What does inflation mean? Why is it so high in NZ? & When will it end?

Inflation is the steady increase in average prices throughout any economy. Inflation means money is steadily losing its value in real terms. Inflation in most developed countries, including NZ, was at low levels for many years, though recently resurfaced with a vengeance.

Inflation, the thief in your wallet

As inflation means money is losing its worth in real-world terms, even the NZ banking regulator refers to inflation as the “thief in your wallet”.

Inflation relates to purchasing power

Purchasing power is the value of a currency in terms of how much goods and services money can buy. Purchasing power is very important because inflation steadily but surely reduces the value of your money, and how much you can purchase with it.

A NZ homebuyer with $600,000 to invest in a home 10 years ago had a lot more choices than a homebuyer who has $600,000 to spend on a home today. But it’s not just house prices that go up. According to the Reserve Bank of NZ’s inflation calculator, the same $100 worth of food in 1970 would cost $1,739 if purchased today! This represents a 94% drop in purchasing power over that period.

In case you missed it NZ inflation is now at a 30-year high.

Why is inflation so high?

Nearly nobody saw the current levels of inflation coming. Understanding this expectation can help us understand why inflation is so high.

How could something that now seems so obvious have eluded the expectations of so many?

A trip back in recent times reveals that what is painfully apparent today was not easy to anticipate and that central banks weren’t the only ones who underestimated the evolving threat.

In 2019, Bloomberg Businessweek led with an article entitled “Did Capitalism Kill Inflation?”. This commentary was typical of thinking at the time and was informed by the experience of the 2010s, which saw extended economic expansions, very low levels of unemployment and muted increases in price levels of most goods and services.

At the time, it appeared that powerful structural factors were governing inflation:

• Globalisation had expanded, meaning goods could be cheaply made or sourced overseas

• E-commerce driving greater price competition

• Technology, which had helped firms to keep costs under control

It appeared that these trends had plenty of room to run.

Back then, central banks in most nations were concerned that inflation was too low. They agonised over falling short of their inflation targets and losing credibility for doing so. Rather than inflation, they warned about the risk of deflation, (when most prices and wages drop across an entire economy). To reorient, they adjusted their operating models. So much so, that even as late as mid-2021 one of NZ’s financial regulators published a report on the readiness of NZ financial services companies for negative interest rates!

The mindset that inflation was dormant was deeply ingrained within both central banks and among private forecasters. This led to an anchoring of expectations that proved difficult to move away from. When the first signs of inflation appeared, they were dismissed as short-term, these signals were viewed as minor shifts that would ease over time.

But, as months went by, inflation broadened and deepened. This suggested a more systemic set of problems. Leading the list of miscalculations are:

1. Policy makers overstimulated their economies

Pandemic relief offered to households and businesses was massive, well beyond anything seen during peacetime before. In the early months of Covid-19, the potential for economic damage seemed limitless; legislators saw the risk of doing too little exceeding the risk of doing too much. Very low interest rates, facilitated in part by central banks, provided cheap financing across the world. In NZ, the government delivered one of the biggest fiscal and monetary policy responses in the OECD in terms of taxpayer money spent and central bank money printed, relative to Gross Domestic Product (GDP).

Partly because of the stimulus and partly because of advancing medical responses to the virus, activity in many markets recovered much more rapidly than anticipated. Yet government support continued to flood into the world’s economies, leading to an immense increase in saving. The demand that was generated off the back of those monies has stressed supplies and contributed to price increases.

While it is easy to criticise such policies in hindsight, at the time overheating was a risk that governments were willing to take. Fortunately or unfortunately, depending on your perspective, they got more than their money’s worth.

2. Supply chains have not recovered

Pre-pandemic, modern logistics had become a fine art. Periodic interruptions (for weather events, strikes, or trade restrictions) were astutely managed, keeping goods on time and in stock. As we now know, “just in time” left little room for “just in case”. The initial pandemic lockdowns in China had broad upstream and downstream consequences which brought manufacturing to a near-standstill. Frictions with overland and overseas transit mushroomed; shipping costs skyrocketed. Nonetheless, most analysts suspected that the world’s logistics experts would solve the problem and have things back on track within months.

