What is inflation?
Inflation is the increase in the cost of living, and the most common measure of inflation is the Consumer Price Index (CPI). If you’re new to the idea of inflation, it may be easiest to think about it in terms of your regular cup of coffee. Once upon a time it may have cost $2, then $3 and depending on where you live you might pay anywhere from $4-6. While the quality of your coffee may have improved, the price has likely also increased.
Based on this, you may be asking how inflation affects your investments, and over time it basically eats away at them. For this reason, holding large amounts of cash as an investment is generally not a good idea. If you’ve ever heard somebody talk about ‘real’ or ‘nominal’ values, they were talking about inflation. In the example above, with your daily coffee going from $2 to $4, the nominal value of your coffee has increased. There is no arguing that you are now handing over more dollars for your coffee than you previously were but are you really paying more? The real value of a product refers to its price after accounting for inflation, so if your coffee cost you $2 in 2010 and inflation over that period was 8% your coffee should actually cost you a little over $4.3 in 2019. This is because the cost of your product has increased 8% every year for 10 years if you’re paying $4 in 2020 for what was a $2 coffee in 2010 the real price has actually decreased.
How Is Inflation Measured?
Despite the example above the current inflation rate is nowhere near 8%. The inflation rate in Australia in 2010 has actually been a lot closer to 1.98% meaning if your coffee cost $2 in 2010 its inflation-adjusted price in 2020 would be $2.43, although I image your cost has likely increased by more.
You now know what a cup of coffee should cost, but how is inflation measured? You might be disappointed to learn that it’s not some complicated formula that only a small group of nerds as NASA can understand, the Australian Bureau of Statistics purchases the same bag of consumer goods/services each year and calculates the percentage change in price from the previous year. Goods and services include housing, food and beverages, medical care, education, apparel, transportation, recreation and many other goods and services.
Although this method of calculating inflation makes it a straightforward process, it does open itself to criticism in several ways:
- Substitution Bias
Often when the price of a product or service rises, substantial consumers will find a cheaper substitute. By sticking with the same product as the previous year, CPI can overstate inflation.
- Quality Bias
Technology is continually improving the life of day to day goods. An example of this is everyday car tires, technological improvements have made them not only safer but last longer meaning they now cost less per km travelled. The Consumer Price Indexes failure to consider these changes can again lead it to overstate inflation
- New Product Bias
New items are not usually added to the ‘basket’ until they are already mainstream products. This means that price decreases in new products due thanks to improvements in technology are not reflected in the CPI measure of inflation and can again lead to overstated values.
- Outlet Bias
Technological advances in the past 10 or so years have seen sweeping changes to where people shop and the way they shop. The Consumer Price Index is not great at taking into account things like online retailers who often offer cheaper pricing, which again leads to the possibility of overstating inflation.
What Causes Inflation?
Inflation is caused by a million and one different things, but the three main reasons for inflation are:
- Demand-Pull Effect
This concept comes back to one of the most basic ideas in economics, increased demand leads to increased pricing. When you’re selling ice cream, and 10 people are queued up you might charge $5, but when it’s hot, and all of a sudden 30 people want ice creams, there’s a good chance that people will pay more than $5.
- Cost-Push Inflation
When the cost of making a product increases, a seller will often pass the cost on to the customer by increasing the price of the final product.
- Built-in Inflation
As the price of products rise with increased demand and higher production costs, employees look for improved pay conditions. Leading to increased production costs which are typically passed on to the consumer in the form of higher prices.
What Is Inflation Important?
There are many theories as to whether and why inflation is good for the economy. Rather than look at how inflation, in theory, increases production and demand, I prefer to consider the negatives of a world without inflation.
There are and have been locations around the world that see the pricing of goods and services fall regularly, this is known as ‘deflation’ and although paying less for everyday products may sound like a great idea it has some terrible consequences. Consider a world where you can buy an item like a fish tank for $1,000. It’s a little out of your budget, so you leave it and come back next year, now the fish tank is $900, wow that’s cheaper than last year, but it’s still too expensive, you’ve only got $800 in your budget, so you leave it. When you return to the store during the third year the fish tank is now $750. This is amazing, in 3 years the price of the fish tank has fallen 25%, and it’s now within your budget, do you buy? The general theory on deflation suggests that you wouldn’t, the reason being is that you’ve just watched the price of this product decline for 3 straight years. Rather than thinking what a bargain I’ll take it, your mind says, “it might be lower next year”, and when everybody feels like that nobody purchases. This may again sound good, but it cements the idea that things always get cheaper in your head and when nobody buys anything the economy plummets.
What Is a Target Inflation Rate?
To stabilise the economy and maintain the highest possible level of employment the Reserve Bank of Australia (RBA) sets a ‘target inflation rate’ which it attempts to maintain through monetary policy adjustments based on movements in the broader economy. The RBA’s current inflation rate target is 2-3% while the current inflation rate in Australia is closer to 1.8%.