What is inflation, and how does it affect your money?

Inflation is the rise in the prices of goods and services over time. As prices increase, your money buys less than it did before.

You may notice this when your usual grocery shop costs more, even though you haven’t bought anything extra.

The inflation rate expresses the increase as a percentage. For example, if the same groceries cost $100 last year and $105 today, their price has risen by 5%.

The country's inflation rate looks beyond a single grocery shop. It combines price changes across a wide range of household purchases, including food, housing, transport and health care.

Inflation means you need more money to buy the same things. Whether that puts pressure on your budget depends on how your income changes alongside prices.

Suppose your regular expenses rise from $2,000 to $2,100 a month. If your take-home pay stays unchanged, you have $100 less available for savings or other purchases.

If your pay increases enough to cover those higher expenses, you may be able to maintain your usual spending. But if it rises by only $50, you still need to find the remaining $50.

The effect also depends on what you buy. A household that drives regularly may feel higher fuel prices more strongly than someone who rarely uses a car. A tenant facing a rent increase has different housing costs from someone who owns their home outright.

Your savings can grow in dollars while buying less.

Suppose you have $10,000 saved for purchases that currently cost that amount. Earning 3% interest would increase your balance to $10,300 after a year, before tax.

If those purchases become 5% more expensive, they now cost $10,500. Your balance has grown, but you are $200 short.

To understand whether your savings are keeping up, consider the interest you receive after tax and how the prices of your intended purchases are changing.

Small, predictable price increases are generally easier to manage than prices rising quickly or unexpectedly.

When prices rise slowly and incomes keep pace, households can maintain their usual spending. Businesses can also plan their costs and prices with more confidence.

If prices rise faster than your pay, your money buys less. You may need to cut spending or use savings to cover essentials.

Businesses face difficulties too. A builder may struggle to quote for work if material prices keep changing. A shop may lose customers if it raises prices, but earn less profit if it absorbs higher costs.

Low inflation is not always a problem. Prices may rise more slowly because businesses find cheaper or better ways to produce things.

But it can also mean people are spending less because they are worried about their jobs or finances. Businesses with fewer customers may then cut staff hours or stop hiring, leaving households with less money to spend.

If prices keep falling across the economy, people may delay some purchases because they expect them to become cheaper. This can weaken sales further and put more jobs at risk.

The RBA aims to keep annual inflation between 2% and 3%. The aim is to keep price increases small and steady enough for households and businesses to plan ahead. Trying to push inflation much lower could require slowing spending so much that businesses cut production and jobs.

The Australian Bureau of Statistics (ABS) measures inflation using the Consumer Price Index (CPI).

CPI tracks the prices of a basket of goods and services that households buy. The basket covers 11 spending categories:

• Food and non-alcoholic drinks
• Alcohol and tobacco
• Clothing and footwear
• Housing
• Furniture, household equipment and services
• Health
• Transport
• Communication
• Recreation and culture
• Education
• Insurance and financial services

These categories include everyday purchases, such as groceries and fuel, and less frequent expenses, such as appliances and insurance.

No. The ABS gives each category a share of the basket based on how much households spend on it. This share is called its weight.

Housing accounts for much more household spending than clothing, for example. A rise in housing costs therefore has more influence on the overall inflation figure than the same percentage rise in clothing prices.

Imagine a simplified basket containing just groceries and clothing. Households spend $80 on groceries and $20 on clothing, making a total of $100.

If grocery prices rise by 10% and clothing prices stay unchanged, the basket now costs $108. The overall increase is 8%.

If clothing prices rise by 10% instead, while grocery prices stay unchanged, the basket costs $102. The overall increase is only 2%.

The price increase is 10% in both cases. But groceries have a greater effect because they account for more of the spending.

The ABS applies this approach across the CPI basket, using household spending information to decide how much influence each category should have.

Headline inflation measures price changes across the full CPI basket. Underlying inflation helps show the broader pattern by reducing the effect of unusually large price rises and falls.

For example, floods might damage crops and cause vegetable prices to jump. That increase affects shoppers, but it does not necessarily mean prices across the economy are rising faster.

A temporary electricity rebate can have the opposite effect. It may lower headline inflation even while many other prices continue increasing.

Underlying measures help the RBA look beyond these large movements when assessing whether inflation is easing or becoming more widespread.

Trimmed mean is one of Australia’s main measures of underlying inflation.

The ABS puts price changes in order, from the largest falls to the largest rises. It then removes the lowest 15% and highest 15%, based on their share of household spending, and calculates the average change across the remaining 70%.

Imagine a simplified basket with 20 categories, each accounting for the same amount of spending. The ABS would remove the three lowest price movements and the three highest, then average the remaining 14.

In the actual CPI basket, categories account for different amounts of spending. The calculation allows for those differences, rather than simply removing a fixed number of categories.

