Inflation or the Consumer Price Index (CPI) has been the topic on nearly everyone's lips for close to three years. Ever since the number began to skyrocket back in 2021, our Government, the Reserve Bank of Australia (RBA), journalists and finance experts have closely watched this number - and have been trying to reduce it.

In Australia, inflation ended up reaching an eye-watering peak of 7.8%. While the number has been trending down since then, it remains sticky. But in the last three months, the monthly inflation data has seen inflation increase from 3.4% to 4.0% - far above the target range of 2-3%.

If you're wondering why inflation is such a sticky problem, and how we're trying to fix it, we're here to explain. As a former finance journalist, I'm running through the situation around inflation in Australia.

What is inflation? And why is it a problem?

Put simply, it's the change in prices.

This is important because it affects the value of money. If a banana cost $1 last year but a $1.10 this year, that means it has inflated by 10%. Now imagine that this happened to every single product, but the amount you earned stayed the same. You'd be able to buy far less, thus the real value of your money has decreased.

Inflation in Australia is calculated by looking at the prices of key areas including food, clothing, insurance, cars, petrol, hotels, electricity, rents, furniture and more. The Australian Bureau of Statistics (ABS) measures the change in these prices quarterly and also monthly. The quarterly figure is the one preferred by economists and finance experts.

High inflation has far reaching consequences including increasing the rate of indexation you pay on your HECS and increasing cost-of-living pressures. Some people even refer to it as a tax on the poor. While a little bit of inflation is good, because it means the economy is growing, too much means that basics and necessities like food and petrol can become completely unaffordable for the average person. The RBA considers 2-3% the target range for inflation, anything higher could have negative impacts for Australians.

Why did inflation go up?

COVID

COVID lockdowns prevented many people from engaging in their day-to-day spending. No restaurants, no need for new shoes, no holidays. As a result, many people saved large sums of money that they'd normally on concerts or cafes. When lockdowns ended, all of this money was very quickly spent. Restaurants were full and hotels were booked out. This increased demand for products and services, meant many businesses increased their prices knowing that people would pay their higher prices.

Weather events

At the same time, environmental and climate change pressures many that people like farmers were simply not able to produce the same amount of fresh produce and meats they normally would. In order to make ends meet, they needed to charge slightly higher prices per unit as the yields were lower.

International supply chain

International pressures also caused pricing chaos. Ukraine and Russia collectively produce a third of the world's wheat. So, when the war in Ukraine started, it caused a shortage of wheat which in turn drove up prices. Also, the continued COVID lockdowns in China slowed the production of goods like furniture, this coupled with a drastic increase to shipping container costs meant higher prices.

Price gouging

Also, evidence from the Australia Institute shows that some companies may have simply increased prices because they could. When consumers constantly hear stories of high inflation, they might come to accept higher prices, meaning some businesses can engage in what is referred to as "price gouging".

How are we trying to get inflation down?

The main mechanism for decreasing inflation is for the RBA to increase the cash rate - this is the guideline for how banks and lenders set their interest rates. Increasing or decreasing the cash rate is a blunt tool, and widely regarded as ineffective, but it is the only one the RBA has.

Why is raising interest rates to curb inflation a flawed strategy?

Not all finance experts will agree, but many do feel that tackling high inflation by simply raising interest rates is flawed.

The premise is simple. If interest rates go up, anyone with a debt (typically a mortgage) with likely have to pay more to service that debt, limiting their disposable income. Additionally, people will be less likely to borrow money because it is more expensive to do so. Finally, people will also be more likely to save money, as they're earning good interest on their deposits.

All of these factors reduce the amount of money being spent, and when spending (or demand) decreases, businesses will theoretically have to drop their prices to entice people to buy their products.

Only a third of Australians have a mortgage, the rest are not affected by higher mortgage rates

Australia used to have a homeownership rate of 70-75%. It's roughly about 66% now. Of that 66%, only half of those people have a mortgage, the rest of them own outright.

As a result, the number of people affected by higher mortgage costs is smaller than ever. Even if mortgages rates continue to skyrocket, two thirds of the population will be untouched by these impacts. In fact, if this group has money in a savings account, they will actually be earning money as rates continue to go up. As such, raising interest rates is not as effective as combatting inflation as it was in the past.

The industries pushing up inflation are often not affected by lowered demand

Most luxury items are already sitting comfortably in the inflation target range. The areas pushing up inflation unfortunately are unlikely to be affected by interesting rate increases and limiting household budgets.

There are some products that we simply don't have the option to stop buying. Even if interest rate increases cripple budgets, there are certain things we need to function.

For example, looking at the May 2024 CPI data, some of the segments with the highest inflation are electricity at 6.5%, health care at 6.1%, fuel at 9.3% and insurance at 7.8%. These are essentials.

Health insurance is a requirement for those over 31 or earning more than $93,000. Home insurance is a requirement of many mortgage contracts. Most Australians do not have the luxury of not purchasing insurance. It's a non-negotiable, meaning insurance companies can set prices as they please.

Electricity is also a non-negotiable. You cannot simply decide to live without electricity. So again, Australians are at the mercy of how these companies want to set prices.

Compare this to the non-essentials where Australians have the option to stop or change purchasing behaviour if budgets are too tight. Recreation and culture was 2.0%, clothing and footwear was 2.8%, food was 3.4% and furniture was -1.1%.

What else could be done?

The RBA is currently at an impasse. The third of Australians bearing the weight of interest rate increases are at near breaking point. Our measure of economic output (GDP) has already been negative on a per capita basis for four quarters. If our overall GDP is negative for two quarters, we will formally enter a recession. And some expert fear that a further interest rate increase will plunge the country into a formal recession. It is a very narrow path from here.

The reality is, the RBA could possibly need help from other bodies to manage this situation.

The Federal Government could put measures in place to reduce inflation like increasing taxes or increasing compulsory superannuation contributions. But they often don't as these policies are unpopular and can affect whether or not they are re-elected.

Alternative measures could be increasing or promoting competition in the market. The Federal Government or the ACCC could also investigate the way businesses set prices and regulate this process. There is a current investigation into supermarket prices to determine whether this monopolised sphere engaged in anti-competitive price gouging.

Actively combating climate change is another way to reduce inflation. Adverse weather events like flooding or fires mean that many insurance companies put their prices up. High temperatures and droughts can impact the amount of produce farmers can grow, which causes and increase to the price of food. High temperatures are linked to adverse health outcomes which puts additional pressure on the healthcare system, again requiring higher prices.

If you're wondering what you can do as an individual, if you see something that is too expensive, don't buy it. Send a message to the business that customers won't accept overly inflated prices. Always compare insurance or hotel prices, and try to look for the option that gives you the best value for money.