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If it feels like your money doesn’t go quite as far as it used to, you aren’t imagining it. Australia is experiencing high levels of employment, and, yet, many people are struggling to make ends meet. The reason is inflation, which describes the gradual rise in prices and slow decline in purchasing power of your money over time. Here’s how to better understand inflation, plus steps you can take to protect the value of your money in the face of rising prices.
How Does Inflation Work?
Inflation occurs when prices rise across the economy, decreasing the purchasing power of your money. In 1980, for example, unleaded petrol cost 30c a litre on average in Victoria, whereas nowadays a tank of fuel costs around $1.87 in Victoria, according to the RACV.
Don’t think of inflation in terms of higher prices for just one item or service, however. Inflation refers to the broad increase in prices across a sector or an industry, like the petrol, energy, or construction sector—and ultimately a country’s entire economy.
In Australia, the chief measure of inflation is the Consumer Price Index (CPI), which is created through an aggregation of price analyses, and released by the Australian Bureau of Statistics (ABS). Previously, the ABS only released inflation updates on a quarterly basis, leading critics to complain of a lag in informative data, but in 2022 the ABS started producing monthly data to keep Australians abreast of rising costs. The most recent monthly inflation data came in at 3.6%, slightly higher than expected. However, the quarterly data release is still considered the benchmark data, as the monthly updates assess about 70% of the goods and services that contribute to inflation.
In the US, the chief measures of inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI) and the Personal Consumption Expenditures Price Index (PCE), all of which use varying measures to track the change in prices consumers pay and producers receive in industries across the American economy.
Though it can be frustrating to think about your dollar losing value, most economists consider a small amount of inflation a sign of a healthy economy. A moderate inflation rate encourages you to spend or invest your money today, rather than stuff it under your mattress and watch its value diminish. The Reserve Bank of Australia (RBA) aims for a target inflation of between 2% to 3%. In the December 2022 quarter, Australia’s inflation rate peaked at 7.8%. To put that number into context: it was 1.7% in 2019. While the annual inflation figure has since dropped—to 3.5% annually to March 2024—it is proving stickier than expected.
Inflation can become a destructive force in an economy if it is allowed to get out of hand and rise dramatically. Unchecked inflation can topple a country’s economy, like in 2018 when Venezuela’s inflation rate hit over 1,000,000% a month, causing the economy to collapse and forcing countless citizens to flee the country.
Related: Why is Australia’s Inflation Rate So High?
When prices decline across a sector of the economy or throughout the entire economy, it’s called deflation. While it might seem nice that you can buy more for less tomorrow, economists warn that deflation can be even more dangerous for an economy than unchecked inflation.
When deflation takes hold, consumers delay purchases in the present as they wait for prices to decline even further in the future. If left unchecked, deflation can diminish or freeze economic growth, which in turn decimates wages and paralyses an economy.
Extreme Inflation: Hyperinflation & Stagflation
When inflation isn’t kept in check, it’s commonly known as hyperinflation or stagflation. These terms describe out-of-control inflation that cripples consumers’ purchasing power and economies.
What Is Hyperinflation?
Hyperinflation occurs when inflation rises rapidly and the value of the currency of the country tumbles. Economists define hyperinflation as taking place when prices rise by at least 50% each month. Though rare, past instances of hyperinflation have taken place during civil unrest, during war time or when regimes have been taken over, rendering currency effectively worthless.
Perhaps the best-known example of hyperinflation took place in Weimar Germany, in the early 1920s. Prices rose by tens of thousands of percent each month, which very badly damaged the German economy.
What Is Stagflation?
Stagflation occurs when inflation remains high, but a country’s economy is not growing and its unemployment is rising. Usually, when unemployment increases, consumer demand decreases as people watch their spending more closely. This decrease in demand lowers prices, helping to recalibrate your purchasing power.
When stagflation happens, however, prices remain high even as consumer spending decreases, making it increasingly expensive to buy the same goods. The US experienced stagflation in the mid to late 1970s, as high prices from OPEC oil embargoes drove inflation higher even as recession lowered GDP and increased unemployment. Similarly here in Australia, we last experienced stagflation in the 1970s when wages, unemployment and inflation all rose quickly.
What Causes Inflation?