Trimmed mean does not always exclude food or fuel. What gets removed depends on how large each price movement is during that period. Nor does removing a price change mean it does not matter to households. It helps prevent a few large movements from dominating the result.

No. Easing inflation usually means prices are rising more slowly.

Suppose the same groceries cost $100 one year and $105 the next. Their price has risen by 5%.

If the increase slows to 2% the following year, those groceries cost around $107. The rate of increase has fallen, but the groceries have become more expensive again.

For prices to fall, the percentage change would need to be negative. If the grocery bill dropped from $105 to $102.90, that would be a 2% decrease.

This is why lower inflation may not immediately make your budget feel easier. Earlier price increases remain, and your income may still need to catch up.

Some individual prices can also fall while inflation stays positive overall. Cheaper fuel may provide relief, for example, while higher rent and insurance costs leave your total expenses higher.

The RBA looks at how quickly prices are rising, what is causing the increases and whether they are likely to continue.

Its 2–3% inflation target applies to headline CPI inflation. It also watches trimmed mean inflation to understand whether price rises are widespread or concentrated in a few categories.

For example, a temporary electricity rebate could lower headline inflation without reducing the pressure behind other price increases. The RBA would consider whether inflation might rise again when that rebate ends.

Similarly, a sharp increase in fuel prices could lift inflation even as households cut other spending. The RBA would examine whether higher fuel costs are spreading into delivery charges, shop prices and other services.

It also considers jobs, wages, household spending and how easily businesses can meet demand. These help it judge where inflation may be heading and whether interest rates need to change. One inflation result does not automatically lead to a rate rise or cut.

Inflation can affect your mortgage through the RBA’s decisions about the cash rate.

The cash rate influences interest rates across the economy. If the RBA expects inflation to remain too high, it may raise the cash rate or keep it elevated. Lenders may then charge borrowers higher interest rates.

However, the RBA does not set your home-loan rate. Lenders also consider their own funding costs, competition and the type of loan. Your mortgage rate will not necessarily move by the same amount as the cash rate.

The effect depends on your loan:

• Variable-rate loan: A higher interest rate generally increases the repayments needed to pay off your balance over the remaining term.
• Existing fixed-rate loan: Your rate generally stays unchanged until the fixed period ends. After that, the rate available could be higher or lower.
• Split loan: The variable portion can change, while the fixed portion generally keeps its agreed rate until the fixed period ends.

For some borrowers, higher repayments arrive while groceries, insurance and other bills are also becoming more expensive.

Suppose your mortgage repayment increases by $150 a month and your other essential expenses rise by $100. You need an additional $250 each month to maintain the same spending.

An existing fixed-rate borrower may avoid the immediate repayment increase, but still face higher everyday expenses. This is why inflation can put pressure on a household even before its mortgage rate changes.

A higher cash rate can make borrowing more expensive and saving more attractive. This encourages households and businesses to reconsider spending.

If your mortgage repayments increase, you may have less money for meals out, holidays or household purchases. You might also postpone buying a car because the repayments on a new loan would cost more.

Businesses face similar decisions. Higher savings rates may also encourage people to keep money in the bank rather than spend it.

When enough households and businesses spend less, businesses face less demand for their goods and services. They may find it harder to raise prices without losing customers. Over time, this can help slow inflation.

People and businesses take time to adjust. Some borrowers have fixed-rate loans, while others can initially cover higher costs from savings. Businesses may continue projects they have already committed to.

Higher rates also cannot directly fix shortages. They do not produce more fuel, build more homes or train additional workers. Prices can therefore keep rising because of supply problems, even while customers cut spending.

The RBA must assess whether earlier rate increases are doing enough to slow inflation, while considering how weaker spending affects businesses and jobs.

Start with your own income and expenses. The national inflation rate explains the wider trend, but your bills show how much your costs have changed.

Check what you pay now against the same period last year. Include groceries, housing, transport, utilities and insurance.

Try to separate higher prices from changes in usage. If your electricity bill has increased, check whether the rate went up, you used more electricity or both.

Compare any increase in take-home pay with the increase in your expenses.

If your pay rises by $100 a month but your regular costs rise by $150, you have $50 less available for other spending or saving.

For savings, compare the interest you receive after tax with changes in the cost of what you are saving for. A growing balance doesn't always mean you can afford more.

If you have a mortgage, use your current balance, interest rate and remaining term to calculate repayments at different rates.

For example, check what an increase of 0.25 percentage points would add to your monthly repayment. Then include that amount alongside your other expenses to see whether your income could cover it.

These calculations are scenarios, rather than predictions. They help you understand how a rate change could affect your budget before it happens. Bheja's repayment calculator can help you crunch the numbers and plan ahead.