Inflation this, inflation that. We’ve all been hearing the word thrown around everywhere now, it’s become part of our everyday language. Of course, it’s not just as a singular entity either, the word has also been coupled with other common phrases such as high petrol prices, interest rate hikes and rising costs of living. Sure, inflation is most people’s go-to response to describe the rising cost of living but truthfully, not everyone knows exactly what inflation is. So, I thought it would be relevant to explore the basics of inflation, its main causes and how it can affect everything in our day to day lives.
At its core, inflation is a measure of the rise of goods and services within the economy, with the end result being that effectively your money won’t go as far as it used to. Inflation refers to an increase in a broad sense (entire industries etc) and isn’t limited to specific items. Thus, the best way to think of inflation is as a measure of the declining purchasing power of a currency. Although, if one wanted to use inflation to measure the increase of, let’s say a haircut, you could easily do so. Inflation isn’t as big of an issue if wage growth moves with it, but when wages rise at a much slower pace, Inflation has the power to ruin a consumer’s purchasing power.
When currencies lose value and people are unable to stretch their money as much as they used to, this impacts the general cost of living (which is exactly what we’re seeing happening worldwide now). The end result is a drop in economic growth. Hence, too much inflation is generally bad for an economy (as it leads to less spending), however so is too little. Thus, most economists believe that low to moderate inflation of around 2% per year is a good place to sit. The issue we’re facing right now is that we’re sitting at a much higher rate of inflation, hence the noticeable price hike of just about everything.
It’s worth taking a look at the Consumer Price Index, which is the most common method for measuring inflation as it includes statistical data on price changes for goods and services. Some countries also use the Wholesale Price Index as a measure of inflation as it looks at the price of items before retail.
There are a multitude of variables that cause inflation such as but not limited to an increase in the circulating money supply, rising wages, supply chain disruptions and worker shortages. The best way to break the central causes of inflation down is into the 3 main models.
Demand-pull: This occurs when the supply of money increases to the point where demand exceeds production capacity. As there is higher demand for something with less supply, the end result is higher prices.
Cost-push: This form of inflation is comparable to demand-pull. How it differs is that cost-push occurs as a result of an increase in wages and raw material costs. Thus, it is also known as wage-push inflation. Think of it like this, as there is an increase in production costs, this can decrease the overall supply. Essentially, this means that the demand hasn’t changed at all but the cost of production is higher, therefore the price increase is passed onto the consumer.
A great current example is the timber and silica shortage that the building industry is facing. Hence why it is important to find alternative methods of producing aggregate, for both the business and the consumer.
Built-in: The expectation that current inflation rates will continue in the future leading to employee’s demanding that their salaries will increase to match living costs. That’s what built-in is and fair enough for employee’s to expect that, right? The issue is that if a skilled worker for example demands a higher salary, this leads to an increase in production costs, resulting in rising living prices. As you can see, the factors are all influencing each other in a vicious cycle. Built-in inflation is considered a major cause but for this inflation to occur, either cost-push or demand-pull must also have some part to play.
The Bottom Line
So, in essence, low to moderate inflation can be good as it’s a sign of a growing economy. When the rate of inflation is predictable, it helps with decision making on interest rates and price adjustment contracts. Of course, where we are sitting right now is at a much higher than expected rate of inflation due to a multitude of variables. In Australia, the first quarter alone saw inflation increase to 5.1% due to fuel prices and rising construction costs. In fact, ABS reported the highest annual rate of inflation in June 2022 in almost 32 years at 7% before dropping to 6.8% in August. In a recent report from the ABS, the Consumer Price Index (CPI) rose 1.9 per cent in the December 2022 quarter and 7.8 percent annually. Did you know that fuel prices in Australia have increased a whopping 37% in the last year alone? Thankfully, the price of fuel has managed to stay somewhat consistent over the most recent months.
Something we’ve seen all over the world are supply shocks over the last few years, which started with the pandemic and the current war is exacerbating the issue, particularly when it comes to fuel and energy. The above mentioned supply issues in the building industry are another problem as well, and all these variables have created a melting pot, hitting businesses first and then the consumer.
If inflation is getting you worried, be sure to look at our other articles that explore ways to mitigate the risk through making the right investment decisions. You CAN offset the pain of rising living costs.
DISCLAIMER: The contents of this newsletter are intended as general advice only. No specific person’s circumstances, financial situation or objectives have been taken into consideration. You should not act on the information provided without seeking personal advice from an appropriately qualified financial planner.