Inflation explained

Inflation and the cost-of-living crisis have been buzzwords for some time. To dig deeper into what exactly inflation means for Kiwi, we sat down with our economist Mary Jo Vergara. This is inflation explained.

Mary Jo - 7444

Kiwibank Economist Mary Jo Vergara talks inflation.

What exactly is inflation?

Inflation describes the general increase in the price of goods and services in the economy - everything from food to fuel, and health to housing.

Inflation is measured by the Consumer Price Index (CPI) - this index is created by Stats NZ, who sample the prices of a representative basket of goods and services each quarter and record any changes. The (weighted average) price of today’s basket is compared to the basket of a different point in time. A positive change means a rise in prices, which is called inflation. A negative change means a decline in prices, which is called deflation.

In 2022, annual inflation reached a 32-year high of 7.3% which appears to be the peak.

What is a “cost-of-living crisis” and are we in one?

A cost-of-living crisis is a situation in which the rise in consumer prices is outpacing the rise in wages.

Wage inflation, as measured by the private sector's Labour Cost Index, hit around 4% in 2022. This means wages in Aotearoa are growing at a slower pace than inflation, and households are seeing their real incomes eroded. So, it’s fair to say that we, like many countries around the world, are currently experiencing a cost-of-living crisis.

Unfortunately, households on low or fixed incomes are hardest hit. Food and fuel – both of which have seen the largest increases in price – make up a larger share of household budgets, and these households typically don’t have as much wriggle room. Budgeting becomes that much more of a head-scratching exercise.

Find out more about how you can manage the cost of living.

How are prices for goods and services determined?

Some items in the Consumer Price Index basket face foreign competition. These items include petrol, food and apparel and are vulnerable to international price movements and fluctuations in the New Zealand dollar exchange rate. A weaker Kiwi dollar lifts the price of imported goods, and our exports become more attractive on the international stage. More demand for what we produce is also inflationary.

Items that make up the tradable – or imported – component of inflation account for around 40% of the Consumer Price Index. The remaining 60% are goods and services that we produce here in Aotearoa for our own exclusive consumption, including council rates, rents and education, whose prices are influenced by developments in the domestic economy. These items make up the non-tradable – or domestic – component of inflation.

How did we get to a 7.3% inflation rate?

The recent surge in inflation certainly has its origins from overseas. Covid disrupted trading ports, which pushed up shipping costs. And the war in Ukraine sent commodity prices, especially oil, spiralling higher. Imported inflation hit a high of 8.7% in 2022. That’s the largest annual rise since Stats NZ began reporting the domestic/imported split in 2000. We continue to import inflation from offshore. Around 46% of the overall increase in consumer prices has been driven by international price pressures. That’s an outsized move given it’s approximately 40% weight in the CPI basket.

The growing strength of domestically generated inflation however is more concerning. This is because it’s the kind of inflation that stems from strong demand and so is harder to tame. Domestic inflation hit a record high of 6.6% in 2022. Demand is far outstripping supply in the economy. Excess demand and domestic capacity pressures are sustaining inflation. So, while imported inflation is big in terms of contribution to total inflation, domestic inflation is still bigger. Around 54% of the annual jump in prices was domestically generated.

Where to from here for inflation?

The good news is the path for inflation looks to be downhill from here. The bad news is it’s likely to be a slow trek back to the Reserve Bank of New Zealand’s (RBNZ) 2% target rate.

Several indicators suggest the pressure on global supply chains has eased materially. Global shipping costs have firmly turned south, and capacity is expanding with more ships being built.

Strong domestic inflation however risks an extended period of high inflation. We see inflation remaining stubbornly above 3% through to the middle of 2023. Inflation indicators continue to flash red-hot and there’s real risk long-dated inflation expectations become unanchored from the target. And that’s not something the RBNZ wants to see.

How does inflation affect interest rates?

The RBNZ’s primary tool in delivering monetary policy is the official cash rate (OCR). The OCR is the interest rate that sets all interest rates in the economy.

Given the state of the economy, the OCR is accordingly shifted up or down. When economic activity is slowing and inflation is falling below target, interest rates are slashed to stimulate growth. Conversely, when the economy is heating up, interest rates are lifted to cool down the economy and rein in rising inflation. With pandemic-induced disruptions and unprecedented amounts of fiscal and monetary stimulus, economies across the world find themselves in the latter environment. Central banks from Washington to Wellington are aggressively lifting interest rates in response to the rapid rise in consumer prices.

What’s happened to interest rates in Aotearoa?

Following the OCR’s lead, interest rates have risen swiftly since mid-2021. Mortgage rates are no longer at the record-low, emergency levels that were needed early in the pandemic to support the economy. The two-year fixed rate, for example, has gone from around 2-2.5% to 6-7% per annum. And the speed at which rates have increased has taken many by surprise.

You can find out more about why interest rates change.

What do higher interest rates mean for me and my whānau?

The RBNZ is lifting interest rates to dampen demand, better balance the economy and ultimately bring inflation back to target. But it takes time for changes in monetary policy to take effect. Given the overwhelming preference among Kiwi mortgage holders for fixed rates, the impact of higher interest rates comes later. Monetary policy operates with around an 18-month lag in Aotearoa. But the tighter monetary conditions will be felt, and soon. A significant chunk of the stock of Kiwi mortgages is due to be re-fixed in 2023. And they’ll be rolling onto materially higher rates.

Higher rates should have a profound impact on household budgets. We are far more sensitive to rising interest rates given the significant run up of household debt over the past two years. Supported by historically low levels of unemployment, household consumption is holding up for now. But a slowdown in 2023 is expected. With high cost of living and rising debt servicing costs, it’s an increasingly expensive environment. As a result, there’s less appetite to spend.

Find out more about how to prepare for increasing interest rates.

You might also be interested in...