Is global inflation deflating your wealth?

Around the world, many governments and central banks are struggling to control inflation, and many of us here in New Zealand are feeling the pinch from higher prices and higher borrowing costs, but what does it all mean and more importantly, what can you do during this time? This blog will highlight some of the common causes of inflation and we'll cover what you can be doing to manage inflation.

Consumer prices are increasing. Many people, including the experts, originally felt this inflation was "transitory", and due to the restrictions from COVID-19, but now it seems to have settled in for the long haul.

The annual inflation rate in New Zealand is 6.9% over the year to March 2022 - drastically higher than our average of 1.6% for the decade prior to the start of the pandemic in 2020. 

We experience inflation as the price of goods and services increases over time. It is not just one thing becoming more expensive, but many of the things we buy on a daily basis - from a cup of coffee or a tank of petrol, to rent and the cost of the roofs over our heads. As a result of inflation, our money becomes less and less valuable. A dollar is still a dollar - but it buys less than it could a year or even a few months ago. 

So, what causes inflation? Many things can lead to price increases - and a concern is that once inflation starts to pick up like it has this year, it can be hard to stop. Let's run through what we think are the three common causes of inflation that are occurring now:

1: Supply shocks can be a significant source of inflation pressure

For example, in 1973 the main oil-producing nations of the Middle East severely restricted volumes of oil they exported. Oil prices increased dramatically here and abroad - it was no surprise that it was called the "Oil Shock". Because oil was so essential to the economy, production costs and thus retail prices increased on just about everything. The rate of inflation went from 4% at the start of the 1970s to over 18% on several occasions over the next 20 years. The oil shocks in the 1970s led to a prolonged period of intrenched inflation both here and abroad. New Zealand consumer price inflation averaged 11.7% per year over the period from 1970 to 1990.

Supply-driven inflation is one of the causes of our current bout of inflation. Covid-19 lockdowns and home isolation requirements reduced production levels around the world. Global supply chains from the factory floors to shop shelves have been severely disrupted. This has affected many parts of the economy, including transport, farming, mining, energy, manufacturing, and retailing. Many of life's essential goods were both in short supply and hard to get to consumers, which increased prices on almost everything. This year, the war in Ukraine has added to the pressure on food and energy prices as supply of both is reduced and restricted because of the tragic conflict.

2: Sometimes inflation is driven by high demand, when there is a lot of money circulating in an economy

Governments of many developed economies around the world pumped huge amounts of cash into their economies to help cushion the blow of COVID 19. Central banks also cut interest rates to all-time lows, to help drive down the cost of borrowing during the pandemic. 

The support from government spending and low interest rates kept the wheels of the economy spinning - but they also created inflationary pressure because demand for many goods remained strong, at a time when supply of some products people wanted to buy was restricted. 

The Government and central bank responses during the pandemic also contributed to consumer demand being stronger than expected during a period of such challenging circumstances. 

3: Very low unemployment can also contribute to inflation pressures

Low unemployment rates feel like a good news story, and it is. Full employment is a target that both the Government and the RBNZ have in mind when they make their decisions. But when the labour market gets very tight, and the unemployment rate is very low like it is now, it also creates inflationary pressures in an economy. If there's no one looking for a job, employers will try to attract and keep their workers with higher wages. That increases the cost of production. Businesses then want to increase their prices to cover those higher costs to maintain their profits. 

Again, Covid has introduced this pressure. Unemployment was already low prior to the pandemic, and the lift in the unemployment rate during the pandemic was very low compared with early estimates. A shortage of workers and restricted movements of people, combined with a strong economic recovery and strong employment after the initial shock of the pandemic has led to upward pressure on wages. This wage growth is part of an inflation trifecta.

An economy is big enough to absorb one of these things, especially if it is short-lived. But if the impact is strong or long, inflation can take hold as it starts to feed on itself. 

Widespread and sustained price increases mean people can't get by on the same income. They demand more pay, which kicks off another round of price increases. Getting it under control is hard, and usually involves central banks, like the Reserve Bank of NZ, slowing down the economy by increasing interest rates. That acts like a brake on the economy, slowing it down and reducing demand to a more sustainable level.

Inflation can eat away at the returns on investments - especially income assets, like bonds or term deposits. For example, if the interest rate return on income assets is a solid 5%, but the purchasing power, or value of money is reducing by 7% because of inflation, then your position is going backwards. Your $100 invested at the start of the year turns into $105 by the end of the year, but a purchase of a good that cost $100 at the start of the year costs $107 at the end of the year. 

Growth assets, such as shares and property, can be less affected by inflation. But now, both shares and property are going down in value. Property values are easing, following very strong growth over the last two years.

Add in the decline in value we are seeing in bonds because of rising interest rates, and it makes for a tough investment environment. From time-to-time shares, bonds and property do all go down in value at the same time, but not very often. 

What can you do to manage inflation? Until recently, inflation has been under control, and in fact has been too low for many central banks (including the RBNZ which has a 1-3% annual target range for consumer price inflation). A spike like we have seen over the past few quarters can create a lot of uncertainty for both investors and policy makers at the central banks and governments around the world. 

The good news is that sticking to your investment plan will be one of the best ways to keep up with inflation.   

Seeing your investment drop in value is hard. But if you switch and put your money into cash, you lock in that loss - and inflation can erode the purchasing power of your remaining cash if the return from cash is not exceeding the level of inflation.

We make sure all our diversified ASB investments hold assets that can help cope with higher inflation. They include shares in companies, real estate, gold, and inflation-linked bonds (we recently published a blog about how we've done that).

ASB believes that your long-term returns will always be stronger if you stick to well thought-out, long-term plans. Whatever happens month-to-month, if your long-term goal does not change, generally speaking, neither should your long-term investment plan.

If you're using your KiwiSaver savings as a source of retirement income, leaving your funds invested gives them the opportunity for growth. Our funds are designed with different goals and timeframes, with different potential investment risk and returns.

Choosing the right fund is an important part of achieving your savings goal. Check out our Help me choose tool to see if you're in the right fund for your goal.  

Everyone's situation is different. If you'd like to talk about your investment options, or review your plan, we're always here to help. Our qualified financial advisors are happy to have a chat - you can give them a ring on 0800 272 738 and you can book an online appointment here. Be sure to check out some of our recent ASB Investment Podcast episodes, for more useful information to help you make smart decisions about your investments. 

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