While there may not be any doctor who can remedy our inflation disease, the RBA and the boffins in Canberra certainly can, as long as we can stomach the bad, bad fiscal medicine explains Steve McKnight, host of the popular podcast, The Money Magnet.

What is inflation?

Inflation, the term economists use to describe rising prices, is presently at the forefront of many people’s minds. For instance, you may have heard about the “2 per cent to 3 per cent target inflation band” that the Reserve Bank of Australia (RBA) regards as its Goldilocks sweet spot – a number that we currently exceed.

If you’re wondering why high inflation is problematic, the answer is that it erodes consumers’ buying power and the stored value of wealth. How? Because your salary or wage buys less than it used to, and so does the value of your savings and investments.

The last time inflation was a serious problem was in the early 1990s when interest rates were quickly hiked up, leading to “the recession that we had to have”.

Why are interest rates rising?

The RBA has one ‘all-fixing’ tool in its toolkit: its ability to influence interest rates. As it increases its cash benchmark rate, the cost of borrowing for banks increases, and they pass on that extra cost in the form of higher home loan interest rates. This is what we are experiencing right now.

The reason why the RBA wants home loan interest rates to increase is that it means borrowers will have less money left over (after their loan repayments) to spend on other things. The economic theory is that as demand falls, so will prices and inflation.

However, how accurate this theory will be – in a world where the prices of essential goods that people have little choice about purchasing, such as electricity, rent, fuel, insurance, etc., are key contributors to the inflation problem – remains to be seen. I don’t want to unnecessarily alarm you, but there is a possibility that the RBA will keep using their ‘all-fixing’ tool, even if it causes indiscriminate pain.

How high might interest rates go?

This is the question everyone wants answered, but it is presently impossible to know. What is known is:

1. Interest rates were the lowest in living memory only two years ago.
2. The level of household debt exploded when interest rates were so low.
3. Interest rates have risen sharply but are not presently considered ‘high’ by historical standards.
4. The reason for the squeeze many consumers are feeling right now is not high interest rates, but rather high debt levels.

As mentioned earlier, it may well come to pass that interest rates will keep rising. If they do and that would make your home loan unaffordable, it would be sensible to see your financial advisor or mortgage broker to discuss fixing some (or all) of your home loan.

What will make inflation worse?

One thing certain to make inflation worse is unfolding before our eyes: demands for higher pay to continue to afford the increasing costs of everyday essentials.

This may seem reasonable until you step back and understand that wages are an input cost to producers, and that their wage cost increases will likely be passed on through higher prices, leading to higher inflation. This is known as a wage-price spiral and was (again) last seen in the early 1990s.

What is the cure?

Setting emotion and humanity aside for a moment, the quickest way to decrease inflation is to increase unemployment.

Australia has been experiencing low unemployment for some years now, but the situation is slowly reversing as migration brings in the extra workers needed. Unemployment can be ‘hastened’ if the government reduces payments and increases taxes, as doing this takes money out of the economy, and as people have less, they spend less.

There is also a psychological effect: as people see unemployment increasing, they naturally fear for their own jobs and tighten their fiscal belts and save for the possible coming rainy days, rather than spend.

And herein lies the problem because prescribing the bad medicine needed would be deeply politically unpopular – just ask Paul Keating who was the last to dispense a fiscal cure to an inflation problem. This accounts for the present friction between the RBA and the Federal Treasurer. One works as an employee in the world of economics, the other in the world of getting re-elected. One has the foot on the fiscal brake, the other on the fiscal accelerator.

In summary

So, what have we learned?

Firstly, the cure for inflation is the opposite of the cause. The inflation problem we are experiencing now is a result of excessive consumption funded by debt, poor government planning in the energy sector (a decade of dithering instead of transitioning to cleaner energy sources), and world events beyond our control, such as COVID supply shocks, wars, and global political bickering and posturing.

That might get me an A on my economics exam, but for those in the real world, here’s a simpler explanation: the lifestyles we have become accustomed to, which were paid for via the use and abuse of debt, are no longer sustainable or affordable. We can either take a small amount of medicine now and live with lower living standards for a while, or we’ll be force-fed a monster dose later that will trash living standards for longer.

Canberra has the answer, but whether or not they have the political fortitude needed to dispense the dose remains to be seen.

Want more? Get our newsletter delivered straight to your inbox! Follow Kochie’s Business Builders on Facebook, Twitter, Instagram, and LinkedIn.