You might be hearing quite a bit about inflation lately. So, what is it and do we need to be worried?

Economists define inflation as a fall in the ‘purchasing power’ of a dollar. Purchasing power means ‘what you can buy,’ so the effect of inflation is that the same number of dollars can buy fewer things. To give a simple but fun example: according to this US website, the price of a Big Mac was $US0.65 in the 1970s. Nowadays, the same burger costs about $US4.65. So, if you had $US5 in 1971, you could buy seven Big Macs and get some change. Today, you would not get less change after buying just the one. That’s inflation.

Inflation makes a dollar less powerful. That can be an obvious problem for people who are holding dollars. However, the problem can be offset if you find a way to create more dollars to compensate for the loss in purchasing power of each one. For example, if you hold your wealth as cash, meaning that the number of dollars stays the same, then inflation makes that cash less powerful. However, if you hold your wealth in some other form that grows in value, you tend not to lose purchasing power. Again, as an example, in 1971 the median house price in Sydney was $21,200. Today, that figure may be as high as $1.4 million. If you had $21,200 cash fifty years ago, and you kept it as cash, inflation has reduced your purchasing power substantially. But if you converted that cash to a house, then you have maintained your personal purchasing power. Individual dollars have fallen in value – but you have found a way to create additional dollars to compensate.

So, inflation tends to have the most negative impact on people holding cash.

Funnily enough, some inflation is generally seen as a good thing. Australia’s Reserve Bank likes to try to aim for an annual inflation rate of 2-3%. The upper limit of 3% makes sense (after all, inflation above that limit means the value of a dollar is dropping quite a lot each year). But why would the RBA set a minimum level of target inflation?

Low levels of inflation can be good for the economy. Inflation encourages people not to defer spending. If you think that the value of your dollar is likely to fall, you will spend that dollar sooner before it loses value. Your spending is someone else’s income, so the more spending, the more income for the community.

A fall in the value of a dollar is also good news for anyone who owes money. Let’s say I borrow $100,000 and I have to pay it back in ten years’ time. If inflation is running at 2%, then $100,000 today is the equivalent of $121,899 in ten years’ time. Looked at from the other point of view, $100,000 in ten years’ time is only worth $82,000 in today’s dollars. So, where there is inflation, the real value of the repayment of a loan is less than the nominal amount that was borrowed. As long as I can create more dollars (for example, if my income is pegged to inflation), debt becomes easier to repay.

Thirdly, a fall in the value of dollars encourages people to keep doing things that will earn them dollars, such as working or investing. If you retired 30 years ago with $500,000 in the bank, you would have felt quite wealthy and have been comfortable about retiring. Today, if you are thinking about retiring and you have $500,000 in the bank, you might be inclined to work for a few more years to generate more dollars (and shorten the period those dollars need to last). Or, you might be inclined to invest in something that generates more dollars. Either way, the impact of inflation and the likelihood that it will continue encourages you to remain engaged with the economy, either through your labour or through your investing.

Lately, some commentators have become concerned that inflation may be rising. A relatively sudden rise in inflation is shown in this graph from the RBA, which goes right back to the 1950s. As you can see at the right-hand side of the graph, the most recent inflation figure was nudging 4%.

The question is: is this spike in inflation temporary, or will it last? Lasting inflation is the really bad type, as the power of compounding means that purchasing power can really plummet in a relatively short space of time.

Some commentators – including the RBA itself – argue that this recent inflation is a temporary effect due to things like supply restrictions, which have caused prices for various things to increase, and people having more cash due to things like Jobkeeper and the increase to Jobseeker last year. In addition, because of social distancing, people have not been able to buy ‘experiences’ like holidays for a couple of years, and so they have re-directed their spending towards physical things. As an example, this time last year major homewares retailer Harvey Norman announced that sales had increased by more than 30%, as people had (i) fewer things to spend their money on and (ii) more money to spend. In this sense, ‘inflation’ is really a price adjustment to a change in demand and supply.

Hopefully, the RBA is correct and prices will settle down again soon and nestle within the target range of 2-3%. Time will tell.