There will be a lot of talk about inflation this year.
So let’s make sure we know what we’re talking about.
What is Inflation?
What does this have to do with the cost of living?
And why the surge in real estate prices are not included in the official inflation figure?
What is Inflation?
At its most basic level, “inflation” refers to a general increase in the level of prices in an economy over time.
It is also the phenomenon that explains why a monetary unit loses its purchasing power over the decades.
What does it mean?
Watch the video below.
Hear Kurt Cobain and his Nirvana bandmates talk about ticket prices for their concerts in the early 1990s.
At the time, they were charging around US$17 ($24) per ticket, and they were stunned to learn that Madonna was charging US$50 or more.
To their ears, $50 was exorbitant.
But, to our ears, it sounds comically cheap.
And part The reason it seems so cheap is because the face value of the currency we use has deteriorated so much over the past 30 years, thanks to inflation.
As the saying goes, a dollar isn’t what it used to be.
And here is how this process works.
Inflation is built into the system
Inflation comes from many sources.
I described some of them in a previous article.
But consider the obvious.
Imagine a city full of all kinds of people – traders, workers, consumers, manufacturers, farmers – you name it.
Every day they scramble to try to make a little more money.
Now let’s say that the prices of some very important goods in the city, such as gasoline and electricity, suddenly increase.
We see this happen quite regularly to petrol prices in Australia.
Since gasoline and electricity are major “inputs” in the production process, their higher prices will flow through the system to make other city goods more expensive.
For example, when gasoline prices rise, it makes it more expensive to transport goods across the country, so transportation costs increase.
When transport costs rise, retailers may try to pass the higher costs onto consumers by raising the prices of the goods they sell.
If consumers – who are also workers – notice that prices are rising, they will want their wages to rise as well, otherwise they cannot afford to buy the same basket of goods that they are used to buying.
However, if they manage to get a raise from their employers, the latter will try to pass on their higher labor costs to their own customers, which leads those clients demand higher wages from their bosses.
And we turn around.
Inflation is built into the system, in a feedback loop, as everyone is constantly jostling for a little extra cash.
That’s why the prices of everything from gas and rent to utility bills and insurance slowly increase over time.
This process explains why prices have risen in Australia over the past 30 years at an average rate of 2.4% per year.
What is consumer price inflation?
By now you may have heard how the Reserve Bank of Australia has an inflation “target”.
It tries to keep inflation somewhere between 2 and 3 percent per year on average.
See that gray area in the graph below?
This is his target range.
However, “inflation” which the RBA is concerned about has a specific definition.
It’s not about all prices.
Far from there.
It’s just price increases households they face for the goods and services they consume in other sectors of the economy, such as the business sector and the public sector.
Why? Because it’s household-induced inflation consumption.
Household consumption is the largest component of the economy, accounting for more than 50% of the country’s economic activity each year.
This is why the RBA is so interested in the inflation generated by the sector.
He is specifically interested in consumer inflation.
If this nuance is lost, it can lead to some confusion in the national conversation.
What about soaring real estate prices?
The inflation measures used by the RBA come from the Consumer Price Index (CPI), compiled by the Australian Bureau of Statistics.
As its name suggests, the CPI tracks changes in consumer prices.
In fact, it tracks the prices of over 100,000 goods and services in the economy each year.
However, it only tracks the prices of things that households buy from other sectors.
It does not track the prices of things that households sell to each other.
For example, if someone asks a builder to build him a brand new house or to do major renovations in an existing house, this is considered consumption..
Why? Because the household sector buys a good or service from the business sector, so there is trade between two different sectors.
And this means that the prices of building materials and everything needed to build the house will be included in the official measures of consumer inflation.
However, if someone buys an already existing house from someone else, it will not be included in the inflation calculations.
Why? For several reasons.
First, it is because the household sector buys a good at in the household sector, so the purchase and sale of the good cancel each other out within the same sector.
Second, an existing dwelling does not add anything to the housing supply and did not require the purchase of anything new. It is considered a active.
And asset prices are not included in the CPI — they are included in measures of wealth.
This is why soaring house prices and land values are excluded from daily inflation measures.
This is why you may hear that “inflation” is only running at 3.5%, even though property prices have skyrocketed over the past 12 months.
What about the cost of living?
Which brings us to the last section.
The Consumer Price Index (CPI) measures inflation, but it is not the same as the “cost of living”.
Inflation is fair a side of the equation.
To know if the cost of living is improving or deteriorating, you need to know how many households live income.
Why? Because if consumer inflation is 2% per year, but your after-tax income is increasing by 3%, that means your salary is increasing faster than prices are increasing, so the purchasing power of your disposable income actually improves.
So that’s something to keep in mind.
We should also be aware that different types of households face very different costs, so there is no singular “cost of living”.
For example, the price of goods and services that most of us have to pay – such as rent, electricity and water bills, or gasoline – often rises faster than the prices of things we can pass us.
This is why the “cost of living” is often higher for the poorest households.
They are forced to spend a greater proportion of their income on more expensive goods and services that cannot be avoided.
The ABS publishes “Cost of Living Indices” to show how different types of households cope with different financial pressures.
See the table below? Notice how, in 2021, the cost of living has increased the most for older pensioner households and self-funded pensioner households?
This is a useful concept to remember.