Why is it so important to keep inflation in check?

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The Reserve Bank surprised most of us by raising interest rates once again at the beginning of this month. With recent inflation data trending down, the expectation was that the current settings would be left alone to do their work. Clearly, though, the RBA felt that inflation wasn’t coming down quickly enough.

For those feeling the hit of higher mortgage repayments, it’s reasonable to question why inflation matters so much. Is beating it really worth the pain?

Inflation is keeping the cost of goods high, but why does it matter?Credit: Penny Stephens

In a nutshell, inflation is prices going up. Some inflation is good, but too much is bad.

Low levels of inflation drive economic activity. If you expected the cost to build a home would be lower a year or two from now, then it would be rational for you to put off building your home. And if enough people do the same, the economy grinds to a halt.

High inflation, however, is something all economic managers work very hard to avoid. You might have seen the photos from 1920s Germany of people with wheelbarrows of cash heading out to buy a loaf of bread. Argentina is experiencing something similar right now.

Inflation makes your money worth less, that is, what it can buy is reduced. Those hit hardest are those with savings.

Inflation devalues a country’s currency. Most countries are not self-sufficient, relying on imports of food, materials or, as in Australia’s case, manufactured goods. If your currency is devalued because of inflation, then buying these imports will become increasingly expensive, potentially reaching the point where they become unaffordable entirely.

To help protect against this risk most countries have a central bank with a mandate given to them by their government that specifically provides an inflation target. Here in Australia, our central bank is the Reserve Bank of Australia and their target is to have inflation running at between 2 and 3 per cent, per year. The equivalent in the United States is the Federal Reserve, and their target is 1 to 2 per cent.

The primary instrument central banks have for managing inflation is interest rates. By forcing households and businesses to pay higher rates of interest on their debt, money is sucked out of the economy.

Consumption reduces, and the heat comes out of the economy, easing price rises and therefore inflation. But slowing down the economy, without bringing it to a complete halt is about as easy as the Titanic trying to steer around an iceberg. The potential for recession looms large.

The RBA’s target is to have inflation running at between 2 and 3 per cent, per year.Credit: Brendon Thorne/Bloomberg

The challenge with inflation is that it can become a spiral. If prices go up, then employees need pay rises so they can continue to afford the goods and services. If the employer grants them a pay rise, then the employer needs to go back and put their prices up again to recover the extra wages expense that they have now incurred. Which then circles back to the employees needing another pay rise, and on and on we go.

Even worse is when you have expectations built-in that inflation will be at a high level for a long period of time. Imagine you run a business that builds freeways. When you quote, you know the work is going to take several years to deliver.

If you have an expectation that inflation will be persistently high, then you will factor that into your pricing, meaning your customer, in this case taxpayers, will pay a higher price than would have been the case in a low inflation world. In this way, inflation can get “baked in” to the economy, and once that happens it’s very difficult to unwind.

Paul Benson is a Certified Financial Planner, and the host of the Financial Autonomy podcast.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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