As major economies begin to recover from the impacts of COVID-19, central banks everywhere, including in New Zealand, are preparing to manage a marked increase in inflation.

Inflation is an issue that can quickly get confusing. On one hand, countries and central banks maintain target inflation rates, using them as a positive indicator for growth. On the other, it’s also viewed as an economic bogeyman, threatening to raise the cost of borrowing and raw materials. To understand how it can both help and threaten economies, we need to take a closer look at what inflation is, and how it works.

How Inflation Works

Fundamentally, inflation is an increase in the prices for goods and services. This can happen because, as more money becomes available, people are also willing to spend more for any given product or service. Inflation can occur through two main mechanisms: economic growth and an increase in the supply of money.

Economic Growth

Economic growth is simply an increase in the amount of goods and services that are produced and sold. Depending on what amount might be saved growth can lead to an increase in the velocity (speed of circulation) of money. This means that the dollars in the system are each spent more often in a given time frame than they were before. For example, a dollar that was used by five different people to buy five different products can represent $5 worth of economic productivity, while a dollar that sat in someone’s wallet all year represents no productivity at all. The more often money is spent within an economy in any time period, the more money that functionally existed during that period. If the supply of goods and services in such a situation is unable to meet growth in demand prices can rise. Often such inflation is termed “demand pull inflation”.

Increasing the Money Supply

When economic growth stalls—such as during a global pandemic—people reduce their spending, which brings down the velocity of money (and the supply of cash as a result). When this happens, a central bank can stimulate economic activity by simply creating more money. One way of doing this is by buying back bonds issued by Central and Local Government. If the seller of these bonds is a bank, the bank will have more cash to lend out. With more money in the system, the impact of the economic slowdown is blunted, helping to prevent massive cash shortages and job losses that could otherwise create a downward spiral. This sort of strategy sits under the general heading of Monetary Policy.

Recovery can be an Inflationary Threat

In order to offset the threat of a severe economic contraction during the COVID-19 crisis, New Zealand initiated the Large-Scale Asset Purchase (LSAP) Programme in 2020 which allows the RBNZ to buy back bonds. This will funnel $100 billion into the economy by June 2022. This has helped to lower interest rates and encourage economic growth but at nearly half of New Zealand’s GDP, it has also raised significant concerns about future inflation.

As the economy recovers, people and businesses will begin spending money more freely again, driving up the velocity of the now much larger pool of cash. When economic activity returns to normal, the total supply of money will be much larger than it was before.

Another potential contributor to inflation at this time is the disruption many businesses are facing to the supply of material they use to make things with, and to the supply of finished goods. With a lot of additional money in the system shortages can lead to prices of goods and services going up. This is often termed “cost push inflation”.

Too Much Inflation Can Be Bad

While inflation can be the result of economic growth (generally seen as good), it can also increase financial stresses on consumers and businesses. In order to generate profit through lending, for example, lenders need to charge interest rates that exceed the inflation rate. Otherwise, the sum of money paid back to the lender in the future would have less total value than the money lent out. This makes borrowing more expensive for businesses and consumers, many of whose revenues and wages will not instantly inflate alongside the economy as a whole.

At the same time, suppliers will raise prices for raw materials and services. This leads to increased costs for businesses, which, in the absence of competition, many will necessarily pass on to consumers in the form of higher prices. If consumers think things will cost more tomorrow, they will spend more today. This can lead to an inflationary spiral. This would be of great concern to a central bank which would be forced to increase interest rates to reduce economic activity. A higher price for money tends to dampen demand for money and decrease the tendency for businesses to invest.

At this point in time a bit of inflation will be a sign that things are improving which would be welcomed However, beyond, say, a 3% annual consumer price increase, inflation will likely become problematic. This is why governments aim to maintain a low, but positive level of inflation which is supportive of stable growth. The challenge for governments and central banks in the next year or two will be to manage a path where the extra-ordinary stimulus to economies over the last year or more can be withdrawn gradually, keeping the economic recovery going but keeping the inflation genie corked in the bottle.