The gradually rising prices associated with inflation can be caused two main ways: demand-pull inflation and cost-push inflation. Both come back to the fundamental economic principles of supply and demand.
Demand-Pull Inflation
Demand-pull inflation is when demand for goods or services increases but supply remains the same, pulling up prices.
Demand-pull inflation can be caused a few ways. In a healthy economy, people and companies increasingly make more money. This growing purchasing power allows consumers to buy more than they could before, increasing competition for existing goods and raising prices while companies attempt to ramp up production. On a smaller scale, demand-pull inflation can be caused by the popularity of certain products.
For example, at the start of the coronavirus pandemic, the increase in demand for indoor, socially distant activities combined with the highly anticipated release of Animal Crossing: New Horizons saw the price of the Nintendo Switch gaming system almost double on some secondary markets. Because Nintendo could not increase production, due to factory production halts from Covid-19, Nintendo could not raise its supply to meet rising consumer demand, resulting in increasingly higher prices.
Cost-Push Inflation
Cost-push inflation is when supply of goods or services is limited in some way but demand remains the same, pushing up prices. Usually, some sort of external event, like a natural disaster, hinders companies’ abilities to produce enough of certain goods to keep up with consumer demand. This allows them to raise prices, resulting in inflation.
For example, think about oil prices. You—and pretty much everyone else—need a certain amount of petrol in your car. When international treaties or disasters drastically reduce the oil supply, fuel prices rise because demand remains relatively stable even as supply shrinks.
The RBA also notes that the psychology of inflation—what it terms ‘inflation expectations’—can also play a large role in inflationary impacts. As the central bank states: “… If firms expect future inflation to be higher and act on those beliefs, they may raise the prices of their goods and services at a faster rate.”
How Is Inflation Measured?
In Australia, the level of inflation in the economy, known as headline inflation, is chiefly measured by the CPI, which tracks the price of goods and services over time. The ABS gathers pricing information on thousands of goods and services, which are then sorted into more than 80 separate categories and 11 groups. The ABS then publishes the price changes for these categories each quarter, which helps the bureau to determine the overall inflationary rate for that period. For example, in the most recent quarterly release—the March 2024 quarter—Australia’s inflation rate came in at 3.6%.
How households in Australia spend their income on certain goods will determine the various weights for each calculation. This means that if consumers on average spend more of their income on childcare, for example, rather than new dwellings, that item will be given a larger weight in the CPI basket.
The CPI is not a full-proof measure of inflation, as the ABS points out, but it’s seen as the ‘proxy’ measure of rising or falling costs. There are other data sets that also provide insight into Australians’ standard of living, and these include:
- the Selected Living Cost Indexes (SLCIs) which measure changes in living costs for certain population sub-groups. “They are particularly suited for assessing whether or not the disposable incomes of households have kept pace with price changes,” the ABS notes;
- the Wage Price Index (WPI) that tracks changes to the wages in the job market;
- the Producer Price Index (PPI) which measures changes in the price of products at the point of leaving the place of production or entering the production phase;
- the International Trade Price Index (ITPI) which records prices paid for imports and exports in and out of Australia each quarter.
In the US, the inflation rate is measured by the CPI, PPI and PCE indexes. Because no single index captures the full range of price changes in the US economy, economists must consider these multiple indexes to get a comprehensive picture of the rate of inflation.
The Producer Price Index (PPI) is published by the Bureau of Labor Statistics, and tracks the changes in prices that companies receive for the goods and services they sell each month, while the Personal Consumption Expenditures Index (PCE) tracks how much consumers pay for goods and services in the US economy. This index considers a broader range of consumer expenditures than the CPI, such as healthcare spending, and is especially important because it’s the US Federal Reserve’s preferred measure of inflation when making monetary decisions.
Inflation and the RBA
The Reserve Bank of Australia—the nation’s central bank—is tasked with analysing inflation and economic data. Headed by Governor Michele Bullock, the bank meets every six weeks for a total of eight meetings each year, spread across two days.
At these meetings the bank’s board will determine whether to hold interest rates, to lift rates to take the heat out of the economy, or to stimulate the economy by lowering rates. Over the last two years, the RBA lifted rates 13 times in a bid to bring inflation to heel. It came after years of historically low interest rates that saw the cash rate slashed to .1% at the beginning of 2022. It is now at 4.35%.
