Remember when you could buy a Big Mac at McDonald's for $1?
That was 25 years ago.
Today, a Big Mac costs $7.
This increase in prices over time is known as "inflation".
Interest rates, economic activity, and the supply of money all affect inflation.
Inflation is an important part of economics for an investor to understand, because the level of inflation affects everything from house prices to mortgage rates to the share market.
In this article you will learn exactly why inflation happens, how government's control it and what you can do as an investor.
How Is Inflation Measured?
The government measures inflation by taking a "basket of goods" that the average citizen buys regularly, then watching how the price of that basket of goods increases over time.
If the price of the basket increases 5% over a year, inflation is recorded as 5%.
The NZ government says their current basket of goods includes 11 categories:
Housing and utilities
Recreation and culture
Clothing and footwear
Alcohol and tobacco
Household contents and services
Miscellaneous contents and services
This price of this basket is referred to as the CPI (Consumers Price Index).
Don't be scared by the fancy name. It's just a way of saying "prices of all the stuff in the basket".
If the government says the CPI went up 2%, it means inflation for the year was 2%.
What is inflation right now in New Zealand?
Take a look at the historic inflation figures according to the NZ government:
As you can see, inflation has mostly been around 1-2% for the past thirty years.
However, in recent years it's been higher than it's ever been (we'll discuss why later on).
Inflation is not bad!
Remember - the goal is not to avoid inflation.
Inflation is like Marmite; too much is a disaster, but too little isn't fun either.
There's a sweet spot to aim for where it's just right.
However, this can be difficult because inflation has lots of moving parts.
Let's take a look at them:
Why would we WANT inflation?
You might think, best to avoid inflation, we don't want prices going up!
But the reality is, prices going up is much better than prices going down (deflation).
If prices are always going down, nobody would want to start businesses (would you want to open a shop just to sell things for less and less every year?)
People would also buy fewer things, because they know if they wait they'll be able to buy it cheaper in the future (would you ever buy a house, if you expected the price of it to keep going down every year?)
When we have inflation, the effect is the opposite.
People try and buy things now, because they know the price will rise in the future.
They also invest more, because they know their money is losing buying power as the prices of things go up.
Therefore, it's important to have some inflation so people will want to own businesses, people will buy things, and this will lead to the economy growing rather than shrinking.
In the past, deflationary periods (prices going down) have always proven bad for a country's economy (such as The Great Depression).
Why would we NOT want inflation?
The obvious reason is as prices go up, life becomes more expensive.
If people cannot afford their basic "basket of goods", the quality of life in the country deteriorates.
If people are struggling and cannot afford things, businesses will struggle to make sales and the economy will struggle to grow.
Inflation also affects the value of your currency.
If prices are rising quickly in NZ, people will hyper spend and want to get rid of all their dollars quickly, as they know the dollars will buy less and less each month.
This can lead to a situation where NZD starts becoming worthless - huge amounts of NZD will be floating around that nobody wants (like what happened in Argentina, Zimbabwe and Venezuela).
So, we want a little bit of inflation, but not too much.
It is the government's job to keep inflation under control.
How The Government Controls Inflation
In NZ, the government's current inflation target is 1% to 3% per year.
The government controls inflation with two main "levers".
What happens when inflation is going down in New Zealand?
If the government believes inflation is too low, they will reduce interest rates.
When interest rates are low, people don't save. Since they're earning so little at the bank, they look for ways to spend/invest their money instead.
Cash leaves people's bank accounts and floods the economy, flowing to businesses and markets, and the economy grows.
People also borrow more when interest rates are low (how many times have you heard "now is a great time to buy, rates are low!").
Attracted by low interest rates, people will take on loans and debt, put holidays and expensive clothes on credit cards and not worry too much about the repayments.
What happens when inflation is going up in New Zealand?
When inflation gets too high governments do the opposite - they raise interest rates.
This cools down spending and people start keeping more money in the bank (if your bank offered you 15% interest on a term deposit, wouldn't you be encouraged to save more?)
