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Inflation explained: Simple way to understand 'vicious cycle' in cost of living crisis

David Koch explains the technical economic terms you may not understand so you can hold your own in a rate rise chat over dinner.

Explainer: Aussies are in the fight of a generation against inflation - and another rate hike would be proof of how that trickles down.

But does the concept confuse you? Money expert David Koch explains what inflation is, how wages and Aussies losing their jobs influence it, and more importantly, how we can control it to help alleviate the cost-of-living crisis.

What is inflation and why can it be bad?

Inflation is the reason a loaf of bread that cost 18 cents in 1962 costs $3 today.

Put simply, it’s the increase in price for goods and services. It’s happening all the time but when things are going well, you barely notice it.

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That’s because, in an ideal world, wages are also rising at a steady rate to help you pay for the cost increases.

The Reserve Bank of Australia’s (RBA) central role is to control inflation, keep our economy healthy and ensure everyday Aussies are living comfortably and in a job.

Inflation expert David Koch with a picture of Australian money in front
Inflation and how it's impacting you can be a hard thing to explain. Unless you're David Koch.

Do you have a story to tell or a question to answer? Contact belinda.grantgeary@yahooinc.com

To do this, the RBA has an inflation target of 2-3 per cent, which it monitors through the consumer price index. The RBA reckons this is the perfect inflation range to support a strong economy.

The problem we have now is that inflation is climbing at a hot pace, which has been difficult to tame. High inflation erodes the spending power of every dollar you earn so, when it gets too high, it can wreck an economy.

For the past 18 months, the RBA has been using its biggest hammer - interest rates - to slow economic growth and bring inflation back under control.

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For a generation, Australians have enjoyed ultra-low interest rates, making the current rate-rise cycle a particularly tough adjustment. It is the sharpest and quickest rise in interest rates since the 1990s.

A Compare the Market survey of 1,005 mortgagors found 12.5 per cent had used a hardship or payment program to cope with repayments during the 12 months to September 2023.

Inflation is not always our friend but, for those with a mortgage, the rate rises are often much more painful.

Why do people need to lose their jobs to bring down inflation?

People shouldn’t need to lose their jobs, but something has to give.

The RBA looks at a number of different measures when deciding whether to increase rates, including the impact on employment, wages, and spending.

High employment (low unemployment) can be seen as a concern because it means wages go up as bosses compete for staff. This, in turn, means those staff have more money to spend, which increases demand for goods and services, which means prices go up, which feeds into inflation.

It can be a really vicious cycle.

When people are out of employment, they usually have no choice but to rein in their spending to focus on the necessities. This reduces demand for goods and services so suppliers have to drop their prices to attract customers and inflation goes down.

But there are other ways to tame inflation without putting people’s jobs and livelihoods on the line.

Increased productivity, for example, would help increase the supply of in-demand products.

And, of course, higher interest rates will help to curb consumer spending and reduce their borrowing.

I’m crossing all my fingers and toes that we don’t have to sacrifice jobs because that would have a devastating effect on families.

And, to be honest, governments at all levels can also help and not just leave it up to the RBA to do their dirty work and tackle inflation. Governments can cut their spending (aka fiscal policy) on goods and services to reduce demand and bring down prices.

Why are rate hikes not helping with issues like the housing crisis, petrol, energy?

There are a lot of factors impacting prices outside of the RBA's control.

The price of petrol is affected by global supply pressures, international conflicts and production directives.

Gas and electricity now cost more to generate and transmit due to material and infrastructure costs, network poles and wiring costs, environmental costs, and retailer and residual costs.

And, while some people argue the RBA should take house prices into account, property affordability is not currently part of its remit. Property prices are about demand and supply and, currently, there is not enough supply of new housing stock to cope with our population growth and big immigration program.

With building approvals currently at 10-year lows, that housing shortage is expected to get a lot worse before any improvement.

We want wages to go up, right? How does this play into economic woes?

Remember that vicious cycle? Workers need higher salaries to beat the rising cost of living, but bigger wages mean more spending and higher costs - which fuels inflation.

Ultimately, the RBA wants to see less of the kind of discretionary spending that having a bigger wage affords us. So, it puts up interest rates so we need to spend more on the mortgage repayment and less at the shops.

The trouble is that means Aussies living on low incomes are just scraping to get by.

Their budget considerations are not: “Will we go on a second family holiday this year?” Instead, they are: “Can I afford food for the week”, or “Should I skip lunch or breakfast”.

Compare the Market research shows that as many as two in five Aussies have cut back on spending at the supermarket to afford other household bills.

Most alarmingly, 17.7 per cent said they had been skipping meals.

We need to remember the pressure is not spread equally. Employers should be mindful of this when considering salaries next year.

What's migration got to do with inflation?

We often hear about global factors that drive inflation. Things like labour issues, supply shortages and political unrest all play a role.

But, even at home, there are a number of compounding factors feeding the inflationary fire, such as migration.

Net overseas migration added 454,400 to the population in the 12 months to March 31 this year.

There is no doubt we are desperate for skilled workers and welcome the financial injection by international students, but it also means there are 454,400 more people who need a roof over their heads and food on their plates.

That is an extra 454,400 customers for retailers but it also puts pressure on housing, goods and services.

It should be a serious priority for government to make sure we have the infrastructure and housing to support that migration policy.

David Koch is Compare the Market’s economic director, leading research and campaigns to help Australians make educated financial decisions.

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