Explainer: What in the world is inflation and why do we care?

Saturday, 26 November 2022

The overall inflation rate gives a good measure of the bigger picture, but it’s just an average. Video first published August 30 2022.

It’s been a tough week for homeowners and anyone with a wallet as the Reserve Bank raised the official cash rate and announced a recession was looming.

And it is all thanks to inflation, which reached a 32-year high of 7.3% in July and currently sits at 7.2%.

We asked an economist all the things you might be too afraid to ask about inflation and why it is affecting us so much.

What is inflation?

Inflation is most commonly measured by the consumer price index (CPI).

The CPI tracks the price of a huge basket of goods and services that are chosen and weighted every three years to be reflective of what people are spending their money on.

* Reserve Bank tasked with an impossible riddle

Infometrics principal economist Brad Olsen explains inflation.

* Judith Collins flirts with ACT's Reserve Bank house price policy

Stats NZ makes about 100,000 prices checks every three months to compile its quarterly consumer price index, visiting shops and websites to observe how prices have changed and surveying businesses on their prices.

Inflation relates to supply and demand, so prices will rise if there is more money chasing fewer goods and services. And thanks to the pandemic, this is where we are at right now.

Why is it bad?

Infometrics principal economist Brad Olsen said inflation erodes the purchasing power of money, and so high inflation means Kiwis pay more for stuff, but get less actual stuff for that money,

Inflation is most commonly-measured by the consumer price index (CPI).

Put another way, higher inflation gives you less bang for your buck, with fewer of the same items able to be bought with the same amount of money.

“High inflation can also become both self-reinforcing, and structurally affect how households and businesses plan.”

Let’s say that inflation is high and running at 7% per annum.

If you know that buying something is going to cost you 7% more next year, then you’ll be more likely to want to go out and buy that item now, before the price goes up.

Reserve Bank Governor Adrian Orr holds a press conference after announcing the official cash rate hike of 75 basis points.

“But if everyone does the same thing and goes out and tries to buy that item now rather than next year, demand will outstrip supply, which will cause the seller to raise prices, which will increase inflation – in this scenario, fearing inflation fuels inflation, and it’s a vicious cycle.”

That’s why inflation, and people’s expectations of inflation, are so crucial, Olsen said.

“If people expect that inflation remains low and prices are fairly stable, they won’t change their buying habits too much. If expectations become unanchored and people don’t believe that prices will be fairly stable in the future, then you get problems where people think short term and can’t plan accurately for the future.”

Why is inflation in the hands of the Reserve Bank?

“Everyone’s got a different job to do, and before we had an independent central bank (the RBNZ), inflation got really high and whipsawed a lot,” Olsen said.

The independence of the Reserve Bank, and its focus on inflation, and also maximum sustainable employment, are so that it can make the difficult, but ultimately necessary, decisions on policy that will enable price stability over the medium term so that businesses and households can plan for the future and can be more confident about said plans.

“Making those tough and sometimes unpopular decisions requires independence,” says Olsen.

“Politically, it’d be fairly difficult for the government itself to try and target inflation – what politician is going to like increasing interest rates and making people pay more for their mortgages? It’d be a vote loser, and so it wouldn’t happen and inflation would likely run at a higher rate.”

So instead we give that job to RBNZ – its job is to keep inflation under control by tweaking interest rate settings to dial up or dial down spending and saving signals.

RBNZ tries to keep inflation between 1% and 3%.

“It’s important to note that government has a role to play too,” Olsen said.

The government, through fiscal policy, can target support to those who might be hit the hardest by monetary policy changes, or a lack of monetary policy action, to level out the distributional effects of monetary policy – “a scalpel if you will, with more surgical precision to target outcomes”.

So why do we target the 1-3% range, and why does it matter so much?

A target of 1-3% is seen as an appropriate target for price stability over the medium term, partly because measurement bias means that inflation of around 1-3% might actually be a bit lower than that – hence we’re targeting general price stability with a bit of wriggle room, Olsen said.

“In terms of why it matters so much – it’s because we’ve worked hard over the last couple of decades to focus on achieving price stability and grounding that expectation in people’s heads.

“By anchoring inflation expectations at around this level of 1-3%, people expect that prices next year will be fairly similar to a year before, meaning they can plan better and make longer-term decisions.”

Although it also means that when actual inflation rises, households also expect and trust the Reserve Bank to get it back under control, he said.

“The risk New Zealand and the world faces at the moment is that the longer actual inflation is outside the 1-3% target, the more inflation expectations become unanchored and households expect prices to be rising faster in the future, which risks becoming a self-fulfilling prophecy.”