The inflation rate in New Zealand over the past 12 months has been 4.6 per cent, in part because of the impact of the GST increase in 2010. Over the past five years, inflation has averaged a more modest 2.9 per cent.
At either of these rates, the impact on the spending power of our savings can be substantial, even over relatively short periods. At an annual inflation rate of 2.9 per cent, $100 will buy $87 worth of goods in five years' time, and in 10 years it will have the spending power of only $75. At the rate we have seen over the past year of 4.6 per cent, the impact is even greater. After five years, $100 has the spending power of $80 and, over a decade, this reduces to just $64.
The lesson for investors is that inflation is always in the background, eroding the value of their capital, and it remains one of the key factors to consider when structuring an investment portfolio.
Bank deposit rates are around 4.5 per cent and after tax at 30 per cent this reduces to 3.2 per cent. If inflation is any higher than 3.2 per cent, you've actually lost money because you haven't been able to maintain your spending power.
Even at relatively modest levels, inflation can devastate savings. Long-term investors need to recognise the risk of ignoring growth assets in favour of the havens of fixed-interest and bank deposits.
The inflation rate has averaged 4.5 per cent a year over the past 100 years, which is about how far the data goes back. For other countries where historic inflation data dates back much further, it is clear inflation was relatively calm until the 20th century, since when it has surged.
The attached table, lifted from a study by some of our international research associates, shows the average inflation rate for 20 countries since 1900. While most countries aim for inflation to remain below 3 per cent, Switzerland (with an annual average rate of 2.3 per cent) is the only country that has achieved this.
So why have the world's major economies suddenly found it so difficult to keep inflation under control? For at least 100 years and possibly centuries before World War I, most countries were on some kind of currency regime backed by precious metals.
This effectively meant a country could only create more money that was equal to the amount of gold or other precious metals it had in reserves. If it wanted to print more money, it needed to first have more gold reserves.
The logic of this system was to help ensure that the value of the bills or coins was maintained, because the currency could theoretically be exchanged for precious metals. This tied the hands of domestic policy-makers with regard to increasing the money supply.
The creation of the United States Federal Reserve in 1913 arguably started the modern period of central bank liquidity injections in times of economic hardship. In the aftermath of WWI, some economies suffered hyperinflation. Germany is one of the most well-known examples of this. Authorities tried to finance the war by printing endless amounts of money, which did nothing but reduce the value of the existing money. At one point, workers were paid daily and they would go and shop at lunchtime before their wages depreciated later that day. In 1971, US President Richard Nixon changed the inflationary landscape by suspending the convertibility of US dollars into gold. By the mid-1970s, the world's major currencies became completely floating and the world ended centuries of currency regimes backed by precious metals. From this point, there was little to stop money-printing as an economic policy tool.
This saw the beginning of a new era of fiat currencies and credit creation. A fiat currency is money that has no inherent value, unlike the gold and silver coins of old, or money that was at least linked to these. Fiat currency is "paper money" that a government has declared to be legal tender, and its value relies entirely on our faith and confidence in it.
It's perhaps no coincidence that Switzerland, with the best inflation track record, maintained a currency link to gold until as late as 2000 when a referendum finally loosened the constitutional requirement to hold a certain amount of gold reserves.
Not only does the lack of any linkage to a physical asset make it easier for governments to print money when they need to, but it is much simpler to do so. Fifty years ago, gold standard or not, they had to at least commission the mint of new coins. Today, it's as easy as a few extra numbers entered on a computer keypad.
Printing money doesn't achieve much other than inflation. There is still the same amount of goods and services to go around, but now there is more money chasing the same amount of goods, so the price simply goes up in reaction, which in turn makes your money worth less in terms of its purchasing power.
Given that many Western nations have high debt levels, the temptation for these countries to continue printing money to pay back debt may be too large to resist. The real losers here would be those who have lent them the money, because the currency they are being paid back in is not worth as much as it once was.
This is one reason why investors have flocked to gold in recent years. Gold and precious metals are seen as alternative currencies that central banks can't print more of, and may hold their value more than money sitting in savings accounts.
I see the logic in having a small allocation to precious metals in portfolios, but largely as an insurance policy rather than an investment. I'm also not sure that hefty weightings in gold make sense for private investors looking for ways to inflation-proof their portfolios, one reason being that gold doesn't generate income.
The best strategy is to have at least a portion of your savings in real assets that can grow their earnings to keep pace with inflation. This includes property and good-quality equities, both of which are difficult to replicate or print more of and both of which should be able to pay an ever-increasing dividend or rental stream.
Growth assets are essential for inflation protection, just in case the governments of the Western world can't resist taking the easy way out.
Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as personalised investment advice.