What happens if inflation is left unchecked?

In Australia, the monthly CPI indicator is up 3.5 per cent in the 12 months to March 2024. The Reserve Bank of Australia has an inflation target of between 2 and 3 per cent. The RBA has raised interest rates over almost 2 years to help bring inflation down their target range. However, what happens if inflation is left unchecked?

If this happens, then it can lead to various negative consequences for an economy:

  1. Loss of Purchasing Power: Inflation erodes the value of money over time, meaning that the same amount of money buys fewer goods and services. This reduces the purchasing power of consumers and savers, impacting their standard of living.
  2. Uncertainty: High and unpredictable inflation rates create uncertainty in the economy. Businesses may hesitate to invest or expand, consumers may delay purchases, and lenders may be reluctant to offer loans. This uncertainty can hinder economic growth.
  3. Distorted Economic Decision-Making: Inflation distorts economic decision-making. It can lead to a misallocation of resources as individuals and businesses prioritise short-term gains over long-term investments. Savers may be discouraged from saving, and instead, they might spend or invest in assets that provide higher returns to offset inflation.
  4. Redistribution of Wealth: Inflation can redistribute wealth in an economy. Debtors benefit from inflation because they repay loans with money that is worth less than when they borrowed it. Conversely, creditors lose purchasing power as the real value of their loans decreases.
  5. Wage-Price Spiral: High inflation can trigger a wage-price spiral. As prices rise, workers demand higher wages to maintain their standard of living. Employers, facing increased labour costs, raise prices to maintain profit margins, leading to further inflationary pressure.
  6. Reduced International Competitiveness: Persistently high inflation can make goods and services produced in a country more expensive relative to those produced abroad. This can reduce export competitiveness and worsen the trade balance.
  7. Central Bank Credibility: Unchecked inflation can undermine the credibility of the central bank tasked with controlling it. If the central bank is perceived as unable or unwilling to control inflation, it can lead to a loss of confidence in the currency and financial instability.

Overall, unchecked inflation can have significant detrimental effects on economic stability, growth, and prosperity. Central banks and the federal government typically aim to maintain low and stable inflation rates to support sustainable economic growth.

Lauren Hua is a private client adviser at Fairmont Equities.

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