INSIGHTS BLOG

WHAT IS INFLATION AND WHY IS EVERYONE SO OBSESSED WITH IT?

Roy Davidson, 19 September 2019

In this article we explain what inflation is, why it’s seen as important, and some potential causes as to why it has been so lacking in recent years.

What is inflation?

Originally, inflation (in an economic sense) meant an increase in the money supply, which would in turn result in higher prices, as more money is now chasing the same amount of goods and services. However, today, inflation simply refers to an increase in the average level of prices across an economy, reflecting a loss in purchasing power of each dollar.

Inflation is the reason a 600ml bottle of coke cost around $2.00 less than 20 years ago, now costs $4.00.

Inflation is most commonly measured by the consumer price index, or CPI. However, other measures may also be used, such as the personal consumption expenditures (PCE) which is the preferred measure of the US Federal Reserve.

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Inflation isn’t the only form of ’flation’ however.

Deflation refers to a decrease in the general price level. In other words, deflation is an inflation rate less than 0%. The last time deflation occurred in New Zealand (on an annual basis) was in 1999.

Hyperinflation is a rapid rise in price levels, usually defined as the monthly inflation rate exceeding 50%, and is caused by a large increase in a country’s money supply. Hyperinflation is crippling for an economy, with people unable to rely on currency as a store of value.
Examples of hyperinflations include:

  • Weimer Republic in the 1920’s - with prices doubling every four days at the peak
  • Zimbabwe in the 2000’s - where the government took to printing a 100 trillion dollar note
  • Hungary in the 1940's - hitting a peak monthly inflation rate of 13,600,000,000,000,000% - or 13.6 quadrillion per cent.

Stagflation (stagnation and inflation) is rarer, and refers to a combination of a rising price level and declining gross domestic product – these two things normally move in the same direction. The most famous example of stagflation is that which occurred almost globally during the 1970’s, caused by a combination of oil price shocks and poor monetary and fiscal policy, and ultimately led to the economic reforms of the 1980’s.

Why do people fixate on inflation?

Targeting a steady rate of inflation (normally around 2%) has become the main goal of central banks around the world. For example, the Reserve Bank of New Zealand (RBNZ), in accordance with the agreement it maintains with the government, aims for an inflation rate of 1-3% over the medium-term, with 2% the target.

The RBNZ was the first central bank to introduce inflation targeting and since doing so, the volatility in rates of inflation in New Zealand has reduced significantly, as illustrated in the chart below. A similar experience has been shared worldwide as other countries introduced inflation targeting.

As a result of central banks targeting a rate of inflation, what is happening to inflation rates has an important bearing on the actions of central banks, and consequently, economic growth.

A high rate of inflation will force a central bank to tighten monetary conditions and raise interest rates, putting a brake on economic growth. Likewise, a low rate of inflation means it is more likely a central bank will maintain more accommodative monetary policy by keeping benchmark interest rates low, thereby stimulating economic activity.

Inflation rates in New Zealand since 1914

Inflation-sep-19

Why has inflation been so low?

This is the million dollar question and, as with most things, it is likely that several factors are at play in offsetting monetary policy actions designed to lift inflation.

Firstly, globalisation has continued to place downward pressure on the prices of consumer goods, with low wage economies such as China replacing manufacturing in higher cost economies in the developed world.

In addition, ongoing technological advancements continue to drastically lower the cost of consumer goods (think TVs or PCs), reducing the reliance on labour, and feeding through to lower overall consumer prices.

Finally, high levels of debt may be a culprit. With consumer and government debt levels at higher levels than in previous cycles, households and politicians across the world may be less willing to borrow and spend at the same rates than in the past.

It is worth noting, however, that while consumer price inflation has been subdued, asset price inflation has been anything but. Ignoring dividends, the NZX 50 surpassed its 2007 high back in 2016 and has increased by around 170% from its 2009 lows. Bolstered by low interest rates, the new money created from loose monetary policy has found itself invested in asset markets.

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