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Image: Tina Tiller
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PartnersNovember 28, 2022

What inflation really means (and why it really matters)

Image: Tina Tiller
Image: Tina Tiller

With the topic of inflation – and whether or not we can curb it – heating to a high boil of late, we asked Kiwibank economist Mary Jo Vergara for a 101 explainer on what it is, why it matters and how consumers can best prepare for it.

Inflation has been a hot topic for a while now. What is it exactly?

Inflation describes the general increase in the price of goods and services in the economy. Everything from food to fuel, and health to housing. And inflation is measured by the Consumer Price Index (CPI). 

Every quarter (three months), Stats NZ samples the prices of a representative basket of goods and services. The (weighted average) price of today’s basket is compared to the basket of a different point in time. A positive change means a rise in prices – inflation. A negative change means a decline in prices – deflation. In 2022, annual inflation reached a 32-year high of 7.3%.

We’re also hearing a lot of the phrase ‘cost-of-living crisis’. What is it, and are we in one?

A cost-of-living crisis is a situation in which the rise in consumer prices is outpacing the rise in wages. At an annual rise of around 4%, wages in Aotearoa are clearly growing at a slower pace than inflation, and households are seeing their real incomes eroded. So it’s fair to say that we, like many countries around the world, are currently experiencing a cost-of-living crisis. 

Unfortunately, households on low or fixed incomes are hardest hit. Food and fuel – both of which have seen the largest increases in price – make up a larger share of the budget, and these households typically don’t have as much wriggle room. Budgeting becomes that much more of a head-scratching exercise.

Kiwibank economist Mary Jo Vergara (Photo: Supplied)

How are prices for goods and services determined? 

Some items in the CPI basket face foreign competition. Items including petrol, food and apparel, are vulnerable to international price movements and fluctuations in the local exchange rate. A weaker NZ dollar lifts the price of imported goods, and our exports become more attractive on the international stage. 

More demand for what we produce is also inflationary. These items make up the tradable – or imported – component of inflation and account for around 40% of the CPI. The remaining 60% are goods and services that we produce here in Aotearoa for our own exclusive consumption. For items including council rates, rents and education, prices are instead influenced by developments in the domestic economy. These items make up the non-tradable – or domestic – component of inflation. 

How did we get to a 7.3% inflation rate?

The recent surge in inflation certainly has its origins offshore. Covid disrupted trading ports which pushed up shipping costs. And the war in Ukraine sent commodity prices, especially oil, spiralling higher. Tradable inflation hit a high of 8.7% in 2022. That’s the largest annual rise since Stats NZ began reporting the domestic/imported split in 2000. We continue to import inflation from offshore. Around 46% of the overall increase in consumer prices has been driven by international price pressures. That’s an outsized move given it’s ~40% weight in the CPI basket. 

The growing strength of domestically generated inflation however is more concerning. Because it’s the kind of inflation that stems from strong demand and so is harder to tame. Domestic inflation is sitting at 6.6%, which is also a record high. Demand is far outstripping supply in the economy. Excess demand and domestic capacity pressures are sustaining inflation. So while tradables inflation is big in terms of contribution to total inflation, non-tradables is still bigger. Around 54% of the annual jump in prices was domestically generated. 

So where to from here for inflation?

Good news, the path for inflation looks to be downhill from here. Bad news, it’s likely to be a slow trek back to the Reserve Bank of New Zealand’s 2% target rate. Several indicators suggest that the pressure on global supply chains has eased materially. Global shipping costs have firmly turned south, and capacity is expanding with more ships being built. 

Strong domestic inflation however risks an extended period of high inflation. We see inflation remaining stubbornly above 3% through to the middle of 2023. Inflation indicators continue to flash red-hot and there’s real risk long-dated expectations become unanchored from the target.

With a recession looming, Reserve Bank governor Adrian Orr warned of a need to curb consumer spending in the lead-up to Christmas. (Photo: Getty Images)

How does inflation affect interest rates? 

The RBNZ’s primary tool in delivering monetary policy is the official cash rate (OCR). It’s the interest rate that sets all interest rates in the economy. Given the state of the economy, the OCR is accordingly shifted up or down. When economic activity is slowing and inflation is falling below target, interest rates are slashed to stimulate growth. Conversely, when the economy is heating up, interest rates are lifted to cool down the economy and rein in rising inflation. 

With pandemic-induced disruptions and unprecedented amounts of fiscal and monetary stimulus, economies across the world find themselves in the latter environment. Central banks from Washington to Wellington are aggressively lifting interest rates in response to the rapid rise in consumer prices. The RBNZ has so far lifted the OCR more than 300 basis points from a record low 0.25%. That’s the fastest tightening cycle since the OCR was introduced in 1999, and the RBNZ is not yet done. More rate hikes are required to tame inflation, and more rate hikes are coming. We forecast the cash rate rising to a peak of 5% in 2023. 

What do higher interest rates mean for me and my whānau?

The RBNZ is lifting interest rates to dampen demand, better balance the economy and ultimately bring inflation back to target. But it takes time for changes in monetary policy to take effect. Given the overwhelming preference among Kiwi mortgage holders for fixed rates, the impact of higher interest rates comes later. Monetary policy operates with around an 18-month lag in Aotearoa. But the tighter monetary conditions will be felt, and soon. The upcoming spring/summer period is setting up to be a busy one. A significant chunk of the stock of Kiwi mortgages is due to be re-fixed in the next 6-12 months. And they’ll be rolling onto materially higher rates.

Higher rates should have a profound impact on household budgets. We are far more sensitive to rising interest rates given the significant run up of household debt over the past two years. Supported by historically low levels of unemployment, household consumption is holding up for now. But a slowdown in 2023 is expected. With high cost of living and rising debt servicing costs, it’s an increasingly expensive environment.

This content was produced in paid partnership with Kiwibank. To learn more about how they could work for your business, visit Kiwibank today.
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