the same time.

What causes inflation?

There are two main causes of inflation:

Too much demand

If there is a high demand for a good or service, but there isn’t enough supply available to satisfy this demand, then the good or service’s price will rise.

Think of it like concert tickets; if 100,000 fans are chasing 1,000 seats, ticket prices are likely to climb quickly.

Higher costs

If the cost of providing a good or service rises, this can push the cost of the good or service itself higher.

For example, if building materials and labour become more expensive, the price of new houses will rise.

Why inflation matters to your money

Inflation affects what your money can actually buy, also known as your purchasing power. If prices rise faster than your income, your budget can come under pressure.
When inflation is high:

• Your everyday costs (groceries, fuel, rent) may increase
• Your income may not stretch as far
• Saving can feel harder
• Interest rates are more likely to rise

High inflation can also influence spending behaviour. You might feel tempted to:

• Bring forward big purchases (before prices rise further)
• Cut back on discretionary spending
• Look for better deals or switch providers

Rushing financial decisions can sometimes lead to paying more in the long run, so it’s worth weighing your options carefully.

Is low inflation a good thing?

Not always. While lower inflation can ease cost-of-living pressure, very low inflation (or deflation, where prices actually fall) can signal a slowing economy.

This can lead to:

• Lower business activity
• Higher unemployment
• Reduced wage growth

When inflation is low, people may feel uncertain about the underlying economy, which ultimately means they have lower confidence in their financial future. When people feel uncertain about the future, they may spend less, which can further slow the economy.

Low inflation can also be a cause and effect of high unemployment, as more people out of work leads to lower demand for goods and services.

How inflation affects Australians differently

Inflation doesn’t hit everyone the same way. Your experience will depend on factors like:

• Your income
• Whether you own or rent your home
• What you spend most of your money on
• The amount of debt or savings you have

For example:

• Someone earning a high income may feel price increases less than someone on a lower income
• Homeowners may be more exposed to falling property prices during deflation
• Renters may feel rising living costs more immediately
• Mortgage holders might be hit with higher repayments, as interest rates are linked to inflation

The most obvious effect of inflation is that prices for goods and services rise. When the inflation rate is high, you may find that your money doesn’t go as far as it used to.

If prices rise faster than incomes, this can put pressure on household budgets. It might also encourage people to make investments or major purchases quickly, as hesitating too long could mean paying a higher price later (even if rushing such decisions risks making mistakes that could cost them even more).

Personal circumstances matter, too. For example, someone on a higher income or with regular pay rises may feel less impact from rising costs than someone whose income hasn’t changed. Similarly, homeowners may feel the effects of falling property values more than renters, who are less directly exposed to changes in house prices.

How is inflation measured in Australia?

Even if the cost of individual items are higher today than they were years ago, that’s not enough to accurately measure the national inflation rate.

Inflation in Australia is measured by the Consumer Price Index (CPI), calculated by the Australian Bureau of Statistics (ABS).

CPI measures the change in the price of a hypothetical ‘basket’ of goods and services. It measures prices in 11 different categories of goods and services:

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

Different spending categories can affect inflation more than others. For example, housing and grocery costs may take a greater portion of an inflation calculation because they cost the average household more than other expenses, such as phone bills.

How does inflation affect interest rates?

If the ABS are the ‘scorekeepers’ of inflation, the RBA are the ‘goal setters’.

Because high inflation can hurt Australian household budgets and low inflation can indicate an economy that’s in trouble, the RBA sets an inflation target. At present, the target inflation rate is between 2% and 3%.

If the inflation rate is outside this band, the RBA may shift the cash rate. If it thinks inflation will be too high for too long, the RBA might raise the cash rate. If inflation is likely to remain too low, the RBA will typically lower the cash rate.

How does changing the cash rate affect inflation?

The cash rate plays a major role in the interest rates that banks charge borrowers and pay out to depositors on products like home loans, savings accounts, and credit cards. In turn, interest rates can influence demand in the economy.

When inflation is too high:

• The RBA may increase the cash rate
• Borrowing becomes more expensive
• Households and businesses may spend less
• Demand slows, helping to ease price growth

When inflation is too low:

• The RBA may decrease the cash rate
  
• Borrowing becomes cheaper
• Spending may increase
• Demand lifts, helping prices rise gradually