Rising inflation: what does this mean for businesses and consumers?
You’ve probably seen on the news that inflation is on the rise and the RBA has recently increased the cash rate.
As young Australians, we weren’t around to experience the high inflation rates that characterised the 1970s and 80s in Australia. During our time as students, we’ve become used to seeing nothing but ‘record low interest rates’ and low inflation in the news. In 2020, inflation was just 0.89% and interest rates were at a record low of 0.10%.
But now, inflation was 5.1% in the March quarter of this year and interest rates have increased to 0.35%, the first increase in interest rates since 2010.
How does higher inflation affect the economy? And how does the RBA respond?
What is inflation?
Inflation refers to the sustained increase in the general level of prices over a period of time, usually one year.
What causes inflation?
The two main causes for inflation are known as ‘demand-pull inflation’ and ‘cost-push inflation’. Demand-pull inflation is when the economy is nearing its supply capacity, but consumer and business demand continues to rise. Rather than more output, prices will increase instead. ‘Cost-push inflation’ is when there is an increase in production costs that producers pass on to consumers with higher prices.
At the moment in Australia, we have a combination of both demand-pull and cost-push inflation. Government spending and low interest rates have increased demand for goods and services. Meanwhile, prices of these goods and services have also risen due to supply chain disruptions, and retailers have passed these prices onto consumers.
Effects of rising inflation on the economy
Inflation can negatively affect consumers and businesses. When inflation is high, business investment tends to fall. This is because businesses will face more uncertainty about their future costs. High inflation also means rising prices for Australia’s exports. This reduces international competitiveness, and Australian exporters may not be able to compete on international markets. This is bad news for Australian businesses who sell a lot of their products overseas.
For us consumers, rising inflation means we are more likely to spend and less likely to save, because the value of our savings may decline in the future. Inflation also worsens income inequality because low income earners may find that their incomes don’t rise as quickly as prices. Employees also demand higher wages, because inflation decreases the purchasing power of their current wages. When wages increase, prices of goods and services also tend to increase. This leads to more wage demands, leading to higher prices, leading to more inflation, and so on. This is known as the ‘wage-price inflationary spiral’. As you can see, inflation can spiral out of control pretty quickly.
Monetary policy: How does the RBA change interest rates?
High inflation is bad news for consumers, businesses, and the economy as a whole. But is there a way of controlling it? This is where the RBA comes in.
Monetary policy is Australia’s tool to keep inflation at a lower level and avoid all the negative impacts mentioned earlier. The RBA tends to have a target band for inflation, which is between 2-3%. If inflation starts to increase, the RBA is able to ‘tighten’ monetary policy by increasing interest rates. This will lower consumer and investment spending, leading to a lower level of economic activity and lower inflation. But higher interest rates can be tough for homeowners, who will have higher mortgage repayments if they have a variable rate loan.
What next?
The RBA predicts that inflation will reach 6% this year and will remain above their target band at least until 2024. This means that higher interest rates seem to be here to stay. The RBA governor, Phillip Lowe, says that interest rates will likely keep rising, and could reach 2.5% in the next couple of years.
You’ve probably seen on the news that inflation is on the rise and the RBA has recently increased the cash rate.
As young Australians, we weren’t around to experience the high inflation rates that characterised the 1970s and 80s in Australia. During our time as students, we’ve become used to seeing nothing but ‘record low interest rates’ and low inflation in the news. In 2020, inflation was just 0.89% and interest rates were at a record low of 0.10%.
But now, inflation was 5.1% in the March quarter of this year and interest rates have increased to 0.35%, the first increase in interest rates since 2010.
How does higher inflation affect the economy? And how does the RBA respond?
What is inflation?
Inflation refers to the sustained increase in the general level of prices over a period of time, usually one year.
What causes inflation?
The two main causes for inflation are known as ‘demand-pull inflation’ and ‘cost-push inflation’. Demand-pull inflation is when the economy is nearing its supply capacity, but consumer and business demand continues to rise. Rather than more output, prices will increase instead. ‘Cost-push inflation’ is when there is an increase in production costs that producers pass on to consumers with higher prices.
At the moment in Australia, we have a combination of both demand-pull and cost-push inflation. Government spending and low interest rates have increased demand for goods and services. Meanwhile, prices of these goods and services have also risen due to supply chain disruptions, and retailers have passed these prices onto consumers.
Effects of rising inflation on the economy
Inflation can negatively affect consumers and businesses. When inflation is high, business investment tends to fall. This is because businesses will face more uncertainty about their future costs. High inflation also means rising prices for Australia’s exports. This reduces international competitiveness, and Australian exporters may not be able to compete on international markets. This is bad news for Australian businesses who sell a lot of their products overseas.
For us consumers, rising inflation means we are more likely to spend and less likely to save, because the value of our savings may decline in the future. Inflation also worsens income inequality because low income earners may find that their incomes don’t rise as quickly as prices. Employees also demand higher wages, because inflation decreases the purchasing power of their current wages. When wages increase, prices of goods and services also tend to increase. This leads to more wage demands, leading to higher prices, leading to more inflation, and so on. This is known as the ‘wage-price inflationary spiral’. As you can see, inflation can spiral out of control pretty quickly.
Monetary policy: How does the RBA change interest rates?
High inflation is bad news for consumers, businesses, and the economy as a whole. But is there a way of controlling it? This is where the RBA comes in.
Monetary policy is Australia’s tool to keep inflation at a lower level and avoid all the negative impacts mentioned earlier. The RBA tends to have a target band for inflation, which is between 2-3%. If inflation starts to increase, the RBA is able to ‘tighten’ monetary policy by increasing interest rates. This will lower consumer and investment spending, leading to a lower level of economic activity and lower inflation. But higher interest rates can be tough for homeowners, who will have higher mortgage repayments if they have a variable rate loan.
What next?
The RBA predicts that inflation will reach 6% this year and will remain above their target band at least until 2024. This means that higher interest rates seem to be here to stay. The RBA governor, Phillip Lowe, says that interest rates will likely keep rising, and could reach 2.5% in the next couple of years.
