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What is inflation? Why is the CPI so high? And how is the RBA planning to bring it back down?

By business reporters Rachel Pupazzoni and Michael Janda and Lori Youmshajekian
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Why is everything so expensive?

If you're the person in your household who usually does the grocery shopping or fills up the car, you won't need a statistician to tell you prices are on the rise.

Nonetheless, the latest official reading on consumer price rises comes out on Wednesday from the Australian Bureau of Statistics.

It's called the Consumer Price Index, or CPI.

"The way that inflation is measured in Australia is by looking at the different categories that consumers spend money on," explains AMP senior economist Diana Mousina.

The number crunchers at the ABS go around all the capital cities and check the latest prices of this "basket of goods", with around 100,000 different individual prices collected every three months.

The statisticians then calculate how much those have changed since the last survey three months earlier.

Every year, the ABS also examines what Australians are typically spending most of their money on, and 'weights' the CPI accordingly, so it reflects where an average household spends most of its money.

"The things that have the largest weighting in the Consumer Price Index are things like food, housing, utilities, education and health," says Ms Mousina.

But the CPI doesn't include everything we spend lots of money on.

Auction sign on house replaced with sold sign
CPI does not include the price of existing houses, because they are considered assets not consumer goods.(ABC News: Ian Cutmore)

"It doesn't account for the cost of land or, therefore, the cost of a mortgage or how much you're paying on a mortgage," Ms Mousina said.

"The reason that the ABS doesn't include the cost of land, which is the biggest component that drives home prices, is because home prices are considered an asset, and the consumer price data is meant to look at everyday spending that consumers do on goods and services, not on assets."

How high is inflation at the moment?

The last inflation figure, calculated during the first three months of the year, was 2.1 per cent.

Over the year to March, that meant the price of that basket of goods rose by 5.1 per cent.

The quarterly figure coming out this week from the ABS is expected to be a little bit lower, at 1.8 per cent according to the average of economists surveyed by Reuters.

But the annual figure is likely to be much higher, around 6.2 per cent, because much lower quarterly price rises from last year keep dropping out of the data.

And many economists, including those at the Reserve Bank of Australia, expect price rises to get even worse before things get better, with CPI tipped to reach 7 per cent by the end of this year.

Price rises are already above that level overseas.

Inflation is at a 40-year high of 9.1 per cent in the US and 8.2 per cent in the UK.

Across the ditch in New Zealand, it is at 7.3 per cent — a 32-year high.

However, price rises in the past have been even steeper than they are now.

Back in the 1970s, inflation spiked around the world, including in Australia, mainly because of oil supply shocks that led to soaring prices for fuel that spread across the economy.

But Australia saw its biggest price increases on record about 20 years before that.

Inflation here was as high as 23.9 per cent in December 1951.

That was caused by global events too — the Korean War triggered a wool boom, with the price of wool tripling almost overnight.

As the world's biggest producer of wool, Australia saw a huge boost to national income and spending power.

The federal government at the time was also providing cheap loans for many people to buy their own houses, in a concerted push to boost home ownership rates and fend off the threat of communism.

Meanwhile, as all this demand was being generated, the global supply of many goods was still struggling to recover from the massive disruption and devastation of World War II.

ABS graph shows Australian CPI since 1948.
The ABS has tracked inflation since 1948 because it is considered one of the most important pieces of data for economic management.(Supplied: ABS)

Why is inflation so high?

You've probably heard the phrase supply and demand.

Supply is how much of something there is available and demand is how much of that thing is wanted.

Probably the most basic concept in economics is that prices will adjust based on supply and demand, and vice-versa.

In other words, if people want to buy more of something than is available, then the price will go up to ration the goods to the people who are willing and able to pay that cost.

If prices remain high long enough, then the idea is that supply will eventually expand to meet the demand, and/or demand will fall because of the higher price, until there is a balance again.

Diana Mousina says the COVID pandemic, and the policy response to it, caused a huge shock in demand, up for some things, and down for others.

