Inflation explained: why it’s not all bad

Ashleigh Pano is a Client Advocate with Gilkison Group.

Newsfeeds and newspapers having been brimming with reports, projections and opinion pieces on the hot topic of inflation. Particularly, in context to the rising costs of living currently challenging Australian’s. As always, we endeavour to cut through the noise and deliver valuable perspectives and information from a trusted source. In this instance, let’s first explain what inflation actually is, how it’s related to the cost of living and why it’s not all bad.

What is inflation?

Inflation is a general increase in prices and fall in the purchasing value of money. Shane Oliver, Head of Investment Strategy and Chief Economist at AMP describes it as a persistent and gentle rise in the cost of living through time. In practice, that means the sudden, one-off rise in the price of lettuce experienced earlier this year cannot be attributed to inflation. The increase in the cost of milk from approximately 19 cents per litre in 1970 to two dollars or more per litre at present day can be attributed to inflation as it occurred incrementally over the last 50 years.

How is inflation related to the cost of living?

Every quarter, the Australian Bureau of Statistics releases the Consumer Price Index (CPI). Covering a typical basket of goods and services (food, clothing, transportation, housing, education and more) consumed by the average household, it measures the changing prices of various items, and therefore the cost of living over time. The CPI is commonly referred to as headline inflation. Whilst the CPI fluctuates over time, the most recent update in March 2022 showed an increase of 5.1% over the 12 months prior – the largest annual increase since the Global Financial Crisis.

Inflation isn’t the only factor that affects the cost of living, it simply represents the change in the cost of living. In more recent times, other factors that have attributed to the increased costs of goods and services in Australia include:

Covid-19 Global Pandemic; having caused major disruptions to the manufacturing and distribution of goods and services all around the world, the pandemic also led to a big increase in demand for goods relative to services.
War in Ukraine; Russia’s invasion of Ukraine has disrupted the global supply of oil, energy and various other commodities.
Natural Disasters in Australia; the devasting floods across Eastern Australia earlier this year has disrupted and diminished the supply of fruit and vegetables.

Taking it back to basic supply and demand, diminished supply means that there’s more demand (relatively). More demand then results in suppliers or businesses increasing their prices as a response to either cover their own increased costs, or to take advantage of the opportunity and increase their profits… By increasing the cost for final consumers, this economic response attributes to the overall increase in the cost of living.

Why inflation isn’t all bad

Whilst the media might be telling you that any inflation is bad inflation, that isn’t actually the case. A little inflation is quite healthy for an economy and can be crucial in helping economies through complex transitions.

Inflation is good when it combats the effects of deflation. In contrast to inflation, deflation is when prices fall, typically in response to an increase in the supply of goods and services. During times of deflation, both businesses and consumers are hesitant to invest in growth, spending is reduced, the real burden of debt increases, and unemployment rates rise.

In addition to combating deflation, inflation can also benefit higher-income households and businesses by making it ‘easier’ to pay back fixed-rate debts, along with owners of physical assets as whilst the real value of the dollar may decrease, physical wealth assets such as land, factories and machinery tend to retain their value.

We hope this article has alleviated some of the fear induced by recent media coverage and helped you understand that inflation is a response to changes in supply or demand – a natural part of the economic cycle. If you have any questions or require any assistance reviewing your cost of living and cash flow mapping, please get in touch.