The Big Squeeze

New Zealand’s rate of inflation continues to be low, even though our economy is growing. Lower petrol prices, cheaper airfares and computer equipment are some of the biggest contributors to low inflation and have reduced the impact of higher prices for housing-related goods and services. However, this is not necessarily cause to celebrate. The way in which people spend and save is very much influenced by the rate of inflation. Rapid increases in prices can cause people to spend now rather than later in order to buy cheaper. Saving becomes less attractive because the purchasing power of money declines over time. On the other hand, when prices are falling, spending is delayed in order to buy cheaper. The economy then slows down and prices can fall even further.

While high inflation is not desirable, neither is deflation (falling prices). The aim of the Reserve Bank is to keep inflation at about 2%; not too high and not too low. The principal tool for achieving this target is the Official Cash Rate (OCR), which in turn has an influence on the interest rates set by banks for deposits and lending. In theory, a lower OCR should mean lower deposit and lending rates for savers and borrowers. This in turn encourages spending and investment, leading to higher inflation. However, the OCR is only one of several factors that determine bank interest rates, so a change does not always achieve the Reserve Bank’s aim.

With inflation only just above zero, there is a danger we will head into deflation and the Reserve Bank is likely to continue to drop the OCR. If this translates into lower bank interest rates, savers will be caught in a big squeeze between falling interest rates and rising inflation. This is an uncomfortable place to be for retirees.