Inflation Nation: Why the cost of living is rising and what we can do about it

The rising cost of living and the return of inflation is hitting Kiwis hard. In a new Herald series, Inflation Nation, we explore the reasons and impacts of the price shock – and possible solutions. We also share some great life hacks on how you can save money and live more affordably.

Here, Liam Dann explains how we got into the inflation spiral – and how we can get out of it.

Inflation is back.

After more than 30 years in the wilderness, its return will trigger bad memories for many New Zealanders.

Inflation was the economic monster that New Zealand vanquished.

It arrived with the oil shocks of the 1970s, it took flight during the boom and bust years of the 1980s.

It turned our politics upside-down, it took us to the brink of bankruptcy and forced us to reinvent our economics.

It pushed mortgage rates to 20 per cent, unemployment to double-digits.

It left scars on a generation and opened up social divides we have never managed to close.

We wrestled with it for years.

But we won.

Our Reserve Bank pioneered a bold new policy approach – it set hard targets for inflation.

We showed the world how to beat it.

We brought inflation down in the hard recessionary grind of the early 1990s.

Now it is back.

Perfect storm

For those aged under 40, rapidly rising prices will be a shock to the system – something they haven’t experienced in their adult life.

Retail interest rates returning to historically normal levels (around 5 per cent) will cause serious pain for new mortgage holders, loaded up with enormous levels of housing debt.

“I don’t believe many have realised yet, the extent of the adjustment that is ahead,” says NZIER (New Zealand Institute of Economic Research) principal economist Christina Leung.

Inflation pressure has been building for at least a year.

In October the Reserve Bank started lifting the official cash rate to try to head it off.

By the end of the year, the annual rate of consumer price inflation was already sitting at a 30-year high of 5.9 per cent.

Just a few weeks ago the Reserve Bank was forecasting it would hit a peak of 6.6 per cent in the first quarter of this year.

But when Russian President Vladimir Putin invaded Ukraine the move delivered an oil shock on a scale we haven’t seen since the 1970s.

Russia and Ukraine also account for a large chunk of the world’s wheat supply, the chemicals for fertiliser, rare minerals and gases for computer processors.

You name it and the price has soared in the past three weeks.

For many New Zealanders the reality of rising costs has just started to hit home.

Mortgages are rolling off their fixed rates.

Suddenly it’s hard to fill a tank of petrol or a shopping trolley without feeling anxious or angry.

Last week economists at the ANZ published sobering new forecasts.

They are picking that inflation will now peak at 7.4 per cent and will linger for longer.

The last time it went higher was June 1990.

The Reserve Bank is “behind the game”, wrote ANZ chief economist Sharon Zollner.

It would need to deliver back-to-back 50 basis-point hikes – doubling the official cash rate by May, she said.

“It is a bit scary to think about how this will all play out,” says the NZIER’s Leung.

What is inflation?

One of the problems with inflation is that the cure – lifting interest rates – can cause its own economic pain.

Good inflation is generally considered to be around 2 per cent per annum.

Central banks try to keep inflation about that level by controlling the money supply.

The main way they do that is to set the cost of borrowing with the official cash rates.

But when economists start to talk about money supply things can get complex fast.

Inflation itself is a relatively simple economic concept to grasp.

It’s the cost of everything going up, the price of everything rising.

That includes obvious consumer products – like the petrol in your fuel tank, your groceries, your power bill.

It also includes services like the cost of getting a plumber or builder in.

It includes labour costs … hopefully that means your wages too.

The problem is that all these things don’t rise equally.

For example, wage increases almost always lag rises in the cost of living.

When inflation runs ahead of the deposit rates you earn on your savings, then it erodes the value of those too.

If you flip the concept around, inflation is the value of a dollar going down.

Not only does that make people poorer, it can undermine the public’s trust in money.

Our behaviour as consumers changes if can’t be sure what a dollar will be worth next month – or next week.

History is dotted with examples of inflation spiralling out of control (dubbed hyper-inflation) and causing social disruption.

Most famously it brought the German economy to its knees in the 1920s and paved the way for the rise of fascism.

