Our response to the threat to the cost of living is paradoxical.

On the one hand, governments introduced subsidies for things like rent and electricity, as the federal government did in this year’s budget.

On the other hand, we are told that these subsidies are inflationary because they give consumers even more cash.

At the same time, when the cost of living rises so much that inflation exceeds the Bank’s target, the Reserve Bank raises interest rates in order to reduce measured inflation.

For mortgage holders, this often results in higher payments, which, although not included in standard inflation measurements, still increase their cost of living.

Higher prices are not a problem in themselves

Although we often describe the cost of living as a problem, it should not bother us much in itself.

The cost of living, measured in terms of the amount needed to meet basic needs, has been rising steadily for at least a century.

In the famous Harvester decision of 1907, Judge Henry Higgins determined that a “living wage” for a family of five was 42 shillings ($4.20) per week.

The cost of living has risen so much that you can hardly afford a cup of coffee these days.

A loaf of bread cost four cents back then; today it is worth 100 times as much.

Nevertheless, no one doubts that the average family is better off today, even though the cost of living has increased.

The reason for this is, of course, that incomes have risen faster than prices for most of the last century.

The average weekly wage today is almost $2,000 a week, 500 times higher than in 1907.

What matters is not the prices, but the purchasing power of our disposable income (i.e. income after deducting taxes, interest and unavoidable costs).

Recently, wage growth has unusually lagged behind price growth. In 2022, the year inflation peaked, consumer prices rose 7.8% while wages rose 3.3%.

The price increase in 2022 was by no means extreme by historical standards. In the 1970s and 1980s, prices rose faster without causing a “cost of living crisis.”

But back in the 1970s and 1980s, wages were price-linked, meaning they kept pace with price increases, so we weren’t as worried about rising living costs.

Sharp interest rate increases are a problem

The response of the Reserve Bank and other central banks to the inflation shock of 2022 was to quickly and repeatedly raise the interest rates they control – in Australia’s case, the so-called cash rate – to bring inflation back to target levels.

It is important to note that no theoretical justification has ever been provided for Australia’s inflation target.

Both the idea of ​​targeting consumer price inflation and the choice of the 2-3% target range are arbitrary, a legacy of the very different circumstances of the early 1990s and the judgment of a right-wing New Zealand finance minister.

The Reserve Bank’s recent review acknowledged but did not address the challenges to this orthodoxy.

A more fundamental but not yet sufficiently analyzed problem is the connection between high interest rates and the purchasing power of disposable income.

Higher interest rates benefit some and harm others

For households with mortgage debt (mostly, but not exclusively, young people), interest payments are a deduction from disposable income, and for households with net financial assets (mostly, but not exclusively, old people), they are a source of income.

The result is a largely random redistribution of the impact of rising interest rates, with losers perceiving it as an increase in the cost of living, while winners perceive it as an unexpected gain that allows them to indulge in certain luxury spending.

I raised this point about the limits of using interest rates to control inflation at a Reserve Bank conference in the late 1990s, but it had little impact at the time.

Since interest rates remained largely stable and showed a slowly declining trend over the next two decades, this point was primarily of academic interest.

Until now. The increase in the Reserve Bank’s base rate by around four percentage points from 2022 is the first really big increase since inflation targeting was introduced in the early 1990s.

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We are now seeing the consequences of using interest rates to control inflation, even if they are not properly understood.

In keeping with well-known narratives, the distributional consequences are portrayed as generational conflicts (Babylon generation versus Millennials) rather than as the product of misguided economic policies.

If drastic interest rate increases are not the right tool for controlling inflation, what is? The experience of the 1980s gives an idea.

The best thing is to avoid income shocks

Rather than seeking a rapid return of inflation to an arbitrary target, we should focus on avoiding large income shocks while achieving a gradual decline in inflation.

This would mean adjusting wages to prices and avoiding sharp shocks like the interest rate hikes in the late 1980s that led to the “inevitable recession.”

That’s not likely to happen anytime soon. In the meantime, it’s a good idea to avoid the pitfalls that come with talking about the “cost of living” and to realize that in a world where the true cost of living includes interest rates, big rate hikes will do little for many people who are barely keeping up.