Everywhere you turn at the moment people are talking about inflation and interest rates. But what is the relationship between them, and what does the Reserve Bank have to do with it? At its heart the issue is about buyers and sellers, what can push prices up and what can cause them to fall.
What is inflation?
Inflation is a term used to describe a rise in the prices of the goods and services in the economy. These price rises mean your money won’t buy as much today, as it did yesterday – something that we’ve all noticed recently, when we’ve done our weekly shop or paid the latest electricity bill.
What causes inflation?
There are a few causes of inflation – the main two causes are what’s known as ‘demand-pull inflation’ and ‘cost-push inflation’. Both cause prices to rise.
Demand-pull inflation is when there’s more demand for goods and services than what’s available. The sellers of the goods and services can’t produce enough to meet the increased demand. This means that the sellers have the luxury of raising prices.
Cost-push inflation occurs when there are increased costs for the suppliers of the goods and services, so they need to raise their prices to still make a profit. The suppliers could be having to pay more for the materials used to make the products, or be paying higher wage costs for their employees, and they need to pass these costs on.
COVID’s impact on inflation
The COVID pandemic has been a key driver of the recent rise in inflation. It caused huge global disruption to the manufacture, supply and distribution of the things we use and consume. Many of the goods that we buy here have been manufactured overseas and shipped to New Zealand. Big ticket items such as furniture and even building supplies became increasingly difficult to get hold of. All those delays pushed prices up as there was less supply, meaning that sellers could charge more for their products, which contributed to inflation.
Inflation at work
To show the impact of inflation let me allow you a sneak peek into a mid-week shop I did on the 7th of March 2020 at my local supermarket, compared with the prices I paid recently for the same goods from the same supermarket.
Now that is inflation at work. I’m pretty sure that nobody has had a 36% pay increase over the last two years, but what this little snapshot shows you is that effectively we have had a 36% pay cut, in terms of what our money will buy. It’s not your imagination, it’s real and it hurts.
How can inflation be controlled?
The causes of inflation are one half of this story – the other half is about what tools are used to control these price increases.
That’s where interest rates come in. In many countries, including New Zealand, central banks are charged with controlling inflation. Interest rates are one tool that central banks use to do this.
We can illustrate how interest rates control price increases using the Bucket Fountain in the middle of Cuba Mall (a core part of my childhood in Wellington).
Water flows from a central spigot into two pipes at the top, then down into the buckets which gradually fill, tip, empty and then drain only for the water to make its way back up to the top of the central spouts starting the whole process over again.
The flow of water through the buckets is like the flow of money through our society. Monetary Policy is the process of increasing or decreasing the flow of money which in turn affects the supply and demand for products and services.
When the Reserve Bank lowers what is known as the Official Cash Rate (OCR), it’s like turning the tap up. Low interest rates encourage spending and discourage saving, which increases the money flow. When they increase interest rates, the exact opposite happens – it’s like turning the tap down. High interest rates encourage saving and discourage spending which decreases the money flow.
A decrease in money flow reduces demand, which causes prices to drop. It’s the interconnectedness of money at work.
During the pandemic the Reserve Bank along with central banks around the world turned the interest rate taps on full, but in the eagerness to protect to global economy caused the fountain to overflow – adding to the inflation problem.
They are now reversing course at breakneck speed, decreasing money flow seeking to control inflation. It is a painful process for financial markets but maybe, just maybe it can bring down the price of my weekly shop.