Australia’s banks take their cue from the RBA on the cost of borrowing money and set their own interest rates in response. They usually pass on the RBA’s rate hikes to consumers in full, which directly impacts the hip-pockets of mortgagees.
In the early 1990s, the RBA adopted an inflation target of 2% to 3%, which has since been enshrined in its Statement on the Conduct of Monetary Policy. This target is considered the ‘goldilocks zone’ of economic growth in Australia (not to hot, not too cold).
In the US, the Federal Reserve is the central bank, and the Fed—like central banks around the world—is tasked with maintaining a stable rate of inflation. The Federal Open Markets Committee (FOMC) has determined that an inflation rate around 2% is optimal employment and price stability.
This level of inflation gives the FOMC scope to jump-start the economy during downturns by decreasing interest rates, which makes borrowing cheaper and helps boost consumption. Lower interest rates reduce costs for businesses and consumers to borrow money, stimulating the economy. Lower interest rates also mean individuals earn less on their savings, encouraging them to spend. But all this extra demand can push up inflation.
What Investments Beat Inflation?
Even a moderate rate of inflation means that money held as cash or in low-interest bank accounts will lose purchasing power over time. You can beat inflation and boost your purchasing power by investing your money in certain assets.
Beat Inflation with Stocks
Investing in the stock market is one way to potentially beat inflation. While individual stock prices may fall or single companies may go out of business, and bear markets may even depress indices for certain periods, broader stock market indexes rise over the long run, beating inflation.
From 1920 to 2020, the S&P 500, which tracks the performance of 500 of the largest companies in the US, generated an average annual return of just over 10%, with dividends reinvested. This is a long-term average—in some years, the S&P 500 had lower or even negative returns. In Australia, the long-term return—about 30 years—on Australian shares averages out at just under 10%. According to investment firm, Vanguard Australia, if you held an “all-equity portfolio in the ASX from 1970 to 2020, your average yearly return over the half century would be about 10%.”
Investing in individual stocks offers no guarantees, but a well-diversified investment in a broad market index fund can grow wealth over decades and beat inflation.
Beat Inflation with Bonds
Bonds on average offer lower returns than stocks, but they can also regularly beat inflation. Risk averse investors or those approaching or in retirement may seek out the more consistent returns of investments in bonds to beat inflation.
In particular, Exchange-traded Treasury Indexed Bonds (eTIBs), are indexed to the CPI, which means the coupon payments from the bonds rise (and fall) in line with inflation, unlike in the case of non-indexed Government bonds. This means that eTIBs offer some degree of protection in a high-inflation environment, although this doesn’t, of course, necessarily make them a great investment—other factors must be taken into consideration.
From June 2005 to June 2020, the Bloomberg Barclays US. Aggregate Bond Index, a benchmark index tracking thousands of US bonds, saw annual returns of 4.47% for US consumers. Even accounting for inflation, those with money in bonds would have seen modest increases in the purchasing power of their money. Keep in mind, though, that bond yields are tied to the overall economy and current bond yields may be less than historical bond yields.
Can You Beat Inflation with Gold?
Many investors consider gold as the ultimate inflation hedge, although the debate over this proposition is far from settled. Nevertheless, many Australian investors opt to sink their money in a gold ETF or other precious metal.
From April 1968 to June 2020, for instance, gold increased in value on average 7.6% a year in the US. When adjusted for inflation, returns average 3.6%. Yet in 2013 and 2015, gold’s value decreased 28% and 12%, respectively, suggesting gold is far from the stable safe-haven some envision it to be. That’s because the price of gold can wildly fluctuate over time and is impacted by movements of global currencies, monetary policy choices made by the US Fed and other central banks, not to mention erratic supply and demand.
Note: When investing, it’s possible to lose some, and very occasionally all, of your money. Past performance is no prediction of future performance and this article is not intended as a recommendation of any particular asset class, investment strategy or product.
FAQs
What is Australia's inflation rate?
As of June 2024, Australia’s monthly and annual inflation rate were both at 3.6%. The Reserve Bank of Australia has a target inflation rate of between 2% and 3%.
What causes inflation in Australia?
Inflation may be the result of prices being either pulled up or pushed up. Prices are pushed up when demand for goods remain the same, but supply of goods and services are limited. Conversely, prices are pulled up when demand rises but supply remains the same.