Diana Mousina
AMP senior economist Diana Mousina says it is a combination of strong demand and supply disruptions that are pushing up prices.(ABC News: John Gunn)

"We had this huge increase in consumer demand over the past two years, especially for goods at a time when global travel was restricted," she observes.

"So they felt more cashed up and they had more excess cash sitting in their bank accounts, and this is what has led to this increase in extra demand for goods."

At the same time, first COVID, then the war in Ukraine and, most recently, repeated waves of flooding across eastern Australia have combined to restrict the production and distribution of many goods.

"We've had the supply chain problems around the world, goods haven't been able to get between countries fast enough to keep up with consumer demand," Ms Mousina says.

"That has caused some blockages in supply chains, and that's allowed companies to increase prices for these goods."

What will the Reserve Bank do about it?

Central banks can't really do much about supply, so they try to alter demand, to speed up or slow down the economy, by playing with their levers, the main one of which is interest rates.

Until the second half of last year, most developed economy central banks had that lever at, or close to zero, some even had it below, like the European Central Bank and Bank of Japan (which still does).

But, starting with the Bank of Korea and Reserve Bank of New Zealand, interest rates started to rise, as policymakers realised that demand had not only survived the pandemic, but had surged, and supply constraints were pushing up prices sharply.

The slow trickle of rate increases turned into a flood this year, with the biggest central bank of them all, the US Federal Reserve, raising rates in March.

Australia's Reserve Bank followed in May, and then backed that up with even larger rate increases in June and July.

Even the European Central Bank has now finally got rates back up to zero, despite the Ukraine war threatening a recession on the continent.

And there's little sign yet the rate rises will stop.

The RBA's cash rate target is currently 1.35 per cent. CBA expects it to hit 2.6 per cent before the end of this year.

ANZ and Westpac's economists are tipping it to hit 3.35 per cent either later this year or early next.

That would be another 2 percentage points of rate increases, which would likely be passed on in full to variable mortgage customers.

Ms Mousina says central banks are hiking rates so fast because they don't want inflation to stay out of control for years, like it did during the 1970s and 80s.

"You had these periods where inflation might fall a little bit and then rise again," she explains.

"But because policymakers were slow to get on top of it, it just kept on rising for a long time before you saw these levels of inflation, they were out of control.

Reserve Bank governor Philip Lowe said as much in a speech last week.

"If people setting prices and wages were to believe that higher inflation will persist, they are more likely to push prices and wages up," he warned.

"This could result in a self-reinforcing cycle: one in which higher inflation leads to firms being more willing to put their prices up and agree to larger wage claims, which then perpetuates the higher rate of inflation, and the cycle repeats itself.

"This is what happened in the 1970s and it ended badly.

"There is little evidence of such a cycle at present and it is important that this remains the case.

Recession risk if rates rise too far, too fast

But they also have to be careful.

If they hit demand too hard, too quickly, then consumption could suddenly drop, risking a recession where the economy shrinks for half a year or more.

That's one reason why the RBA targets price rises of 2-3 per cent, not zero.

"It was thought to be a moderate increase in prices that is sustainable in the long run for consumers," Ms Mousina says.

"When you get price growth of less than 2 per cent, then there can be risks or times where you may go into deflation [falling prices] … and deflation is not seen as a positive thing for consumer or business spending."

That's because, if you expect something to be cheaper tomorrow you are unlikely to buy it today, which depresses demand and can lead to a downward economic spiral.

In fact, the Reserve Bank spent the best part of a decade wishing for prices to increase faster, so it won't want to completely snuff out inflation.

"Not all inflation is bad," explains Ms Mousina.

"If we get wages growth that's a bit closer to the inflation rate that's good for consumers, because we haven't had much wages growth in Australia in the past few years.

Given how indebted Australian households are, and the recent jump in government borrowing, some inflation in wages and taxes would help pay those debts down.

The Reserve Bank is in a tricky position because it needs to balance both sides to get inflation back within its 2-3 per cent target.

Does goldilocks spring to mind?

The interest rate shouldn't be too low, or we spend too much. But if it's too high, we don't spend enough.

So the question is, exactly how much is just right? No-one really knows the answer.

Posted , updated