People are also discouraged from taking on debt, because it becomes more expensive (if mortgages were going for 15% interest, do you think everyone in NZ would still be trying to buy houses?)
The effect is a large amount of money sits in bank accounts, and spending dries up.
This causes the economy to shrink, prices need to come down (to encourage buying), so inflation decreases.
This is exactly why the government started raising interest very quickly in 2022, when inflation in New Zealand started to spike (5.9%).
The second "lever" the government uses for controlling inflation is the money supply.
"Money supply" basically means the amount of money floating around the country.
If inflation in New Zealand is too low, they will aim to increase the money supply.
They can do this easily by printing more money.
By putting more money into people's hands, people will spend more, businesses earn more, inflation goes up and the economy grows (this is why governments started printing a lot of money during Covid, to make sure the economy didn't shrink too much).
If inflation in New Zealand is too high, the government can decrease the money supply.
They do this by selling government bonds (for example, the government could sell 20b of government bonds to citizens, meaning the citizens will give them $20b in cash, and the government will issue them with interest-paying bonds. This effectively takes $20b out of the money supply very quickly and easily).
With less money floating around, spending goes down, prices will need to fall, and inflation decreases.
Inflation Is (Probably) Higher Than You Think
One thing myself and a lot of other investors I talk with have noticed: How low inflation figures are.
For example, in the table I showed earlier, we can see the average rate of inflation since 1990 has been around 2% per year for thirty years.
I also told you a Big Mac used to cost $1 when I was a child., and it now costs $7.
If you take $1, and inflate it at 2% per year for 30 years, do you know what the result it?
Not even close to $7.
For a product to go from $1 to $7 in thirty years, do you know what the required inflation rate is?
6.75% per year.
Let's use some other products.
When I was a kid, a child movie ticket was $5.
It's now $17.50.
That's an inflation rate of 4.3% per year.
A can of Coke used to be $1 from the machine.
It's now $3.
3.8% per year.
I won't even bother with house prices!
I don't know about you, but I can't think of a single product I use regularly that has only increased 2% per year.
What I'm saying is - inflation is almost certainly higher than what official statistics show (in my estimation, about double).
Why is this? Is it because the government is just lying to us?
No, I don't think so. However, I do think they pick and choose which products they use for CPI estimates "strategically", and as most governments do, try to use the numbers that make them look best. Among other things.
That's not my point, though. What the government reports is out of your control. My point is to judge inflation with your own eyes and bank statement, not by a number the government prints on their website.
If you buy the same grocery list every week, and the price has risen by 20%, guess what?
Inflation is 20%.
What if the government says it's only 1%? Does your grocery list magically become 19% cheaper?
It's still 20%.
Inflation is a very important metric for your investment decisions - temper the official statistics with what you see with your own eyes in real life.
What can I do as an investor?
Understand the moving parts of inflation as I have explained them above.
Then, be proactive.
For example, these are some actions I might take:
If inflation is rising
I will anticipate interest rates going up.
I'll give myself breathing room - keep some cash, think about fixing my mortgage at low rates, and I won't over-borrow.
When interest rates go up, stocks and real estate prices will probably fall.
It'll be advantageous to have cash reserves when that happens.
If inflation is falling
I will anticipate interest rates going down (or staying low).
I will keep my mortgage on a floating rate, and if I need to borrow money, I will wait until rates fall.
I will expect asset prices to be slightly inflated, so will very selective with my stocks and be careful to not overpay.
If interest rates are high
I will keep cash to enjoy the high savings rates,
However, I will also anticipate interest rates coming down if inflation is lagging.
Possibly fix some term deposits at good rates, and shop for depressed assets in stocks and real estate (because not many people will be buying).
If lots of money is being printed
I will anticipate high inflation (especially if interest rates are low).
I will probably buy assets, but stick to high dividend paying companies.
I will possibly aim to hold various currencies (or cryptocurrencies) to reduce the risk of holding a weakening NZD.
Finally, during inflationary and money-printing times, I would be in business!
Get customers, sell things! That is the time when money is flowing.