The inflation of currency experienced by the world’s economies is not a new experience.
From the rates of inflation that the world is experiencing today due to COVID-19 and the Russian invasion of Ukraine
, to the inflation of England’s currency experienced during the reign of Henry VIII in the 16th century
, inflation and the management of its effects is a core part of a government’s economic policy and economic management throughout history.
To understand the inflation being experienced in Australia in 2022, it helps to look back at the history of inflation. Let’s start by having a look at the famous English king, Henry VIII - and how he got the nickname “Old Copper Nose”.
The History Of Inflation
Henry VIII And The Great Debasement
Henry VIII wasn’t just famous for his six wives - he was also famous for his insatiable appetite for spending.
In 1544, he devised a scheme to pay for his increasingly lavish lifestyle and fund his wars against France and Scotland. He ordered his treasurers to reduce the amount of silver contained in the British Pound by replacing some of the precious metals with base metals like copper. According to legend, the king's minions would melt down the British pound and re-mint it as a copper coin with a thin coat of silver.
This deceit was soon undone by the king’s vanity. Henry VIII decided to have his portrait minted onto the coins face-forward.
These coins would typically wear at the protruding point of the King’s nose, revealing the copper hidden beneath the silver. It was this sly shortcut that earned him his famous nickname, Old Copper Nose
When his citizens realised their coins had been debased, the value and purchasing power of the coins decreased, while coins with higher precious metal content disappeared from circulation.
This caused inflation of England’s coinage that lasted until the reign of Elizabeth I. In 1560, determined to restore the value of English currency, she ordered all debased coins to be withdrawn from circulation and replaced with coins that had their fineness restored
The Modern History Of Inflation: The Nixon Shock
The Nixon Shock was a series of economic measures undertaken in 1971 by President Nixon.
These measures were enacted in response to increasing inflation and included wage and price freezes, surcharges on imports, and the cancellation of the direct international convertibility system known as the Bretton Woods system
During the post-war era of the 20th century, many countries inherited tremendous debts. Some countries, like the US, managed to pay off their debts
by actively fighting inflation, and even managed to increase the size of the economy. Such lucky parties tended to have hard money, operating on a gold standard from the end of the war until the 1970s.
So what happened in the 1970s? President Nixon, who was deep in the Vietnam war, decided to spend, spend, spend
. Subsequently, in the decades that followed 1971, the US dollar gradually became detached from the gold standard, ushering in a dramatic increase in the supply of US dollars.
Between 1971 and 1981 the money supply had grown by over 200%. This meant the amount of money grew faster than the underlying value created in the economy. Put simply, more dollars were chasing fewer goods. From the 1970s until now, the US economy (and therefore the rest of the world) experienced steady increases in inflation rates.
From the early days of a king debasing his currency to today’s globalised network of financial institutions and governments, the core idea of inflation remains the same. How can the worth and supply of currency be married most effectively to generate more value for everyone without any cheap tricks?
What is inflation?
Inflation is the rate of increase in the price of goods and services over time.
Inflation decreases the purchasing power of your money - you might find that what your dollar buys today, is less than what it bought yesterday. If the prices of consumer goods and services outpace wage growth, you’ll be able to afford fewer goods and services over time
It’s important to know that inflation is different from isolated price fluctuations of some goods and services - for example, an increase in demand for a trendy product that temporarily increases its price.
Over time, an increase in prices is normal and expected in a robust and healthy economy. It is also not unusual for prices to decrease over time, but these periods of deflation are usually short events experienced during times of economic downturn.
Inflation results in everything becoming more expensive because the underlying value of the currency has been inflated, thereby devaluing the purchasing power of your dollar.
What Causes Inflation?
There are many causes of inflation in Australia, ranging from very evident and visible things such as the unusually large increases in award wage rates or a high level of excess demand, to more abstract causes such as people’s expectations of future movements in prices, and the rate of inflation in other major world economies.
Though inflation is a complicated and multi-faceted interplay of multiple economic factors, there are three main contributors to inflation: demand-pull inflation, cost-push inflation, and built-in inflation.
- Demand-pull inflation occurs when economic growth is too fast. This type of inflation occurs when consumers have money to spend and unemployment rates are low, increasing the demand for goods and services. As this demand increases, supply decreases, causing a rise in prices.
- Cost-push inflation is caused by a rise in the cost of raw materials and production. These price rises are passed on to consumers, increasing the costs of goods and services.
- Built-in Inflation is inflation caused by the normalised expected rate of increase of prices that occurs over long periods in combination with the price/wage spiral.
How Does Australia Measure Inflation?
