What’s driving inflation?

Posted: August 01, 2008

Many of the forces pushing up prices lie outside our control.

The Consumer Price Index for the year to the end of March 2008 was 4.2% - well over the target of 2 to 3% set by the Reserve Bank. A little bit of inflation is a good thing because it encourages consumption now rather than putting off purchases until prices fall. But a very high rate of inflation like the 9.7% we experienced in 1986 is definitely not good.

In simple economic terms, prices rise when demand outstrips supply. By far the most significant impact on demand is demographics – the number of people on earth and their lifestyle. World population has grown from 3 billion in 1960 to 6.6 billion in 2008. Over the same period, Australia’s population has more than doubled from 10.5 million to 21.3million.

More people on earth mean a higher demand for food, energy and services. And as we become richer we aspire to higher quality products and services. These trends can be illustrated by what is happening to the price of energy and food.

Petrol prices

The price we pay at the pump is driven by international supply and demand. Prices are rising because

• Increasing demand from China and India for industrial and personal use.
• Disruptions in supply from Nigeria, Iraq and Venezuela.
• Not enough oil refining capacity to convert crude oil to usable products.

Oil is used so widely in all parts of modern society that higher oil prices flow through to higher costs on other products as well as what we see at the pumps. To some extent we can reduce our fuel consumption by changing our behaviour (for example, buying smaller cars or driving less).

Food prices

Food prices worldwide are rising for the similar reasons.

• As developing countries become richer, their people demand more and better food.
• Droughts and floods have disrupted supply.
• Agricultural land is being used for bio-fuel production.

One of the significant trends is a surging demand for meat and wheat as developing countries acquire a taste for 'western styles' of food.

The same story applies to other products and services. Rents are rising because there is not enough housing in the areas where people want to live. Interest rates are rising in part because of the worldwide ‘credit crunch’ that has pushed up the cost of credit for banks.

None of these imbalances between supply and demand are easily fixed. It takes time to develop more oil fields, build refineries, plant wheat or build more houses. If there is any good news in this story, it is that rising prices will slow demand meaning the Reserve Bank may not need to raise interest rates further and that will be a relief for many.