Unfortunately, the state of supply chains is worse today than they were at the start of the pandemic. New waves of Covid-19 in China have forced lockdowns of major cities, and the war in Ukraine has created a whole new category of difficulties. It could take a very long time for things to untangle.

3. Pandemic policy created a housing boom

Support to households, low mortgage rates and (in the case of NZ) increased savings during lockdown by those who could work from home, all served to boost the affordability of homes. The rapid rise of remote working arrangements created a demand for dwellings that had office space and allowed buyers to broaden their geographic search areas, pushing up prices across all markets.

The number of homes for sale has been limited by shortages of building materials, which are the product of global supply chains. The excess of demand over supply caused prices to surge in most countries, NZ included.  

4. Workers regained leverage

Covid-19 seems to have prompted substantial changes in job (labour) markets. Early retirements, medical limitations on some people, no immigration, relocations, and career re-assessments have limited supply.

5. War

Then, the situation abruptly changed with the unexpected full-scale Russian invasion of Ukraine. The humanitarian costs have been substantial; against that backdrop, economic consequences are secondary. Even so, the financial consequences have been enormous: supply interruptions, port closures, sanctions and movement to new energy geography have all added to inflation. The effects are more severe in some places than others, but no country is immune. Food prices are under pressure, with dire consequences for some emerging markets.

Conflict resolution still seems a long way off. Even if an armistice is established, the repair of supply lines from Ukraine could take years. Most of the global community seems intent on severing ties with Russia and its reserves of grains, metals, and fuels.

The reaction

After initially dismissing incipient signs of inflation as ‘transitory’, monetary authorities were slow to recognise the dangers of inflation. They slowly changed tack at the end of last year, ramping up their inflation control efforts over the first half of 2022 via a series of aggressive interest rate hikes.

Inflation and interest rates

Expert and non-expert opinions on inflation and interest rates are everywhere. One of the more interesting takes has been the suggestion that governments want higher inflation combined with low interest rates to eliminate the unsustainable debt burden built up due to the pandemic response. This is known as financial repression and results in governments being able to borrow at extremely low interest rates, obtaining low-cost funding for government expenditure, while the real value of the debt is eroded by inflation.

What next? Expectations about inflation

Humans are always forming expectations of what will happen in the future, and these expectations are an integral part of everyday life, including as it relates to finances. With inflation, expectations are even more important.

If you think there will be a sale in your favourite shop next weekend, you will defer any planned purchases until the sale arrives. However, if you think there will be a jump in price, it would be advantageous to go shopping today instead.

So, what people think may happen with inflation really does matter.

The measurement of inflation expectations is tricky. These expectations cannot be directly observed. They are what people think, and even the best economists cannot go digging around inside people’s brains.

It may be difficult to imagine, but there are good reasons to think that inflation will drop over the next two years. Excess savings will be running down, and consumers could become more discerning. Firms facing worker shortages could redouble efforts to achieve higher productivity and automate or offshore many tasks. Food and energy prices are unlikely to continue upward at their recent trajectories. Fiscal and monetary policies are tightening.

Despite the best intentions to predict what will occur, nobody truly knows.

The bottom line: inflation now dominates NZ, will it go dormant?

Especially when it comes to predictions about the future, they are wrong more often than they’re right. Even the most highly trained, well-intentioned, and intellectual economists still can’t predict the next natural disaster, war, or epidemic – all of which can throw current predictions out the window.

At this point, the most held opinion seems to be that inflation will steady itself in a year or so, then subdue back to more usual levels. Only time will show if this is correct.

If you'd like to discuss what inflation might mean for your personal financial situation with a trained professional, then please get in touch.