There is no prospect of hyper-inflation on the horizon. But we are facing a new economic era.

Who's to blame

“The pandemic definitely reset the economy in a lot of ways,” says NZIER’s Leung.

“First and foremost it moved us out of that period of low inflation.”

The main channel for that shift was through supply constraints, she says.

“We see that with the labour shortage and global supply-chain disruptions.”

As Covid-19 hit the world in late January 2020, local economists were still expressing relief that consumer price inflation had risen to 1.9 per cent for the 2019 year .

Since the last big economic shock (2008’s global financial crisis) our economy had been battling deflation (the problem of falling prices).

The next three months of 2020 delivered an economic shock to rival the GFC.

The pandemic forced the world to lock down. Markets plunged and there were fears that we faced a major recession.

The concern was that consumers in lockdown would stop spending. Businesses would fold and unemployment would rise.

Central banks and governments around the world unleashed trillions in stimulus to maintain confidence, prop up businesses and save jobs.

It worked, but possibly too well.

With hindsight, we have learned that consumer demand can remain strong during a pandemic.

In part because New Zealand’s lockdowns and closed borders allowed long periods of relatively normal activity.

In part, it was because businesses and consumers adapted faster than expected – embracing new technology to keep trading.

“The surge in inflation underscores one of the biggest lessons of the last year: The Covid shock was not like a ‘normal’ recession, where the economy suffers a shortfall in demand,” Westpac economists conclude in their latest quarterly outlook.

“Policymakers responded under the assumption that they would need to revive demand, and that support was particularly valuable during the periods of lockdown.

“But for the most part the pandemic has been a productivity shock, which has weighed on the economy’s operating capacity.

“Demand stimulus, plus capacity constraints, have meant a double whammy for inflation.”

To acknowledge all that is not to put the blame on policymakers, says Westpac chief economist Michael Gordon.

“Their aim was to err on the side of doing too much rather than too little, and they
deserve credit for achieving that – stubborn inflation is a better problem to have than stubborn unemployment,” he says.

“But there was never going to be a cost-free solution to a shock of this nature, and the bill is now coming due.”

However, people feel about New Zealand’s economic Covid response it was hardly unique.

“New Zealand differs from the rest of the world only by a matter of degree,” says Gordon.

The pessimists won

Through 2020 and most of 2021 central banks tried to look through the pandemic-fuelled inflation spike.

Amongst economists, debate raged about whether rising inflation pressure was “transitory” or “structural”.

The optimists were in the former camp, the pessimists in the latter.

Sadly, events have favoured the pessimists.

The rise of new Covid variants extended the time frame of the pandemic. Supply-chain disruptions haven’t eased as quickly as hoped.

This has allowed time for inflation to take hold in the domestic economy.

Essentially, as prices rise workers demand wage rises to keep up – particularly when unemployment is low.

As wages rise businesses have to put up prices to meet costs. And so a self-perpetuating inflationary spiral takes hold.

The question of who to blame for this remains a hot political topic.

Opposition parties and business groups argue that the Government’s policies, like the minimum wage rises, were poorly timed and added to the problem.

Other criticisms lead back to bigger divisions about our Covid response, like the merits of keeping our borders so tightly closed.

Who is hurting?

As well as producing a headline inflation figure with its Consumer Price Index, Stats NZ does a version that weights the cost of living for different demographic groups.

Called the Household Living Costs Price Index, it has shown that those on fixed incomes – such as beneficiaries and superannuants – who spend more of their total weekly income on basic necessities like rent and food are the biggest losers.

The latest data showed high-spending households experienced the greatest rise in living costs last year.

This was mainly influenced by higher prices for petrol, mortgage interest payments, and second-hand motor cars.

Prices for interest payments, including mortgage payments, increased 7.8 per cent in the December 2021 quarter.

Māori households experienced an annual living-cost increase of 5.3 per cent from December 2020 to the December 2021 quarter, compared with the 5.2 per cent experienced by the average household.

