What is the Inflation Target?
Australia’s inflation target is to keep annual consumer price inflation between 2 and 3 per cent, on average, over time. The particular measure of consumer price inflation is the percentage change in the Consumer Price Index (CPI). This is a suitable measure of inflation to target because it captures price changes for the goods and services that households buy, is independently produced by the Australian Bureau of Statistics, is publicly available and historical data for this series does not get revised.
Why Does the Reserve Bank Target Inflation?
The Reserve Bank uses an inflation target to help achieve its goals of price stability, full employment, and prosperity and welfare of the Australian people. This is because price stability – which means low and stable inflation – contributes to sustainable economic growth. Targeting inflation of 2 to 3 per cent avoids the many costs to the economy from inflation that is too high or too low.
If inflation is too high:
Consumers’ purchasing power – the real value of money – is reduced. If prices are increasing faster than people’s nominal incomes, they will be able to afford fewer goods and services over time. Workers may then seek larger wage increases to compensate for the effects of higher inflation on their purchasing power. In turn, higher wage growth raises firms’ costs, which may lead firms to raise prices further and/or reduce the number of workers they employ.
Spending and investment decisions may be distorted. This is because high inflation can influence when households make purchases or businesses make investment decisions. For example, if households expect higher inflation, they may make purchases sooner than originally planned to avoid paying more. Returns on investment may be lower.
Inflation influences investment decisions because a higher inflation rate will reduce the real return on the investment. Inflation can also affect the real interest paid by borrowers to lenders. For example, if inflation turns out to be higher than expected when the loan was agreed, the lender will get less than they had planned because inflation reduces the purchasing power of the interest earnings they receive.
Businesses need to update their prices more frequently and consumers spend more time comparing prices. This increases their uncertainty about the economy, which may discourage spending and investment and reduce economic growth. A country’s international competitiveness may be lowered. If inflation is higher in one country, then the goods and services it produces will become more expensive compared with other countries (unless its currency depreciates)
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