Inflation

Inflation is a rise in the general level of prices, not just the price of one thing. In Australia it is measured by the Consumer Price Index (CPI), which tracks the cost of a typical basket of household spending. Over the year to December 2022 the CPI rose 7.8 per cent, the fastest since 1990.

Economists start with two ideas. Aggregate demand is total spending on Australian-produced goods and services: by households, businesses and governments, plus overseas buyers of our exports, minus the part of all that spending that goes on imports. Aggregate supply is what the economy can produce with the workers, equipment and materials it has. The level of output the economy can sustain without prices speeding up is called its potential.

When spending runs ahead of what can be produced, businesses can raise prices and still sell everything, and they compete harder for scarce workers. That is demand-pull inflation. When something makes production dearer or scarcer, such as an oil price spike or floods destroying crops, prices rise even if demand has not changed. That is cost-push inflation, or a supply shock. The RBA's own explainer on the causes of inflation uses exactly these categories.

Real episodes usually mix both. The debate in this topic is largely about how much of each was behind the 2021–23 surge.

Prices and wages are set by people looking ahead. If a café owner in Hamilton expects her suppliers and staff to cost 6 per cent more next year, she will lift her prices now. If workers expect prices to rise 6 per cent, they will push for pay rises to match. So what people expect inflation to be can help make it happen.

Economists call expectations anchored when people assume inflation will return to around the target whatever happens this year. Then a temporary jump, say in petrol prices, tends to fade, because nobody builds it into next year's prices and wages. If expectations become unanchored, a temporary shock can turn into lasting inflation.

This is why the RBA watches surveys of what households, businesses and economists expect, and the inflation rate implied by government bond prices. It is also one reason it publishes a clear target: the RBA says inflation expectations have been consistent with its target since the early 1990s, and it wants to keep them there. When you hear the RBA say it will 'look through' a temporary price rise, it is betting that expectations stay anchored. When it raises rates in response to a supply shock, it is usually because it fears they will not.

The RBA's main tool is the cash rate, the interest rate on overnight loans between banks. Between May 2022 and November 2023 it raised the cash rate target thirteen times, from 0.10 to 4.35 per cent. Banks pass changes on to mortgages, business loans and deposits.

The RBA describes four main channels through which higher rates slow spending:

• Saving and investment: borrowing costs more and saving pays more, so households and businesses spend and invest less.
• Cash flow: people with variable-rate mortgages pay more interest, leaving less for everything else.
• Asset prices and wealth: higher rates tend to lower house and share prices, so people feel less wealthy and can borrow less against their assets.
• Exchange rate: higher rates tend to lift the Australian dollar, making imports cheaper.

Less spending means less pressure on prices, and over time weaker demand for workers, which slows wage growth. The RBA says monetary policy takes one to two years to have its full effect, and the timing is uncertain. Notice what this mechanism mainly works on: demand. That is why the source of inflation matters so much in the debates that follow.

Several forces can push prices up at once, and economists argue about their weight.

• Supply shocks: pandemic shutdowns, shipping bottlenecks, war-driven energy prices and floods.
• Wages: when wages rise faster than productivity, labour costs per unit of output rise, and firms may pass that on.
• Profit margins and market power: firms decide how much of a cost increase to pass on. Where a few big firms dominate a market, they may find it easier to raise prices together.
• Spending: strong household, business and government spending can push demand beyond what the economy can supply.
• Institutions: many prices are set or adjusted by rules rather than day-to-day competition. The CPI is used to index pensions, some taxes and charges, and business contracts, so past inflation feeds into future prices. Some prices are set by governments or regulators, such as many fees and charges. Governments can lower measured prices directly too: energy bill rebates were the main reason electricity prices fell 9.9 per cent in the December quarter 2024.

No single cause explains every episode. The RBA's framework focuses on demand and expectations, because that is what interest rates act on. Critics in this topic argue profits, market power and supply shocks deserved more attention in 2021–23.