What is inflation and why it matters to you
After nearly a quarter of a century of low inflation in Canada, global prices for everything from basic consumer goods like such as groceries and gasoline to the cost of housing are on the rise. Many countries, including Canada, are seeing higher levels of inflation.
We hear the term "inflation," but how many of us really know what it means and exactly how it affects our daily lives? Put simply, inflation is the rise in prices of products and services that people use every day. When the cost of these goes up, individuals and businesses can’t buy as much as they could before. Multiply this across millions of transactions and the entire Canadian economy feels the effects. Here’s what you need to know about this closely watched economic indicator.
What causes inflation?
It might seem surprising, but economists don’t all agree on what causes inflation. There’s a lot of debate around the topic. What they do agree on is that the sources of inflation can be classified into two broad categories:
- Demand-pull inflation: This essentially means that if more people want to buy something, demand increases and prices go up; or when there’s a limited supply, consumers are willing to pay more.
- Cost-push inflation: The rising costs of doing business—such as increases in the price of raw materials or higher wages—mean, that to remain as profitable, companies often pass along these price increases to their customers.
Rising prices aren’t necessarily a bad thing: A steady pace of price inflation is normal and seen as a sign of a healthy economy. Too much inflation, a rapid uptick in the pace of inflation growth, or unexpected swings in prices can cause real problems though. This is what happened in Canada during the 1970s and early 80s when inflation rates reached 14% as a result of very high global oil prices. During this period, prices increased by approximately 8% annually meaning they would double within only 9 years. (By comparison, when the annual inflation rate is near 2%, prices double within 35 years.)
High prices mean a loss of purchasing power because our money doesn't buy as much as it did before. For example, a cup of coffee that used to cost $2 now costs $4, or a house that used to cost $500,000 now costs over $1,000,000! When prices are rising quickly, consumers and businesses can't easily predict what their costs are going to be tomorrow. This makes it harder for them to make spending and investing decisions: Should they economize by spending less today? Or, on the contrary, should they spend more today in case inflation keeps rising and they lose even more buying power? People whose wages and incomes cannot keep up with inflation or those who are retired and living on a fixed income are penalized because the value of their savings and incomes is rapidly decreasing during periods of high inflation.
How interest rates affect inflation levels
Source: Manulife Investment Management
How is inflation measured?
Inflation is measured by how quickly the Consumer Price Index (CPI) is rising over a specific period. The CPI is a basket of fixed goods and services in Canada that includes eight major components: food, shelter, household expenses, clothing, transportation, health/personal care, recreation/education, and drugs (alcohol, recreational cannabis, tobacco). Critically, your personal rate of CPI inflation may be higher or lower than the standard basket used by the federal government, as it depends on your consumption patterns. For example, if you drive to work every day, your personal inflation rate is affected by changing gas prices (assuming you drive a gas-fueled car). To estimate your personal CPI, try this calculator.
Inflation rates in Canada, 2001-2021
Source: Statistics Canada
Inflation and interest rates: what’s the connection?
How do interest rates affect inflation? Back in 1991, the Government of Canada tasked the Bank of Canada (BoC) to keep the annual inflation rate at around 2% to support Canadians' economic well-being. When the rate of inflation rises above this target for a sustained period, the BoC is prompted to increase its target for the overnight rate by increasing the bank rate. This is the rate it charges private banks to borrow money, and it’s the main determinant of other interest rates in the economy. Any change in the target for the overnight rate triggers banks to change the rates they offer on their savings deposits, as well as the rates they charge on loans and mortgages. Higher rates on savings deposits encourage people to save more, while higher rates on loans discourage people from taking on excessive debt and to spend less. Because businesses need people to spend and invest, they respond to higher interest rates (and lower demand) by slowing down their own price increases. This has the effect of lowering inflation.
Why future rates of inflation matter today
Inflation rates may not matter much day to day, but the longer-term effects can be quite significant. If you’re budgeting for higher tuition rates for your children's future education, save more for a down payment on a house, or increase your contribution to retirement savings because of higher costs down the road, you have to make new choices about how to save and spend today.
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