How Core Inflation Affects the Economy and Interest Rates
By Ian Rogers
Core inflation is a critical measure that excludes volatile items such as food and energy prices, which are more susceptible to short-term fluctuations. It provides a clearer picture of long-term inflationary trends, making it a crucial factor in economic decision-making. Here’s how core inflation affects different aspects of the economy and interest rates:
Impact on Interest Rates
- Guides Central Bank Policy: Central banks, such as the Reserve Bank of Australia (RBA), closely monitor core inflation to decide on interest rate changes. If core inflation remains high, it indicates persistent underlying price pressures in the economy, prompting the RBA to either maintain or increase interest rates to curb inflation.
- Interest Rate Increases to Control Inflation: When core inflation is high, the RBA raises interest rates to cool down the economy, reducing demand for goods and services, which helps bring prices down. Higher rates make borrowing more expensive and encourage saving, reducing consumer spending and business investment.
- Interest Rate Cuts if Core Inflation Drops: Conversely, if core inflation falls to within the RBA’s target range (2-3%), the central bank may lower interest rates to stimulate economic activity. Lower rates make borrowing cheaper, encouraging spending and investment, which can help boost economic growth.
Economic Growth
- High Core Inflation Can Slow Growth: Elevated core inflation indicates rising prices for a broad range of goods and services, reducing purchasing power. Consumers and businesses face higher costs, leading to reduced spending and investment. In response, central banks might raise interest rates, which can further slow economic activity.
- Low Core Inflation Encourages Growth: When core inflation is stable and low, it creates an environment conducive to economic growth. Lower inflation typically means stable prices, allowing consumers to spend more confidently, while businesses are encouraged to invest in expansion, leading to economic growth.
Effect on Wages and Purchasing Power
- Erodes Purchasing Power: High core inflation erodes the purchasing power of households. As prices for essential goods and services rise, consumers are able to buy less with the same amount of money, which can hurt living standards, especially if wages do not keep pace with inflation.
- Wage Pressures: When core inflation is high, workers may demand higher wages to maintain their purchasing power. However, businesses facing higher wage costs may pass these costs onto consumers through price increases, creating a feedback loop that keeps inflation elevated.
Impact on Business Investment
- Uncertainty for Businesses: High core inflation creates uncertainty for businesses as costs rise unpredictably, making it difficult to plan long-term investments. Businesses may delay or scale back investments, which can slow economic growth.
- Investment Opportunities in Low Inflation: On the other hand, when core inflation is low and stable, businesses face more predictable costs, which encourages investment in new projects, technology, and hiring.
Financial Markets
- Stock Market Volatility: High core inflation often leads to interest rate hikes, which can negatively affect the stock market. Higher borrowing costs reduce corporate profits and limit growth, leading to lower stock prices. Conversely, falling inflation can spur rate cuts, which tend to be favourable for stocks, as companies have lower financing costs and investors shift towards riskier assets.
- Bond Market Influence: Core inflation directly impacts the bond market. Rising inflation erodes the value of fixed-income investments like bonds, leading to higher yields. When inflation is under control, bond prices typically rise, and yields fall.
Consumer Confidence
- High Core Inflation Reduces Confidence: When inflation remains persistently high, consumers become more cautious, cutting back on spending. This dampens overall demand in the economy, which can lead to slower economic growth.
- Low Core Inflation Boosts Confidence: With lower inflation, consumers are more confident about their future financial stability and are likely to spend more, supporting economic activity.
Conclusion
Core inflation is a key indicator that central banks like the RBA use to guide their interest rate policies. High core inflation typically leads to higher interest rates to control price increases, while lower core inflation can prompt rate cuts to stimulate the economy. Core inflation affects everything from consumer spending and wage growth to business investment and financial markets, making it a vital factor in both economic stability and growth.
