Inflation – is 3% the new 2%?

Inflation is well down from the multi-decade high of 7.3 per cent that prevailed a few years ago, but it remains stubbornly above that elusive two per cent level.

We’re not the only ones grappling with pricing pressures, and there’s a growing chorus of commentators asking whether something more structural is at play.

In New Zealand, inflation has averaged 4.2 per cent over the past century, driven by the extremely high inflation of the 1970s and 1980s.

The consumer price index (CPI) rose at an annual rate of 11.7 per cent over that 20-year period, wreaking havoc across our economy.

In the US, it was a more modest (but still challenging) 6.2 per cent during those two decades (also above the 100-year average of 2.9 per cent).

That period saw the Reserve Bank of New Zealand (RBNZ) tasked with bringing inflation down, and in 1990 a specific target range of 0-2 per cent was put in place.

That initial range was adjusted to 0-3 per cent in 1996, before it was narrowed to 1-3 per cent in 2002 (where it remains today).

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Other central banks across the world followed our lead and inflation was low and stable for the bulk of the next 30 years.

In fact, inflation was a little too low in the decade following the global financial crisis, averaging 1.6 per cent in New Zealand and 1.8 per cent in the US.

That was despite policymakers employing a raft of measures to try and increase it.

In the US, the Fed Funds Rate spent three quarters of the 2010s below one per cent, while additional stimulus policies like quantitative easing (QE) were in place too.

Our Official Cash Rate (OCR) averaged about 2.5 per cent and never went above 3.5 per cent at any point.

This decade (which coincided with the Covid-19 pandemic in early 2020) has been very different.

Our inflation rate has averaged 4.1 per cent these last six years, while in the US it’s been 3.9 per cent.

Both countries have seen it fall from the recent highs, although we’re still up at 3.1 per cent and in the US inflation has persistently been above target.

Australia and the UK have also found it difficult to get back to their targets, with the respective CPIs in those countries running above three per cent.

This last mile back to two per cent is already proving harder than expected, and many would argue that deglobalisation, demographics and the energy transition might entrench that dynamic.

Fiscal dominance is another factor, and arguably the most important of all.

This describes a world where government debt has become so large that central banks can no longer raise interest rates sharply, without causing damage to public finances.

Higher rates increase the government’s interest bill, and those payments flow directly to households, pension funds and investors as income, which supports spending and economic activity.

Because there is much more debt outstanding today than in the past, these flows are large enough to offset some of the cooling effects of higher interest rates.

Ironically, in some ways this can add to inflation, rather than completely suppressing it.

As a result, policymakers could become happier to tolerate slightly higher inflation rather than risk destabilising growth or triggering any fiscal issues.

If proponents of fiscal dominance are correct, this is creating a structural shift away from the ultra-low inflation environment that defined the decades leading up to the pandemic.

Highly-indebted governments would also benefit from letting inflation run slightly higher.

Conveniently, this would gradually reduce the real (inflation-adjusted) value of their borrowings over time.

If three (or even four) per cent was new two per cent, this would have important implications for investors.

Shares typically perform well against the backdrop of moderate inflation, as companies can grow their revenue and earnings alongside rising prices.

Commodities have proved a good hedge for investors in the past, while other tangible assets like infrastructure and high-quality real estate can also do well.

In contrast, cash and bonds would have a tougher time.

Their returns are fixed, which means their purchasing power can be eroded over time.

Maybe we need to give monetary policy more time to do its job, or maybe there’s been a more permanent change in the landscape.

Without going overboard, investors might be wise to consider an environment where inflation is indeed a little hotter, and ensuring they’ve got assets that can outpace it.

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