Why do we fear inflation?

The RBA has hiked interest rates for 10 consecutive months to combat inflation. In this article we will discuss what is inflation and why it is so bad.

What does inflation mean?

The simple definition of inflation is the general rising of prices. This means the decrease of purchasing value for goods and services. For the average consumer it means there is less money in the household budget when inflation rises which leads to less funds for discretionary spending.

Causes of inflation

There are various reasons for inflation. One cause of inflation is when the economy heats up too fast and demand exceeds supply. This can occur when there are labour shortages and employees can demand higher wages. This can give them more money to spend of goods and services. Another reason for inflation is when companies face increased costs associated with their goods and services, they can pass these increased costs back to the customer. For example, if oil prices are increased then companies which use oil to manufacture and/or transport their products will increase the prices to the consumer so their margins don’t go down.

What is the Inflation target?

The RBA sets out an inflation rate of 2-3 per cent so a moderate level of inflation is good for the economy. Is it too low we may have deflation which is also bad for the economy. If it is too high then it can be bad for the economy due to the reasons outlined below.

When is inflation bad?

When inflation is higher than the set level by the RBA of 2-3 per cent, it is considered too high. High inflation erodes the purchase power of consumers as the prices for goods and services are higher. When inflation is too high, household budgets are stretched as general level of prices have become more expensive so consumers have less capacity to spend money on discretionary items. When consumers decide to reduce spending on goods and services, it can cause a chain reaction of redundancies and high unemployment which further impedes economic growth. High inflation also negatively affects savers as it can reduce the value of money. If savers are getting an interest rate which is lower than the inflation rate, then they are worse off. High inflation also affects the interest rates as central banks will raise rates if they see it suitable to slow the inflation rate. If they think economic growth is too high, higher interest rates will slow down businesses from borrowing money to invest. High interest rates are a negative for the stock market as debt obligations would increase when the interest rates are hiked, which can slow the company’s growth.

When inflation is too high

In Argentina the inflation rate in February 2023 was 102.5%. which is a 32 year high. This means the prices of goods and services have doubled in a year. People in Argentina buy in bulk when they see discounts as prices of everyday grocery items may be significantly higher the next day. There is constant instability in prices. High inflation also deters people from saving as the inflation rate is higher than the bank deposit rates.

Lauren Hua is a private client adviser at Fairmont Equities.

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