You don’t have to be an economist to know Australia is in a cost of living crisis. What are the signs and what needs to change?

This article is part of The Conversation’s series examining��Australia’s��cost��of��living��crisis.

Every day the higher price of seemingly everything is mentioned in the news or in conversations with friends��and��acquaintances.

The impact is clear as we are required to pay more for most things from our weekly shop��and��power bills, to filling the car��and��swimming lessons.

So��what��is the��cost��of��living��and��how is it measured?

The “cost��of��living” refers to the prices people need to pay to meet their��needs��in their everyday lives.

The most commonly cited measure is the Consumer Price Index compiled by the��Australian Bureau of Statistics.

This represents the price of a fixed basket of goods��and��services. The items in the basket reflect the spending of metropolitan households. Each item is given a weight corresponding to its share in the spending of these households. The CPI does not include the price of land��or financial assets such as shares.

The rate of��change��of prices is��known as inflation.

Inflation rose sharply in the 1970s, especially after the oil price shocks. It took a long while to get it down. The Reserve Bank adopted an inflation target of 2-3% in the early 1990s to keep inflation low over the medium term. After a long period of low inflation, it rose sharply again during 2022.

It is now declining.

A similar pattern is seen in comparable economies such as the United States��and��New Zealand. The supply bottlenecks caused by COVID��have��eased��and��economic activity is slowing in response to the increases in interest rates in most economies.

Some prices rise fairly smoothly in line with the overall CPI. Others, such as petrol��and��fresh food, are much more volatile.

Since 1972 the price of the CPI basket has increased almost 12-fold. But some prices��have��increased much more.

Cigarettes��cost��almost 60 times as much (reflecting increased taxes). Labour-intensive hairdressing��costs 20 times as much. Prices of other goods��have��gone up much less, especially after��Australia��cut tariffs��and��started importing more from low-cost��producers. Over the past decade the prices of clothing��and��computers��have��fallen.

People often believe inflation is higher than the CPI reports. Big price rises are more noticeable.��You��seldom see headlines about prices that��have��not��changed.��And��when was the last time��you��heard a discussion about how clothing has been getting cheaper?

House prices are now more than 50 times as high as in 1972, a much larger increase than the CPI. Some of this, however, represents quality��changes rather than pure price��changes. The average��Australian house has roughly doubled in size��and��may now be the largest in the world.

The CPI reflects the prices faced by an average household. About half of households will��have��experienced a higher increase in the prices they pay,��and��half will��have��seen a lower increase.

Different households consume different goods��and��services. Retirees tend to spend more on health care��and��less on childminding. A higher proportion of the spending of lower income households goes on necessities rather than luxuries.

For the “average” household, almost 4% of spending is on tobacco. But of course non-smokers spend nothing while heavy smokers spend much more. So that large rise in cigarette prices affects some people significantly��and��others not at all.

The ABS publishes some separate��living��cost��indices. The data get much less attention, partly because they are released after the CPI. These differ from the CPI in that they include interest charges. They are also prepared relating to different classes of people.

Over the year to June 2023, the��living��costs of employees rose by 9.6% but those of self-funded retirees by 6.3%��and��age pensioners by 6.7%. The main reason for the difference was that interest rates increased��and��employees are more likely to��have��a mortgage than are retirees.

These compare to the 6% increase in the CPI over the same period.

The��cost��of��living��becomes an increasing problem when incomes, notably wages, fail to keep up with it. Over long periods of time, wages tend to grow faster than prices. The economy becomes more productive over time��and��the gains flow to both workers��and��companies.

But over shorter periods, this may not be the case. Last week’s data show wages grew by only 3.6% over the year to the June quarter. This is well below the current inflation rate of 6%. But it is around the growth in prices forecast by the Reserve Bank for the coming year.

As well as an income for workers, wages are a major��cost��for businesses. So if wages grow too fast,��and��particularly were they to accelerate, there is a risk of a wage-price spiral.

The 3.6% annual wage increase for the June quarter is slightly less than the 3.7% recorded in the March quarter. The quarterly growth rate has been steady at 0.8% for the past three quarters. If labour productivity grows close to its medium-term average, this size of wage increase should not be a concern.

If business starts to expect raw material��and��input prices,��and��prices charged by their competitors, to keep growing strongly, they will be likely to keep increasing their own prices a lot. This risks a price-price spiral.

The Reserve Bank is trying to steer the economy along��what��it calls a narrow path.

It hopes it has raised interest rates enough to slow the economy��and��return inflation to its 2-3% target within a reasonable time frame. But it hopes it has not raised them too far, which would push the economy into a recession��and��lead to a large rise in unemployment.

The bank’s goal is to��have��the��cost��of��living��rising by around 2-3% per year��and��incomes a bit more than this, so��living��standards steadily improve for all��Australians over time.