2 min read

Nitpicking inflation

Australia’s rate of inflation – as measured by the Consumer Price Index, or CPI – “rose 1.2 per cent in the September 2023 quarter and 5.4 per cent annually, according to the latest data from the Australian Bureau of Statistics (ABS)”:

“The most significant contributors to the rise in the September quarter were automotive fuel (+7.2 per cent), rents (+2.2 per cent), new dwellings purchased by owner occupiers (+1.3 per cent) and electricity (+4.2 per cent).

Automotive fuel rose 7.2 per cent after two quarters of price falls. This is the largest quarterly rise in fuel prices since March 2022 and is mainly caused by higher global oil prices.”

The CPI measures a fixed basket of goods and services weighted by a measure of household spending, but that basket is only updated about every five years. Naturally, people’s spending habits change all the time, so even if it were updated more frequently it still wouldn’t be perfect.

And therein lies the source of my nitpick: while higher oil prices do raise petrol prices (“automotive fuel”) and cause the CPI to rise, they cannot change the rate of inflation – an increase in the level of all prices – unless the Reserve Bank of Australia (RBA) lets it happen.

Let me try to explain. Higher global oil prices are essentially a negative supply shock. If the supply of money does not change in response, then people have to spend more of their incomes on petrol, and less on all the other goods and services in the economy. Prices for those other goods and services will fall, or output (quantity) will contract, entirely offsetting the increase in oil prices.

There are of course lags – other prices won’t all move at once, and the CPI’s basket won’t capture it all – so while the CPI will show inflation rising in the short-term following an oil price shock, it will moderate over time and the long-run rate of inflation (and inflation expectations) should remain largely unchanged.

The CPI can be distorted in other ways, too. For example, as the ABS explained in its release, the government’s recent childcare and energy subsidies put downward pressure on the CPI, even though the true prices of those services did not in fact go down. The actual rate of inflation didn’t actually change, even though the CPI indicates that it did. When the subsidies run out, the affected components of the CPI will shoot right back up.

Ultimately, it’s up to the RBA as to whether it lets higher global oil prices, or government subsidies, change the actual rate of inflation in Australia. In our economy goods and services are priced relative to money, and the RBA has the ability to expand or contract the quantity of money. If it does nothing, the global oil price shock will alter relative prices until the CPI eventually comes down by about as much as it initially increased. If, instead, the RBA allows the money supply to rise so that consumers don’t have to alter their spending patterns, we’ll get more actual inflation. And finally, if the RBA tightens the money supply in response, it risks causing a larger than necessary economic contraction.

Just remember that while a higher CPI is a necessary outcome of inflation, it is not sufficient to explain inflation. While the RBA now looks set to hike rates again in November, it’s almost certainly not doing so because of the effect of higher global oil prices on the CPI, but because over half of the CPI’s components are still rising at an annualised rate of more than 3%.

In other words, it’s safe to say we still have plenty of actual inflation in this country. Monetary policy has been too loose for too long.