Since the onset of the pandemic, the global economy has been hit by several demand and supply shocks, many of which have contributed to high inflation. This has led to a loss in purchasing power, which we covered in more detail in part 1: Your guide to understanding inflation. In this article we’re looking at the current drivers of inflation, and how investing helps you fight back.
What causes inflation?
There are a few different factors that can cause inflation. The economist Milton Friedman described this simply, as “too much money chasing too few goods”. Some of the factors include:
- An increase in demand, for example from a growing population – because demand is outpacing supply.
- Higher costs, for example when production costs like wages and raw materials rise – and then producers pass the price increases on to consumers.
- Changes in money supply, for example when governments inject cash into the economy by purchasing securities (such as government bonds), which increases the amount of money floating around.
Ok, so what’s driving inflation right now?
Several inflationary drivers have come together recently to create a perfect storm of rising prices. Some of the key factors include:
- Global logistics bottlenecks and supply-chain disruptions throughout the pandemic.
These disruptions limit the availability of goods, which tend to lead to higher prices. And if businesses are unable to get the materials they need, they may have to raise prices to compensate for the increased costs of production.
- Governments around the world increasing money supply to spur economic activity, in response to the pandemic. This led to an increase in the overall amount of money floating around. And with more money in circulation, each dollar is worth less.
- The release of pent-up demand after the lockdowns of 2020 and 2021. People delayed some of their usual purchases during the pandemic, and then later unleashed their savings in a surge of spending. This caused a spike in demand which led to higher prices.
- The 2022 invasion of Ukraine and disruption of energy supplies in Europe. This caused a major supply shock given the disruption of oil and gas supplies from Russia to Europe. There were direct impacts on energy prices, and subsequently the prices of many goods and services that use oil and gas, (or are transported using oil and gas) increased substantially.
With multiple factors coming together, we’ve seen inflation levels increase rapidly and significantly here in New Zealand and around the world, and central banks trying to bring high inflation under control. One of the ways they do this is by increasing interest rates.
What do interest rates have to do with inflation?
Interest rates and inflation are closely related. Central banks raise interest rates to try to calm inflation and limit its harmful effects. This (usually) works because as interest rates rise, the cost of borrowing money increases – higher interest rates encourage people to save money instead of spending it.
With higher borrowing costs passed on to consumers, it leads to some people borrowing less, some cutting back on expenses, and some do a bit of both. For example, higher mortgage repayments due to an increase in interest rates mean that a larger portion of a household budget goes towards repayments. And when mortgage repayments cost more, it’s likely that rental prices will cost more too. The knock-on effect of this is there’s less money in the household budget to go towards other items, putting a brake on consumer spending.
This cut back in borrowing and spending tends to slow the economy down and takes the heat out of inflation levels. When this happens, we may still see some inflation, but prices won’t rise as quickly – the inflation begins to return to an acceptable level. However, no one knows exactly how long this will take, so it’s important to consider the impact on your savings and investments throughout this period.
Investing is one of the primary ways you can protect the purchasing power of your money. This is because during times of inflation, you need a way to safeguard your savings, even when prices are rising. For most people, staying the course with your investment is the best option.
How does staying invested help to fight inflation?
Staying invested means continuing to hold onto and contribute towards your investments, even during challenging times. This could be when the market is experiencing volatility or downturns, or you’re being squeezed by a loss of purchasing power.
Maintaining the course with your investments can be an effective way to fight inflation because it allows your savings to grow in value over time. As prices increase due to inflation, the value of your investments may also increase, which can help to protect your purchasing power. And staying invested can help you to benefit from the potential long-term growth of the market, which can help you to ‘outrun’ the effects of inflation and achieve your savings goals.
Your financial wellbeing is important to us, and we understand that staying the course with your investments can be challenging. We’re here to help if you’d like guidance on managing your everyday finances, as living costs and interest rates rise.
Why is diversification important during times of inflation?
Having a well-diversified investment portfolio is especially important during times of inflation because it can help to protect your wealth and potentially generate better returns over the long term. Diversification means holding different types of assets across many sectors, and sometimes in different parts of the world, because they tend to react differently to the many influences that cause market movements.
It’s important to know that at BNZ, our funds are designed with diversification in mind. One of the key benefits of investment options like the BNZ KiwiSaver Scheme and YouWealth is that you get broad diversification through each fund. So whichever BNZ investment option you choose, your investments are well diversified with a carefully planned mix of investments.
However, during periods of market volatility and turbulence, the benefits of diversification may not be as apparent, and it may seem like there is no safe place for investors to turn. Fortunately, history shows us that these conditions are usually temporary. Market ups and downs can also mean opportunities to buy assets at cheaper prices and set yourself up for potential future gains.
Staying the course with your investment is the best way to safeguard your investments and offset the long-term negative impacts that inflation could have on your savings. This means you give your investments time to grow and potentially outperform inflation over time.
That said, there are no guarantees that financial markets will always outpace inflation, and there’ll be times when investments may underperform or even lose value. However, over the long term, it is generally expected that financial markets will outrun inflation.
Overall, maintaining a consistent approach to your savings and investments will help to protect you from the impacts of inflation, and set you up for a brighter future.
Any views expressed in this article are the personal views the author and do not necessarily represent the views of BNZ, or its related entities. This article is solely for information purposes and is not intended to be financial advice. If you need help, please contact BNZ or your financial adviser.
Neither Bank of New Zealand nor any person involved in this article accepts any liability for any loss or damage whatsoever which may directly or indirectly result from any, information, representation or omission, whether negligent or otherwise, contained in this article.
BNZ Investment Services Limited, a wholly owned subsidiary of Bank of New Zealand, is the issuer and manager of YouWealth and the BNZ KiwiSaver Scheme. Product Disclosure Statements for both products are available at bnz.co.nz Investments in the BNZ KiwiSaver Scheme and YouWealth are not bank deposits or other liabilities of Bank of New Zealand (BNZ) or any other member of the National Australia Bank Limited group. They are subject to investment risk, possible delays in repayment, possible loss of income and possible loss of principal invested. No person (including the New Zealand Government) guarantees (either fully or in part) the performance or returns of the BNZ KiwiSaver Scheme and YouWealth or the repayment of capital. National Australia Bank Limited, the ultimate owner of BNZ, is not a registered bank in New Zealand but a licensed bank in Australia and is not authorised to offer the products referred to in this email to customers in New Zealand.