Over the past 12 months, Australians have been fairly educated on inflation, with the headline CPI recently reaching 6.1 percent.
After more than a decade of largely dormant inflation in relative terms, recent cost-of-living pressures have largely surprised households and even pundits at places like the Reserve Bank (RBA).
As inflationary pressures continue to build within the economy, the Treasury and RBA predict that the worst is not yet upon us and will come later in the year, with headline inflation expected to hit 7.75 percent.
But not all inflation is created equal, and some inflationary forces are seen as much worse than others.
The central bank’s outlook on inflation
For example, gas and food prices can be extremely volatile. Sometimes the cost of fresh produce can skyrocket for months due to natural disasters or droughts, before returning to roughly where it was before the price spike started.
In some previous cases it has been a similar story for fuel prices. A geopolitical event or natural disaster hits oil prices, and before long, we’re all paying more for fuel at the pump. But as the impact of these events fades, prices have in some cases returned to where they were before.
For this reason, central banks around the world, including Australia’s own RBA, prefer inflation measures that eliminate or attempt to smooth out these volatile movements in consumer prices. In Australia, the metric used is called the “trimmed mean”, which is constructed using a weighted average of the middle 70 per cent of the basket of goods and services used to calculate the consumer price index.
For example, after the prices of bananas and other fresh produce soared in the aftermath of Cyclone Larry in 2006, headline inflation jumped from 2.9% to 4.0% in just three months. Meanwhile, the trimmed mean metric saw only an increase from 0.2% to 3.0% during that time.
On the other side of the coin, during the global financial crisis, the collapse in the cost of financial services and other products caused the headline CPI to fall from 5.0 percent in the September quarter of 2008 to just 1.2 percent in the September quarter. quarter of 2009.
Once again, the trimmed-mean metric showed that broader inflationary pressures outside of the more volatile items dipped significantly less over the same time period, from 4.8% to 3.1%.
The experience of the global financial crisis and how it compares
The last time inflation was close to this level was just before the global financial crisis. In both Australia and the United States, inflation peaked just before the collapse of investment bank Lehmann Brothers triggered the collapse of the global financial system.
Perhaps unsurprisingly, the worst financial and economic crisis since the Great Depression caused headline inflation to build up in no time. In five months, US headline inflation fell from the highest level since 1991, to just 0.1 percent.
However, things are quite different now compared to 2008, both in Australia and the United States.
For starters, headline inflation in Australia and the US today will peak significantly higher than in 2008, at 7.75% vs. 5% in 2008 in Australia and 9.1% vs. 5.6% in the US. USA
This brings us back to the central banks’ preferred metrics for measuring inflation: in the case of Australia, the trimmed mean, and in the US core CPI. In the US, the current rate of core inflation (which excludes the impact of food and energy costs) is 5.9 percent, compared with a high of just 2.5 percent in 2008.
In short, in 2008 inflation was largely driven by food and energy, while in 2022 both are significant factors, but inflation pressures are much broader based.
In Australia, the RBA’s preferred inflation metric is already at its highest level (4.9 percent) since the early 1990s and is expected to rise significantly as inflation heads towards its expected peak. 7.75 percent in the December quarter.
With inflation now entrenched in much of the economy, RBA actions and a slowing economy could take quite a while to rein in the cost of living pressures felt by households.
Why does all this matter?
Barring a repeat of the global financial crisis or something similar, inflation is likely to remain a problem for quite some time.
This is the challenge that central banks around the world are considering very carefully. In Britain, the Bank of England has resolved to continue to aggressively raise interest rates, while acknowledging that the UK economy is facing a long and hard recession.
How the RBA ultimately decides to tackle this challenge could decide the fortunes of millions of Australian mortgage holders and homeowners. If they follow the path laid out by the Bank of England, Australians could see rates rise even as the global economy deteriorates significantly and higher rates begin to put pressure on the domestic economy.
With house prices already falling rapidly in Sydney, Melbourne and Brisbane, and the other capitals now also weakening, the RBA’s approach could be the defining factor for at least the short-term future of the housing market.
But as the US Federal Reserve Jerome Powell recently pointed out, from the perspective of central banks, the pain of losing “price stability” aka resulting from high inflation is much worse than falling asset prices or rising interest rates.
On the other hand, they may choose a different path and decide they don’t have the stomach to raise rates on a downturn. But that can also have consequences. In the early 1970s, insufficient commitment to fight inflation by central banks, most notably the US Federal Reserve, helped entrench inflation for years to come.
Headline CPI inflation will always be the metric that grabs people’s attention and tops the nightly news, but it is the underlying inflationary pressures that will ultimately help decide central bank policy and mortgage rates.
Tarric Brooker is a freelance journalist and social commentator | @Avid Commenter