Inflation - the silent thief?
It has been many years since we have had to worry about inflation. In fact, most New Zealanders have benefited from inflation as the value of their property assets have been pushed higher through asset inflation, while at the same time the price of many consumer goods have reduced. In this way we have had the best of both worlds. New Zealand's annual inflation is now running at 3.3% year on year, which is up from 1.5% only 3 months earlier. With inflation forecast to rise further, should we now be concerned?
Inflation can be a complex 'beast'. At its simplest, it can be explained as too many dollars chasing too few goods. The current housing boom is a good example of inflation in play. Low interest rates have increased our ability to borrow, effectively creating more dollars, and, when this is combined with a scarcity of supply, inflation results.
However, as alluded to in the introduction, strong inflation in the value of assets is not always accompanied by general inflation in consumer goods. The last time New Zealand experienced widespread inflation was in the 1980s when our Consumer Price Index (CPI) averaged 11.1% p.a. for the entire decade.1
For those who experienced this period it was a sobering time. If you can imagine the FOMO (fear of missing out) that Millennials are experiencing now, with regard to being shut out of the property market, and then apply this anxiety across all consumer goods, you then have some idea of the psychological impact that inflation can have on an economy.
It was the experience of the 1980s that led to the enactment of the Reserve Bank Act of 1989. The Act established the Reserve Bank's independence and ensured that it could set interest rates (to control inflation) without political interference.2
So why am I worried about the emergence of inflation now and why might it continue to build? It is another column topic on its own, but for now I point to four things.
• COVID-19 has led to central banks worldwide flooding the global economy with additional money.
• The level of independence that the Reserve Bank has historically enjoyed has been recently diluted by the current Government.
• Globalisation, which was responsible for ever cheaper consumer goods, is now being questioned by consumers and politicians alike, which may contribute to higher prices going forward.
• Politicians have a vested interest in allowing inflation to erode the value of debt that they have entered into.
So what does this mean for you and how you manage your money? Investing in an environment with higher inflation requires a different approach – some asset classes are winners, others losers.
Although inflation tends to lead to an increase in interest rates, over the longer term fixed interest investors are the big losers as the price of their bonds decrease. This is because the real value of the interest payments received reduces over time and there is no capital growth occurring to keep pace with inflation. In fact, most fixed interest investors are already seeing the real value (i.e. after the impact of inflation) of their investments reducing. I suspect that this is only going to get worse.
Property has historically been a good hedge against inflation. However, there is always the risk of political interference whether that be via new taxes or more interventionist action through such things as 'rent control'.3
Commodities, whether they be soft agricultural commodities or hard commodities, like copper, tend to be driven higher by virtue of their scarcity and perform well in an environment with higher inflation.
Shares can be a 'mixed bag'; those companies that have the ability to increase the prices they charge their customers without fear of reducing demand can grow in value. However, other areas like discretionary retail can find the environment challenging as the margin between purchasing new stock and selling existing stock gets squeezed.
In addition to these traditional asset classes so called 'non-traditional' assets can assist in the battle against the erosive effect of inflation. This class can be wide ranging and covers such investments as gold, carbon credits and digital assets, including cryptocurrencies.
How well positioned is your portfolio to cope with the prospect of inflation? Hopefully we are not heading back to anything like the inflation rates of the 1980s, but even an inflation rate of 6% p.a. means that the purchasing power of one dollar reduces to 56 cents over a 10-year period. Hence the reference to inflation being 'the silent thief'.
Inflation can be a complex 'beast'. At its simplest, it can be explained as too many dollars chasing too few goods. The current housing boom is a good example of inflation in play. Low interest rates have increased our ability to borrow, effectively creating more dollars, and, when this is combined with a scarcity of supply, inflation results.
However, as alluded to in the introduction, strong inflation in the value of assets is not always accompanied by general inflation in consumer goods. The last time New Zealand experienced widespread inflation was in the 1980s when our Consumer Price Index (CPI) averaged 11.1% p.a. for the entire decade.1
For those who experienced this period it was a sobering time. If you can imagine the FOMO (fear of missing out) that Millennials are experiencing now, with regard to being shut out of the property market, and then apply this anxiety across all consumer goods, you then have some idea of the psychological impact that inflation can have on an economy.
It was the experience of the 1980s that led to the enactment of the Reserve Bank Act of 1989. The Act established the Reserve Bank's independence and ensured that it could set interest rates (to control inflation) without political interference.2
So why am I worried about the emergence of inflation now and why might it continue to build? It is another column topic on its own, but for now I point to four things.
• COVID-19 has led to central banks worldwide flooding the global economy with additional money.
• The level of independence that the Reserve Bank has historically enjoyed has been recently diluted by the current Government.
• Globalisation, which was responsible for ever cheaper consumer goods, is now being questioned by consumers and politicians alike, which may contribute to higher prices going forward.
• Politicians have a vested interest in allowing inflation to erode the value of debt that they have entered into.
So what does this mean for you and how you manage your money? Investing in an environment with higher inflation requires a different approach – some asset classes are winners, others losers.
Although inflation tends to lead to an increase in interest rates, over the longer term fixed interest investors are the big losers as the price of their bonds decrease. This is because the real value of the interest payments received reduces over time and there is no capital growth occurring to keep pace with inflation. In fact, most fixed interest investors are already seeing the real value (i.e. after the impact of inflation) of their investments reducing. I suspect that this is only going to get worse.
Property has historically been a good hedge against inflation. However, there is always the risk of political interference whether that be via new taxes or more interventionist action through such things as 'rent control'.3
Commodities, whether they be soft agricultural commodities or hard commodities, like copper, tend to be driven higher by virtue of their scarcity and perform well in an environment with higher inflation.
Shares can be a 'mixed bag'; those companies that have the ability to increase the prices they charge their customers without fear of reducing demand can grow in value. However, other areas like discretionary retail can find the environment challenging as the margin between purchasing new stock and selling existing stock gets squeezed.
In addition to these traditional asset classes so called 'non-traditional' assets can assist in the battle against the erosive effect of inflation. This class can be wide ranging and covers such investments as gold, carbon credits and digital assets, including cryptocurrencies.
How well positioned is your portfolio to cope with the prospect of inflation? Hopefully we are not heading back to anything like the inflation rates of the 1980s, but even an inflation rate of 6% p.a. means that the purchasing power of one dollar reduces to 56 cents over a 10-year period. Hence the reference to inflation being 'the silent thief'.
1. Reserve Bank of New Zealand - Inflation calculator.
2. Inflation targeting in New Zealand: an experience in evolution A speech delivered to the Reserve Bank of Australia conference on central bank frameworks by Dr John McDermott, Assistant Governor and Rebecca Williams, Economics Advisor, RBNZ, 12 April 2018.
3. 'Rent controls not the answer' goodreturns.co.nz, 11 May 2021.
2. Inflation targeting in New Zealand: an experience in evolution A speech delivered to the Reserve Bank of Australia conference on central bank frameworks by Dr John McDermott, Assistant Governor and Rebecca Williams, Economics Advisor, RBNZ, 12 April 2018.
3. 'Rent controls not the answer' goodreturns.co.nz, 11 May 2021.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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Peter Ashworth is a Principal of New Zealand Funds Management Limited and a Financial Adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily those of NZ Funds. His disclosure statements are available on request and free of charge.
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First published in the Otago Daily Times on 13 August 2021, as 'Should we worry about the 'silent thief' of inflation?'