Technically, beneficiary households actually saw the lower annual living-cost inflation of 4.8 per cent from December 2020 to the December 2021 quarter.

But that was simply because, in relative terms, those households spend a small proportion of weekly income on petrol and interest payments when compared with the average household, Stats NZ said.

In real terms, if your household costs rise by $50 or $100 that will be far more difficult to manage if your household income is only $500 a week – compared with salaried workers taking home $1000 a week or more.

Inflation eroding the value of your savings is one thing. Inflation leaving you unable to feed your children is another level of concern.

Can we beat it?

The good news is that history tells us we will beat inflation.

The bad news is that more often than not it takes a cycle of rate hikes pushing the economy into recession before it is beaten.

Some analysts, such as Fisher Funds’ head of fixed income, David McLeish, have urged caution.

“There seems to be an assumption that interest rates can bring this sort of inflation down. And what’s more, that it can bring it down without causing an economic downturn,” he told the Herald after the Reserve Bank’s monetary policy statement last month.

“Higher interest rates, in my opinion, have very little impact on this kind of inflation,” McLeish said.

“How are you going to fix supply bottlenecks around the world by raising New Zealand interest rates? I’d actually go as far as to say that it will make things harder.”

Higher interest rates could curb investment in production as the cost of capital rises.

“That actually flies in the face of what they’re doing,” he said. “So there are risks.”

But others, like ANZ’s Zollner, are more hawkish, arguing the opportunity to sit back and let global supply pressure ease has passed.

“With inflation heading to almost 7.5 per cent, the wiggle room to add judgment, to give growth a chance, to take a punt on allowing inflation to return to target a bit more slowly, to see whether inflation shocks dissipate on their own, is gone,” she says.

NZIER’s Leung has no doubt that, one or another, we can beat this latest cycle of inflation.

“Certainly if you were to keep ramping up interest rates you will,” she says.

But there will be economic costs to doing that.

“I guess the more critical question is [what’s] the transition path we take to get on topof inflation.”

That debate gets political fast.

There are still plenty of New Zealanders who feel the price of fighting inflation so aggressively in the early 90s – pushing unemployment to 12 per cent – was too high.

But, says Leung, New Zealand’s economy is much stronger this time around.

“In a time of low unemployment, people still have areasonable degree of job security, that provides quite a solid foundation.”

These are not the 1980s and the economy is not as fragile as it once was.

Still, there’s no doubt the Reserve Bank faces a difficult and delicate balancing act if we are to get through this without a recession.

If rising interest rates and other costs like petrol and food start to slow spending too rapidly we could start to see economic growth stall and unemployment rise before inflation abates.

That could see a return to the conditions of the 1980s.

“The dreaded word: Stagflation,” says Leung.

Another problem is that the housing boom has inflated the size of mortgages to a precarious level.

“Given in that we’ve been in that time of loose monetary policy for so long and people were encouraged to take on all that debt, how all that will unravel will be interesting to watch,” says Leung.

“It’s the end of easy money, says Kiwibank chief economist Jarrod Kerr.

He notes that about 70 per cent of mortgagees will face higher mortgage rates as their loan rolls over in the next year.

He estimates that most fixed mortgage rates will be between 1 and 2.5 percentage points higher than the rates offered today.

“We expect mortgage rates to end 2023 between 5 and 6 per cent,” he says.

If there is an optimistic scenario here, it’s that the global and local economies are rebalancing in a direction that was long overdue.

Even before the pandemic, economists were warning that interest rates need to rise.

Unfortunately, as is usually the case, the economy isn’t rebalancing in an orderly fashion.

Instead, it’s all happening fast, triggered by events that were largely unpredictable.

But pandemic pressure is easing, eventually efficiencies will return to the supply chain, technology will reassert its downward pressure on prices and the cost of production.

The price surge of the past few weeks should ease eventually. Ideally, the war will end and commodity prices will fall back.

But even if they just plateau, the inflation shock will diminish as supply and demand find a new balance.

Business and consumers will adjust to tougher credit conditions and life will carry on.

“As I always say, ” says Leung. “It all comes back to supply and demand.”

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