The inflation rate
In June last year, Australia experienced an inflation rate of 3.8 per cent; the highest it has been since the 2008 Global Financial Crisis.[1] While the rate has somewhat simmered since then – lowering to 3.5 per cent in December – the jump from its meagre numbers of 1 to 2 per cent in previous years has left Australians feeling uncertain about the future.[2]
What is inflation?
Inflation is the rate of change of prices of goods and services over a certain period of time (usually a year). These prices are taken from a weighted average basket of goods and services that a typical household purchases each year (known as the consumer price index: CPI). An increase in inflation means that prices across the economy have increased overall, while a fall in inflation means that they have decreased.
Each year, the Reserve Bank of Australia aims for an inflation rate of 2 to 3 per cent: low enough so as to ‘not materially distort economic decisions’ but high enough to prevent a liquidity trap.[3]
Inflation and wages
A popular misconception fuelling the fear around inflation is that it results in falling consumer purchasing power. While it is true that increasing inflation diminishes the value of money – that is, $1 will buy less this year than it did last year – economists stress that it does not decrease living standards as wages should be expected to rise at the same rate.
Wages are calculated as the product of the marginal product of labour (the additional output that each new worker produces) and price of the good or service sold:
Wage = Marginal Product of Labour x Price
With this formula in mind, as prices in the economy increase workers’ wages will also increase.
On average, real wage growth shows an annual increase which is on average higher than the increase of inflation. However, the difference between real wages and inflation is decreasing with real wages facing an average growth of 0.98 per cent in 2001 to 2007 but only a 0.46 per cent growth in 2013 to 2018.[4] This marks a slowdown in wage growth in Australia. This means living standards are stagnating despite developments in growth areas such as technology and innovation.
However, going forward, the RBA suggests that wages are to grow at the fastest rate in a decade in response to the signs of a strong post-COVID economic recovery. This growth is expected to be at 3 per cent by the end of 2023.[5]
Inflation and real interest rates
Real interest rates capture the real return on, or cost of, a loan. This is formulated by subtracting the inflation rate from the nominal interest rate.
Real Interest Rate = Nominal Interest Rate – Inflation Rate
This formula suggests that banks will increase their nominal interest rates in response to rising inflation so as to not lose their real returns. But by increasing nominal interest rates, both consumption and investment are driven down as spending becomes more costly and saving becomes more profitable. While this decrease in aggregate demand may drive back down the inflation rate, it will ultimately further entrench the economic downturn experienced post-COVID as production is further decreased. As economic downturns can prolong for years, increasing interest rates is a high price to pay for stabilising short-term returns. Luckily, the Australian Reserve Bank has the power to set interest rates across the economy, and their aim is nationwide economic prosperity, not profit.
The RBA sets the interest rate by controlling the overnight cash rate which significantly affects other interest rates in the economy. The overnight cash rate has seen its historically lowest levels, sitting at 0.05 per cent in January 2021.[6]
So in actuality, interest rates have been declining: a decision made by the RBA to stimulate household spending and investment, prioritising long-term prosperity. Unfortunately for lenders, however, this does mean that the returns on loans have been redistributed from them to their borrowers. Although it should be noted that this trade-off to reinvigorate the economy in the future will bring in more future investment opportunities and thus greater returns.
Conclusion
The inflation increase Australia is experiencing should not be concerning to consumers. Due to COVID recovery efforts, we are in a period of both falling interest rates and expected growth of wages – a combination we shouldn’t fear but embrace.
[1] Reserve Bank of Australia (2022) Measures of Consumer Price Inflation, RBA, accessed 13 March 2022. https://www.rba.gov.au/inflation/measures-cpi.html
[2] Ibid.
[3] Reserve Bank of Australia (n.d.) Inflation Target, RBA, accessed 13 of March 2022. https://www.rba.gov.au/inflation/inflation-target.html#:~:text=The%20Governor%20and%20the%20Treasurer,economic%20decisions%20in%20the%20community
[4] Andrews D, Deutscher N, Hambur J & Hansell D (2019) Wage Growth in Australia: Lessons from Longitudinal Microdata, RBA, accessed 13 of March 2022. https://www.rba.gov.au/publications/confs/2019/pdf/rba-conference-2019-andrews-deutscher-hambur-hansell-discussion.pdf
[5] Gareth Hutchens (2021) Reserve Bank sees wage growth hitting fastest pace in years – by 2023, ABC, accessed 13 of March 2022. https://www.abc.net.au/news/2021-11-05/reserve-bank-statement-on-monetary-policy-wages-growth/100597464
[6] Reserve Bank of Australia (n.d.) Statistical Tables (F1.1), RBA, accessed 13 of March 2022. https://www.rba.gov.au/statistics/tables/