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Interest Rates & Inflation Watch

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	Inflation
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Interest Rate News

Reserve Bank of Australia Monetary Policy Reports
	August 2010

Inflation
The topic of inflation receives a lot of attention in the media, often because of its impact on monetary policy and hence interest rates. It is something that affects everybody because of its bearing on things such as mortgage repayments (through interest rates), the costs of goods and services and purchasing power (i.e. how much you can buy for $1 today versus tomorrow).

	Causes of inflation
	Measuring inflation
	The effects of inflation

Causes of inflation
There are two major cause of inflation:

Cost push inflation
This is when increases in costs are passed onto the consumer causing higher prices. Higher costs can arise from increases in the cost of labour (wages), rising interest rates or rising import prices (either through rising overseas costs or a devaluation in the Australian dollar).

Demand pull inflation
This occurs when the demand for goods and services exceeds the supply. In this instance the excess demand leads to an increase in the price of the under supplied goods and services, i.e. too much money is chasing too few goods.

Measuring inflation
The consumer price index (CPI) is the most commonly used form of inflation measure. This index measures quarterly price changes in a basket of goods and services that account for a high proportion of metropolitan household expenditure.

The effects of inflation
Generally rising price levels lead to uncertainty over future economic conditions, this has differing impacts on the economy, and differing impacts for businesses and individuals, borrowers and lenders.

Generally those that benefit from inflation are:

	Borrowers of funds as the real value of repayments falls over time, all else being equal.
	Holders of real assets such as property and land whose value can keep pace with the rising price level.
	Workers who have market power and are able to increase their wages in line with the rising price level and so protect the purchasing power of their incomes.

Generally those that lose out in times of inflation are:

The headline CPI fell by 0.3%in the December quarter, following a rise of 1.2% in the September quarter. This is the largest quarterly fall since September quarter 1997. Annual inflation rose by 3.7% to the end of December. This was at market expectations. As global and domestic conditions deteriorated over the December quarter, the inflation rate fell more quickly than expected. Inflation is expected to fall further over the course of 2009, which in a continuing deteriorating economic environment, leaves room for further reductions in interest rates.

Inflation can and does have varying impacts on different people and on the economy. For this reason, price stability is an important consideration. The Australian government recognises this fact, as does the Australian central bank (Reserve Bank of Australia (RBA)). For this reason, since 1993 the RBA has had an inflation target to ensure that price stability is maintained and increases in the general price level are kept to a minimum. Under the policy of inflation targeting, the RBA is aiming to keep the inflation rate, as measured by the CPI, to an average of 2 to 3% per annum in the medium-term.

Annual inflation at 3.1%
The headline CPI rose by 0.6% in the June quarter, following a rise of 0.9% in the March quarter.  This rise was in line with market expectations (which were for a 1.0% increase).  In annual terms, a 3.1% increase was recorded for the year to June 2010, compared to a 2.9% increase for the year to March 2010.

Price changes were varied over the quarter, with falls in 3 of the 11 major categories. The biggest fall for the quarter was in recreation (-1.8%), food (-0.3%) and communication (-0.1%). The largest rises were recorded for alcohol and tobacco (5.9%), due to the 25% increase in excise tax and some general price rises. This was followed by health (2.2%), household contents and services (0.9%) and housing (0.6%).

On an annual basis, eight of the eleven groups recorded rises. Alcohol and tobacco recorded the largest rise (8.7%) due to increases in tobacco (+17.1%), beer (+6.1%), spirits (+2.6%) and wine (+1.5%). This was followed by housing (5.8%), education (5.7%) and health (5.0%).  Clothing and footwear (-3.8%), recreation (-0.6%) and communication (-0.2%) were all weaker.

Whilst the headline inflation rate edged up, underlying inflation eased.  Underlying inflation recorded an annual rise of 2.7%, following a 3.05% rise in the year to the end of March. This moderation in inflation is consistent with the July RBA Board Meeting minutes, where underlying inflation was expected to moderate to under 3% for the first time in three years. Given the current view on the economic front, interest rates are likely to remain on hold for the medium term.  However, risks still remain to the upside and the RBA will act to move interest rates higher should conditions change.

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