What is inflation? - why your dollars could soon be worth less

What is inflation?

Your dollars could soon be worth a lot less

Inflation is the steady increase in average prices throughout any economy. It means that money is steadily losing its value in real terms. Inflation in most developed countries, including NZ, has been at low levels for many years, though many leading financial minds now believe inflation could come back 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”.

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.

For example, a New Zealand homebuyer with $500,000 to invest in a home 10 years ago had a lot more choice than a homebuyer who has $500,000 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 a whopping $1,508 if purchased in 2020! This represents a 93.4 percent drop in purchasing power over that period.

So?

After many years of subdued inflation, there is now plenty of talk about inflation going up.

Why would inflation rise?

In the wake of the disruption caused by Covid-19, NZ’s economic recovery is well-established (less a few key areas, such as tourism), and the global economic recovery is now firing too.

In recent months, inflation expectations have jumped in many countries. As the global economy recovers from the Covid-19 pandemic, demand for goods and services is increasing; unfortunately, continuing supply chain disruptions make meeting this demand difficult. In NZ, we also face the challenge of limited skilled professionals in some areas too. When demand outstrips supply, inflation is sure to follow.

The rise in inflation in the US, from near zero inflation to over 4%, has alarmed financial market participants across the globe. Some commentators in NZ now expect our rate to reach 3.2% by the end of 2021.

The background

If you expected inflation to be 3% and the banks only offer a 1% interest rate for savings, the real return for depositing money with banks is negative 2%. That means savers will be losing money in real terms. In such a situation, you are better off looking for other investments, and businesses are better off using any cash they have to increase expenditure on capital (such as a trucking company buying new trucks, or a computer firm pumping more into research and development) rather than hoarding it.

Expectations about inflation matter

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. 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.

What people think may happen with inflation actually matters.

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 is reasonable for people to match their expectations to recent historical periods. Inflation expectations have been firmly anchored at low levels in NZ because this has been our experience since the global financial crisis over 10 years ago. These expectations alter people’s perceptions of what the future holds, significantly affecting consumption, investment, and pricing decisions.

Inflation and interest rates

Inflation expectations are likely to stay elevated for the remainder of the year, but central banks the world over (including the Reserve Bank of NZ, who indirectly control NZ interest rates) continue to be committed to keeping interest rates low. The result will be a welcome boost to investment, but probably an unwelcome continuation of increasing house prices. Beyond 2021 it will be ever more difficult for central banks to keep interest rates low without un-anchoring expectations and creating instability in prices and output. The time to raise interest rates may well be sooner than previously promised.

Expert and non-expert opinions on inflation and interest rates are everywhere. One of the more interesting takes has been the suggestion that governments actually want higher inflation combined with low interest rates to eliminate the unsustainable debt burden that has built up recently. 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 might higher inflation mean for the ‘average Kiwi’?

Savers face more punishment

If you’ve read this far, you’ve probably got the message that any person, family, or business with banked savings (including in term deposits), could see the value of those dollars quickly eroded. Even low inflation can be disastrous to your term deposit returns.

Borrowers could benefit

In the exact same way that some have suggested, higher inflation and low interest rates should also benefit debt-riddled governments the world over, and Kiwi families or individuals with chunky debts such as mortgages might welcome inflation. The value of their debt in real terms will shrink, and assuming a few other things, like their income rises with inflation too, they’ll be left owing a smaller sum in real terms.

Higher prices

Higher inflation usually means higher prices for goods and services. The complicated bit is that the price of all things doesn’t usually rise equally. So, maybe the price of groceries stays the same, maybe electricity prices fall, and maybe the prices of other things like petrol and housing increase. Maybe the opposite happens.

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

The bottom line - inflation could mean your dollars are worth less

Take everything written here with a grain of salt. Predictions about the future are wrong more often than they’re right, and 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. Present-day predictions are even more tricky to make while Covid is so rampant across most of the world.

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

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