In a world where the cost of living consistently captures headlines and conversations, there is an underlying paradox that often goes unnoticed. On one side, governments strive to ease the financial burden on citizens by implementing subsidies for essentials like rent and electricity, as seen in the federal government’s recent budget measures. On the other hand, these very subsidies are criticized for being inflationary, as they provide consumers with more disposable income.
At the same time, central banks, such as the Reserve Bank, respond to inflation by raising interest rates to keep it within target limits. These increased rates, while meant to control inflation, often result in higher mortgage payments, contributing to the financial strain on households. This paradox raises a critical question: How can we manage the cost of living effectively without unintentionally exacerbating the very problems we aim to solve?
The cost of living, defined as the amount of money needed to cover basic expenses, has been on an upward trajectory for over a century. This trend is not inherently problematic. Consider the famous Harvester Judgment of 1907, where Justice Henry Higgins determined that a living wage for a family of five was 42 shillings ($4.20) per week. At that time, a loaf of bread cost four pennies. Today, that same loaf costs 100 times more, and $4.20 is hardly enough to buy a cup of coffee. Yet, despite this apparent increase in living costs, few would argue that families are worse off today than they were a century ago.
The reason for this discrepancy lies in the growth of incomes, which have generally outpaced the rise in prices over the long term. In 1907, average weekly earnings were meager compared to today, where they hover around $2,000, approximately 500 times higher. The key factor is not the absolute level of prices but the purchasing power of disposable incomes. This purchasing power takes into account not only wages but also the effect of taxes, interest payments, and other unavoidable costs.
Recently, however, there has been a notable deviation from this historical pattern. In 2022, consumer prices surged by 7.8%, a substantial rise compared to the 3.3% growth in wages. This divergence marks a departure from the past, where wage growth typically kept pace with, or exceeded, price increases. Notably, this increase in prices, while significant, was not extreme by historical standards. The 1970s and 1980s saw even higher inflation rates without precipitating a widespread cost of living crisis. The crucial difference in those decades was wage indexing, which ensured that wages increased alongside prices, mitigating the impact on households.
The response to the inflation surge of 2022, both in Australia and globally, has been a rapid increase in interest rates. Central banks, including the Reserve Bank of Australia, hiked rates in a bid to bring inflation back within target ranges. In Australia, the Reserve Bank’s cash rate increased by about four percentage points, marking the most significant rise since the early 1990s when inflation targeting was first adopted.
Interestingly, no formal theoretical basis for Australia’s inflation target has been articulated. The 2–3% target range is a somewhat arbitrary choice, inherited from the economic conditions of the early 1990s and the policy decisions of a right-wing New Zealand finance minister. Despite the absence of a strong theoretical foundation, this target has become a cornerstone of economic policy, shaping decisions with far-reaching consequences.
A critical issue with using interest rates to manage inflation is their effect on disposable income, which is what really matters when assessing the cost of living. For households with mortgage debt, higher interest rates mean increased monthly payments, effectively reducing disposable income. Conversely, those with net financial wealth benefit from higher interest rates, as they see increased returns on savings and investments. This results in a redistribution of wealth, perceived by mortgage holders as an increased cost of living and by savers as a windfall gain.
This redistribution is largely random, dependent on factors such as age, financial position, and the timing of property purchases. Younger households, often burdened with mortgage debt, tend to lose out, while older, wealthier households, more likely to have net financial assets, benefit. This dynamic feeds into broader narratives of intergenerational conflict, pitting Millennials against Baby Boomers in the struggle over economic policy outcomes.
If sharp increases in interest rates are not the optimal tool for controlling inflation, what alternatives exist? The economic experience of the 1980s provides a potential blueprint. Rather than pursuing a rapid return to inflation targets, a more measured approach could focus on minimizing large income shocks while allowing inflation to decline gradually.
One option could involve reintroducing wage indexing, ensuring that wage growth keeps pace with inflation. This would help maintain purchasing power without the need for drastic interest rate hikes. By aligning wage increases with inflation, the pressure on household budgets could be alleviated, reducing the likelihood of a cost of living crisis.
The recession of the late 1980s, often referred to as “the recession we had to have,” was largely a consequence of aggressive interest rate hikes. These increases aimed to bring inflation under control but had severe economic and social consequences. A similar scenario could unfold today if high interest rates persist, leading to economic contraction and job losses.
Instead of focusing solely on inflation targets, economic policy could benefit from a broader perspective, considering the overall impact on household income and economic stability. This approach would recognize that the cost of living encompasses not just prices but also the broader economic context, including employment, wage growth, and interest rates.
As we move forward, it is essential to navigate the complexities of the cost of living debate carefully. One of the inherent traps in discussing the cost of living is the tendency to focus solely on prices, without considering the broader economic factors at play. The cost of living is not just about how much goods and services cost but also about the purchasing power of households and the distribution of income and wealth.
Sharp increases in interest rates may help contain inflation, but they also impose significant costs on certain segments of the population, particularly those with mortgage debt. These costs manifest as higher monthly payments, reducing disposable income and increasing the financial strain on households. For many, this feels like an increase in the cost of living, even if it is not captured in official inflation measures.
To address the cost of living effectively, policymakers need to balance short-term and long-term considerations. In the short term, targeted subsidies and support measures can help ease the burden on vulnerable households. However, these measures should be carefully designed to avoid contributing to inflationary pressures.
In the longer term, a more nuanced approach to managing inflation is needed. This approach would recognize that inflation targeting, while important, should not be pursued at the expense of economic stability and household welfare. By considering the distributional effects of interest rate changes and the broader economic context, policymakers can develop strategies that promote sustainable growth and protect the purchasing power of households.
Finally, it is crucial to foster an informed public discourse on the cost of living and economic policy. Simplistic narratives that pit generations against each other or blame specific groups for economic challenges do little to advance our understanding or solve the underlying issues. By promoting a deeper understanding of the factors influencing the cost of living, we can encourage more constructive discussions and policies that address the needs of all citizens.
The cost of living paradox reveals the complexities and challenges of managing economic policy in a way that balances inflation control with the well-being of households. While subsidies and interest rate hikes are tools in the policymaker’s arsenal, their impact on the real lives of citizens must be carefully considered. By learning from the past, questioning established economic orthodoxies, and promoting a balanced approach, we can navigate the cost of living challenges and build a more equitable and sustainable economic future.
In a world where the cost of living will likely continue to rise, the goal should not be to return to a bygone era of low prices but to ensure that incomes, purchasing power, and economic policies work together to provide a decent standard of living for all. The path forward requires a careful balancing act, but with thoughtful policy and informed public engagement, it is a challenge we can meet.
