What is inflation?
Inflation is defined as the rate of increase in prices over a given period of time and it is expressed as a percentage.
There are different ways to measure inflation, but one of the most common methods used by the New Zealand Government is the Consumer Price Index (CPI).
To calculate CPI inflation, the Government collects the prices of a fixed basket of around 700 goods and services (for example milk, bread, gym memberships) every quarter, and then measures the weighted average change in price across these goods and services versus the previous quarter (quarterly inflation rate), and versus the same quarter of the prior year (annual inflation rate).
What is our inflation rate at the moment?
Based on the latest released in January 2023, the annual inflation in New Zealand is 7.2%.
This is one of the highest recorded inflation rates in New Zealand since 1990. For comparison, inflation in 2019 was 1.6% and in 2020 inflation was 1.7%.
Around the world:
- Inflation in Australia is at 7.8% - the highest in Australia in 32 years
- Inflation in the United States of America is 6.5%, slightly down from 7.1% the previous quarter, but still high in a historical context
Why is inflation so high?
Since 2021, most of the world has been dealing with high inflation.
While there are many factors at play, two of the major factors for this include:
- The Covid-19 pandemic
- Geopolitical volatility across the world
As countries tried to manage the economic effects of the covid-19 pandemic, governments, including the New Zealand Government, borrowed more money to spend on things like (but not limited to) support for our health system, vaccines, and business bailouts, while central banks around the world cut interest rates and increased the money supply to support economies. This led to a broad-ranging increase in the demand for goods and services.
At the same time, both the Covid-19 pandemic and the geopolitical volatility, contributed to major supply shortages around the world, as countries went into lockdown and a major war broke out in Europe.
This imbalance between the demand for goods and services at a time when the supply of said goods and services became constrained, was a key contributor to rising prices.
Why is inflation bad?
Not all inflation is bad.
An inflation rate between 1 and 3% is generally viewed as ideal, as it tends to be associated with positive economic growth, rising profits and stock price gains.
But high inflation is a problem because it reduces the value of people’s savings and purchasing power. For example, as inflation increases and the cost of goods rises, $100 spent at the supermarket will buy you less and less. The ‘real’ value of money becomes less.
High inflation is also bad for companies. The big risk is that a company’s costs rise with inflation, but they can’t pass these costs on to their customers, and so their profit margins get compressed. They also find it harder to plan for the long term, to invest in new projects, since they find it difficult to predict what prices they will be able to charge at a later date and what returns they will earn on the projects. This is bad for everyone, as this is what often leads to staff lay-offs and a rise in unemployment.
How do we lower our inflation rate
The main purpose of the Reserve Bank of New Zealand [RBNZ] is to keep annual increases of the Consumer Price Index [CPI] between 1 and 3% on average over the medium term. The primary tool that the RBNZ use to manage this is interest rates, specifically, the Official Cash Rate.
By increasing interest rates, they aim to reduce demand – and find a new balance of supply and demand.
While using ‘interest rates’ as a tool may have you thinking this only relates to demand for new houses – raising interest rates actually has a flow on effect and affects demand for everything. The logic being if everyone has to pay higher interest rates, then they have less money to spend on other goods and services, and therefore ‘demand’ for other goods and services (holidays, handbags, chocolates) will be reduced.
The hope is we can achieve this rebalance of supply and demand, without interest rates climbing too high or having us fall too deeply into recession.