Your guide to understanding inflation

Over the past 12 months we’ve experienced the largest increase in living costs in more than 30 years. And it’s not just here in New Zealand where prices are rising. The cost of living has soared across many global economies, including in the US, UK, Europe, and the Asia-Pacific region. But what exactly is inflation? What causes it? And how does it affect you? Read our two-part inflation series to find out more.

What is inflation?

Inflation refers to the way that prices increase over time. It’s not just the price of one thing going up, but a range of everyday items including food, fuel, and housing. Take a few things you might need to buy today. These could include a tank of petrol, a few groceries, your weekly rent payment, and a cup of coffee on your way to work. With high inflation, you’ll be paying a lot more for these items than you did this time last year.

And this matters because when inflation is high, your dollar doesn’t buy as much as it used to. Which is why it’s important to understand inflation, how to measure it, and where it comes from. It’s also why central banks are making so much effort to bring the rate of inflation down (we’ll explain more about how they do this in part two of this inflation series: How investing helps you fight back).

Just how high is inflation? And how do we measure it?

Inflation is measured by the Consumer Price Index (CPI). The CPI includes a ‘basket’ of goods and services that have been selected to represent household spending patterns across the country. Every three months, Statistics New Zealand collects the prices of all the items in the basket to measure how they have changed. This is referred to as the CPI inflation rate.

In 2022, the CPI annual inflation rate in New Zealand reached 7.3% and is now sitting at 7.2% per year. This is the highest it’s been since 1990. Following around three decades of stable inflation, the sudden and sustained increase is putting pressure on people’s budgets and leading to financial strain and a cost-of-living crisis.

A cost-of-living crisis can happen when inflation is rising faster than wages. In New Zealand, average wages have increased over the past 12 months. However, for many people, they’re not keeping up with the inflation rate. And when wages aren’t keeping up with inflation, you need to spend more of your income to buy the same things, which will tend to mean a loss in purchasing power.

What do we mean by a loss of purchasing power?

You can think of purchasing power as how much your money can buy, or the power of your cash to buy the things you need. And when wages don’t keep up with inflation, it costs more money to buy the same thing.

Unfortunately, a loss in purchasing power tends to hit lower-income households the hardest. That’s because these households spend a greater proportion of their money than before on essentials like food, fuel, and housing, and have less ‘wiggle room’ in the household budget to cover the rising costs. This is one reason why central banks work to keep inflation to an acceptable level.

What is an acceptable level of inflation?

While high inflation can be harmful, moderate inflation levels are generally a sign of a healthy economy. The Reserve Bank of New Zealand targets an annual inflation rate of 1-3%, based on the CPI. This target rate focuses on supporting economic growth and stability, as households and businesses can plan ahead more easily when prices are stable. So not all inflation is ‘bad’, but when we’re experiencing high inflation as we are now, this can be harmful.

What can I do about high inflation?

Having a plan and sticking to your budget is more important than ever during times of high inflation. So now is a good time to review your budget, or get one set up if you don’t have one already (you can learn more about this here). Identify any costs which you can cut back on, as this will help you manage your money through the worst of the inflation period. We know that this is not easy, particularly if your income is not rising as quickly as prices are going up, and you’re feeling the effects of a loss of purchasing power.

Everyone experiences inflation slightly differently because we all buy a slightly different basket of goods and services. Monitoring your spending and having a plan can help you better manage some of the challenges. And if you do need some help managing your everyday finances, there are some helpful tools and guides available here, or you can get a free financial health check here.

Staying invested and having a well-diversified investment plan is an important way of helping you keep up with inflation so you can avoid some of the long-term impacts this has on your savings. We cover this in more detail in part two of our inflation series: How investing helps you fight back.

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.