Whats up with Inflation in Australia?
By SmallStocks on Oct 27, 2008 in Business
I have had a few people asking me questions over the weekend about inflation and why it’s on the move up. The most typical comment has been around “with everything in the world going so bad, how can inflation be moving up?” – It’s a good question and one that I am going to answer now.
Firstly, lets explore what inflation is?
Basically, Inflation is the general rise in the price of goods and services in the economy over a measured period of time. As general prices rise, the price of each dollar in the economy buys less goods and services – so this is why inflation is always associated with a “devaluing of purchasing power”. The Inflation Rate – the indicator that you always hear about in the news – is basically the percentage change in the price index over time. So if the inflation rate is rising – it means that each dollar you have is actually worth less, since it costs more and more to buy goods and services.
The reason inflation is such a concern – is that it typically discourages people from saving, because they are worried that the cost of buying goods and services now is going to be cheaper than buying them in the future. If inflation gets really high, its called hyperinflation, and this leads to shortages of goods because people begin to buy as much of everything as they can out of concern that the prices of those goods will increase drastically in the future. This also means that inflation is typically associated to an ‘over-supply’ of money in the economy, as people are spending most of the money available to them.
So why is inflation still rising in the financial crisis? I thought people didn’t have any money to spend?
Generally, when inflation is on the rise, the Reverse Bank tries to implement monetary policies to reduce the amount of money available to consumers. For example, an increase in interest rates, puts greater pressure on people to repay loans and decreases the amount of money they have available to them. Equivalently, if the Government introduces a tax increase through fiscal policies, this decreases the amount of money available to consumers.
In the current financial crisis, the reason inflation is on the rise is that not only is the RBA reducing interest rates in order to help out large financial institutions trapped with high risk debt obligations oversea’s – it is also providing additional income back to consumers to spend. As unemployment in Australia is quite low at the moment, it means that the majority of Australians have more money to spend on goods and services which pushes inflation higher. Combine this with the underlying financial crisis media coverage and consumers start to spend slightly more on goods and services to ensure that they get them now, while they are cheaper – instead of later when recessionary action has forced business to increase there prices.
However, this doesn’t mean that this is going to continue in the long term at all. History has shown that recessions usually always solve inflation problems – this is why the RBA is not overtly concerned about it at the moment. Recessions typically increase unemployment levels, reduce the amount of money available to businesses which consequently puts more pressure on wage growth. The more pressure on wage growth, the less money people have available to them and so the less that inflation rises.
As people begin to worry more and more about the state of their financial affairs, this “forces” them to start saving to ensure they have “money in reserve” – that is, that they have a liquid asset they can access really quickly. As this begins to happen, the level of inflation will reduce as people are “saving money” rather than spending it.
Make sense ? Drop a comment below.
Sarah | Nov 19, 2008 | Reply
Hi
The thing I am hearing about and not understanding is that with the current financial crisis it is expected that property prices will fall, and so cash is king if wanting to buy, but at some point globally there can be escalating inflation and so this will be impacted, i.e one may not be able to afford teh house one wants, so cash will not be king. I think people mean that inflation must then drive house prices up and out of reach? Can you shed any light on these concerns I have heard around coffee tables?
Many thanks
Sarah
SmallStocks | Nov 19, 2008 | Reply
Hi Sarah,
Thanks for your comment. Ultimately, inflation comes from an ‘oversupply of money’ in the economy. The more money available to people – the more they will spend and the more prices will rise as a result. Property prices are typically correlated to wage growth (among other things). So if wages are increasing, the economy is moving strongly and businesses are earning more money – which means that people can afford to spend more – and so on.
A “property” collapse will occur when people are refusing to spend – because they either don’t have money to spend, they cant get credit and/or the prices of houses have been ‘overinflated’ from the last economic cycle boom – meaning they simply can’t afford the debt obligation associated with the property. This is when you hear the property is ‘out-of-reach’ of consumers.
Recessionary action will typically bring the price of homes back to their ‘true level’ – that is, any “over inflated” property prices will be restored to the level that consumers will pay. Less wage growth, means less money, means tighter credit, means less lending, means a reduction in ‘demand’ for houses. This will causes property prices to fall if there are many houses for sale in the market – which will subsequently reduce the supply of houses in the market.
A lack of money in consumers pockets – either due to them being paid less, or saving more – means that inflation will come down. If inflation falls too much, or too quickly, this results in ‘deflation’.
In terms of ‘drives housing prices up and out of reach’ – I think really this relates to ‘credit and lending’ more than anything. The price of funding to big banks must come down for people to borrow for houses. At the moment, most of these institutions have big debts from overseas (i.e. what you are hearing about in the news) and so their ‘credit lending’ practices become more strict and they lend people less money.
Intervention from the Government can help (fiscal policy) but usually only to a point. If people are genuinely ‘scared’ about what is happening the market – they will refuse to buy – no matter what incentives are provided.
Of course, as the economy starts moving again, interest rates become lower – then pretty much all I have said ‘reverses’
i.e. More wage growth, more money, means looser credit, means more lending, means an increase in ‘demand’ for houses. This will causes property prices to rise if there are not many houses for sale in the market – which will subsequently increase the supply of houses in the market.
Hope this makes sense and answers your questions?
Tim
Hunter | Jun 15, 2009 | Reply
Regarding to the point you’ve made on the last paragraph. “More wage growth, more money, means looser credit, means more lending, means an increase in ‘demand’ for houses ” and the point you’ve made in the previous one “At the moment, most of these institutions have big debts from overseas (i.e. what you are hearing about in the news) and so their ‘credit lending’ practices become more strict and they lend people less money.”
Aren’t they a bit contradicting ?
Hunter | Jun 15, 2009 | Reply
Does everyone think the economy is starting to moving again ? or is it just like a dead cat bounce ? I think when this market moves again, the inflation will goes up, interest will increase to put the pressure on the inflation rate.
I am a bit confused about these, can someone give more explanation ?