Is deflation good news for your living costs?

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With the economy shrinking, there has been talk about deflation. Deflation is where average prices go down, not up. You might think that deflation is good for people’s cost of living. If the products you’re buying are going down in price, that’s a good thing, right?

Well the standard answer from an economist is, ‘that depends’.

Deflation occurs when the economy is doing very badly. We have Consumer Price Index (CPI) data going back to 1948 and over those 70-odd years there have been only 10 quarters of deflation. Almost all were when the economy was in recession. Deflation often happens when a significant proportion of businesses are worried they’re going to lose customers and start cutting prices in order to limit the losses.

If deflation happens mainly during recessions, then it is also happening when people are losing their jobs. Things might cost less, but fewer people have income to make purchases.

But if you’re a retiree and your income is largely shielded from falls, such as someone on an Age Pension, are you better off?

Again, it depends. First, some retirees’ incomes are safe, others are not. If you get most of your income from superannuation or other investments, then you’re at risk of going down in a recession. Business profits are likely to fall, and even rents will be under pressure to drop. Either retirees will need to use up more of their savings to maintain their income or they will have to take a cut to income.

Second, measures of inflation work best when people’s spending doesn’t change radically. The problem with a recession, and particularly for one caused by a pandemic lockdown, is that many people’s spending patterns have been upended.

Next quarter’s CPI will capture a full three months of the pandemic shutdown and that has had a big effect on some prices. This means that the CPI and our Retirement Affordability Index might be a less accurate measure of inflation.

That’s because the increase in prices that you face is dependent on the sorts of things you buy. For example, if one household spends more on health and another spends more on transport, and healthcare and transport go up at different rates, then those households will have different inflation rates. If health goes up faster than transport, then the health household is more likely to have a higher inflation rate than the transport household.

Of course, it will also depend on all the other things the household buys. Every household spends its money on different things. Your household’s inflation rate will be higher if you spend more on things that are seeing large increases in prices and your inflation will be less if you’re spending more on things that aren’t increasing as much.

The Retirement Affordability Index – and its six tribes with six different spending patterns – allows retired households to find a spending pattern that more closely matches their own and thus gives them the most accurate inflation rate.

But there is a problem at the heart of all attempts to measure inflation and cost of living. The measurements become less accurate if there is a sudden change in households’ spending patterns and the changes in spending are on items that have seen big changes in price.

The COVID-19 lockdown has changed spending patterns. People stuck at home are spending less on eating out at restaurants, but more on takeaway foods. People are spending less on entertainment that involves going out, such as movie tickets, but more on entertainment that involves staying in, such as jigsaw puzzles. And because people are going out less, they’re spending less on transport.

People are spending less on transport all over the world. More people are working from home and not going out to see family and friends. This has pushed down world oil prices, which in turn has led to a big fall in petrol prices. In some places in Australia, they’ve fallen below a dollar a litre.

The table below shows the proportion of total spending that each tribe makes on transport. Transport includes such things as fuel, the purchase and maintenance of a vehicle, as well as bus, train and taxi expenses.

Ordinarily, lower petrol prices help to contain living costs, but that is only the case if you continue to use your car as normal. With the lockdown in place, people have been going out less often, so the proportion of their spending on transport has gone down. But the Retirement Affordability Index doesn’t account for this. If instead of spending on transport, households spent more on other things that didn’t fall in price, then the index would show a bigger decrease in their cost of living than was actually the case.

So why not just adjust the Retirement Affordability Index for the new spend on transport? The problem with that is we don’t have up-to-the-minute data on exactly how much households spend on different things. We use Australian Bureau of Statistics (ABS) data from the Household Expenditure Survey and that comes out only every five years.

There is another price change that will have a big impact on the CPI – childcare – but that will not impact our tribes.

The outcome of all of this is that next quarter we might see a big fall in the cost of living for each of our tribes, but because of the chaos of the recession and how we measure inflation, the real impact on cost of living might be smaller than the Retirement Affordability Index shows. The same will be true of the official CPI inflation numbers. The drop in inflation won’t be as big as the numbers show.

Have you noticed changes in your living costs? What have been the welcome changes? And the not so welcome?

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Disclaimer: All content in the Retirement Affordability Index™ is of a general nature and has been prepared without taking into account your objectives, financial situation or needs. It has been prepared with due care but no guarantees are provided for the ongoing accuracy or relevance. Before making a decision based on this information, you should consider its appropriateness in regard to your own circumstances. You should seek professional advice from a financial planner, lawyer or tax agent in relation to any aspects that affect your financial and legal circumstances.

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Written by Matt Grudnoff



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