The most well-known measure of inflation in Australia is the Consumer Price Index (CPI). First published by the Australian Bureau of Statistics in 1960, the CPI is the principal way the Reserve Bank of Australia measures inflation.
What is the CPI? The CPI is a report that is produced to measure the rate of change in inflation. The ABS does this by measuring the prices of many commonly bought goods and services over time. It’s this report that helps inform the RBA whether they need to implement certain monetary policies to manage inflation and keep inflation within the targeted range of 2% to 3%.
Fast forward to 2022: The latest CPI report shows that the cost of living has indeed increased for all Australians. Released in March 2022, the report showed a CPI rise of 3.0% in the previous quarter, with a total rise of 5.0% over the 12 months leading up to the March 2022 report. This is the largest CPI increase since the introduction of the GST in July 2000.
Why Is the Australian Economy Currently Experiencing Inflation?
Multiple factors are causing the inflation our economy is experiencing.
The Russian invasion of Ukraine and the easing of COVID-19 restrictions have contributed to price rises in Australia and worldwide. The March 2022 CPI
reported an 11% rise in the cost of fuel. In dollar terms, the national quarterly average price for unleaded petrol increased to $1.83 per litre, $0.19 higher than the average of $1.64 in the previous quarter.
A rise in the cost of oil doesn’t just affect the cost of petrol at the pump - it affects all industries that rely on the transport of goods and the use of oil products. The increased cost of production passed on to you, the consumer.
Inflation is being felt by Australian households at the supermarket too. If you’ve noticed an increase in the price of your groceries, you’re not alone. The March 2022 CPI saw a 2.8% rise in food, caused by increased costs of fertiliser, packaging, ingredients, and transport, and the effect of supply chain disruptions and weather events
We’re not just seeing an increase in the price of oil and food - this trend is occurring across the range of goods and services measured by the CPI.
How is inflation controlled in Australia?
The Reserve Bank of Australia is responsible for implementing monetary policy that targets inflation. The RBA’s main goal is to maintain sustainable economic growth, which it does by setting an inflation target of 2-3%
By setting an inflation target, the RBA can establish inflation expectations, increasing the confidence of households and businesses in making decisions about saving and investment by reducing economic uncertainty.
The RBA controls inflation by raising the cash rate and enacting monetary policy that causes changes in interest rates. This change in interest rates is primarily what affects changes in economic activity and inflation. The first steps the RBA takes to control inflation are to increase the cash rate and to enact other monetary policy tools that target longer-term interest rates in the economy.
- The cash rate is the market interest rate for overnight loans between financial institutions. It impacts other interest rates, such as deposit and lending rates for households and businesses.
- Enacting monetary policy is determined by the Reserve Bank board. It includes measures such as forward guidance, setting quantity and price targets for government bond purchases, and the dispensation of low-cost fixed-term funding to financial institutions.
The way that changes to the cash rate and monetary policy measures are used is dependent on the specific factors and causes of inflation at the time.
The RBA closely monitors the effect of its changes and adjusts accordingly. The flowchart below, published by the RBA, shows the flow-on effects that changes in the cash rate and the use of monetary policy tools have on inflation.
The Impact Of RBA Measures That Target Inflation
: Reserve Bank of Australia 
Inflation and Investments
Inflation has the power to impact existing and potential investments in a number of ways.
The main way inflation impacts investments is that it reduces the purchasing power of your investment capital and returns. Most investors are looking to increase their long-term purchasing power, so in order for your investments to do this, your returns should at least keep up with inflation, and ultimately outpace it.
The investments most vulnerable to the effects of inflation are those with higher liquidity, such as savings accounts, shares, and bonds, which means that inflation can reduce the purchasing power of your capital and the returns of these types of investments. The average return on savings accounts in 2022 is already at an abysmally-low .43%, meaning that higher inflation will see the purchasing power of your capital reduced even further.
Inflation, Savings Accounts, And Term Deposits
Traditional fixed investments, such as savings accounts and term deposits, are particularly vulnerable to the negative effects of inflation. Higher levels of inflations will reduce the purchasing power of each dollar of both investment capital and returns. If you’re looking to borrow against an asset or investment, such as property, you might find that the interest rates you pay for borrowing are higher, as economies often raise interest rates to combat the rates of inflation.
Term deposits offer slightly higher rates than a savings account (the average in 2022 is about 1.4%, still lower than the RBA’s targeted rate of inflation), but your funds are locked away for a fixed term and are also negatively impacted by inflation. They also provide less flexibility should your situation or investment plans change, as breaking a term deposit carries financial penalties and long waiting periods.
How To Protect Your Investments From The Effects Of Inflation
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