What Is Inflation? What You Need To Know

Why is everyone talking about inflation right now?

At a high level, inflation is the increase in the prices of certain goods and services. Over the last few years, inflation has run rampant in Canada and other parts of the world. For this reason, it’s a hotly discussed topic. Currently, the inflation rate sits at 3.1%, but it was at an all time high of 8% in 2022. If you’ve noticed prices rising at the grocery store or gas station, it’s not your mind playing tricks on you! It makes sense that everyone is talking about it because no one knows what will happen in our economy if the rate remains unchecked. 

In this guide, we review everything you need to know about inflation. The next time it comes up with your peers, you’ll have something smart to say!

What is inflation?

Why is everyone talking about inflation right now?

Currently, inflation in Canada is abnormally high. The rate has not been this high since the 1990s – that’s about 30 years ago in inflation history. For this reason, the high rate in Canada is alarming. The topic ties into other hot issues right now, such as the COVID-19 pandemic and housing crises in leading Canadian cities.

The pandemic is having a lasting effect on the Canadian economy. The main factor is ongoing supply chain disruptions. Since it is more challenging to get resources from point A to point B, costs are rising for the end consumer. Many believe Trudeau is overspending and printing money to compensate – a very common reason why high inflation arises. In addition, the financial relief provided to Canadians in the past few years, such as the Canada Emergency Response Benefit (CERB), helped in the short term. But unfortunately, the long term outlook is not looking great.

When rates go up, it’s usually a sign of an unstable economy. Many are worried about their finances and livelihood if inflation and other aspects of the economy aren’t controlled soon. 

What is inflation?

In technical terms, inflation is the decline of purchasing power of a specific currency over time. In plain words, that means more money is required to buy the same amount of a certain good compared to a prior period. It means the value of money is decreasing.

Why does inflation occur?

The root cause of price inflation is an increase in the supply of money. However, this can happen in a number of ways. Often, what is increasing the supply of money is not always clear in a market with high inflation. Below are the various causes: 

  • Demand-pull inflation. Occurs when demand for products and services increases due to an increase in supply of money and credit. In most cases, production of products and services cannot keep up which increases prices and inflation. 
  • Cost-push inflation. Occurs when prices in the production process of goods and services increase to the supplier. Since it is more expensive for the supplier to produce, those costs are reflected in the price consumers pay. Eventually this leads to inflation.
  • Built-in inflation. Occurs when people expect current rates to continue in the future. As prices of goods and services increase, workers expect their pay to rise at a similar rate. They will demand higher costs and wages to maintain their standard of living. However, this causes an upward wage-price spiral until inflation is inevitable. 

Unfortunately, Canada is a victim of all three at the moment. In 2020, Canada’s economy filled with money from emergency financial support like the Canada Emergency Response Benefit (CERB). This caused demand for products and services to rise through demand-pull inflation. From 2020 until now, there have been various supply chain disruptions which made it costly for suppliers to continue operations. This has shaken the international supply chain and the higher costs are reflected in prices consumers pay through cost-push inflation. Finally, throughout the 2010s, most Canadians expected their salaries to rise, at the very least, in accordance. The built-in inflation from the past decade may be haunting us now. 

Related Reading: Understanding the Various Types of Inflation: A Comprehensive Guide

What happens when inflation rises?

Simply put, everything gets more expensive, including the cost of living expenses. You have probably noticed the effects in your daily life. For example, gas prices are expensive and grocery bills are going up and up. 

In the short term, inflation is not necessarily harmful. A temporary rise in costs is not enough to trigger an economic crisis. But if it doesn’t go down, long-term effects can be disastrous. Unstable prices mean people on fixed incomes can no longer reasonably afford their current standard of living. Then, those individuals are no longer stimulating the economy which can cause collapse. Much of Canada is on a fixed income which is why the situation is so alarming at the moment. 

Related Reading: The Best Budgeting Apps And Tools For Canadians

How is inflation measured?

The basis for inflation is the Consumer Price Index (CPI). This index measures the overall price level paid by consumers for a “basket” of goods and services they purchase. A basket is a variety of goods and services that are lumped together for the purpose of calculating CPI. Often, baskets consist of products and services from a certain industry or requirement. Most inflation considers primary consumer needs which are usually transportation, food, and medical care. When a certain CPI increases, it’s safe to say inflation is increasing too. 

Inflation can be measured using other indices as well. This includes the Producer Price Index (PPI) and the Wholesale Price Index (WPI). However, the CPI is the most common index used to measure inflation. The Bank of Canada (BoC) uses CPI to calculate Canadian inflation. 

What is the inflation rate in Canada? 

As of December 2021, the inflation rate in Canada was reported at 4.8 percent. In November, it was 4.7 percent. And as mentioned above, the inflation rate rose to 7% in September 2022 — essentially doubling what it was at the end of 2021. Currently it’s 3.1% as of November 2023.

Where should the rate *actually* sit? The Bank of Canada’s target range for a normal rate is between 1 and 3 percent. This was the inflation rate we saw in 2020 and early 2021. Now, it is completely outside of the normal parameters.

What are the effects of inflation?

The primary effect is higher, more unpredictable costs for consumers, as discussed above. However, there are other effects. Let’s look at a few of these.

How does inflation affect interest rates?

Inflation and interest rates normally have an inverse relationship. This means when one goes up, the other goes down and vice versa. This is because low interest rates tend to stimulate economic expansion. But high interest rates tend to limit economic expansion. 

Since inflation is high, interest rates should also be high to combat what’s happening in the Canadian economy. Originally, the Bank of Canada’s overnight rate was low causing many economists to forecast that it would go up quickly. During 2022, Canadians saw just that. The Bank of Canada’s overnight rate is currently 3.25% (September 2022) and has risen from 1% since April of 2022. Prior to the pandemic, the prime rate was 2%. The prime rate set by the Bank of Canada trickles down into the interest rates consumers pay. Since the prime rate is high, borrowing rates for consumers are high too. Canadians may be struggling with debt since the overnight rate rose which means carrying debt has become more expensive. While this is a challenge, the Bank of Canada is attempting to combat inflation by increasing the overnight rate.

Does low interest rates cause inflation? 

Low interest rates can cause inflation through demand-pull. When interest rates are low, people are motivated to purchase more which helps the economy grow. When there is more demand, production may not be able to keep up which raises prices. The rise in prices can cause inflation over time. 

How does inflation affect stocks?

The effect of inflation on stocks is indirect and difficult to measure or predict. The impact on stocks depends on how management handles the situation and what you’ve invested in. Most companies will simply increase the price of their goods or services in response to inflation. But this doesn’t protect corporations from rising costs, which can cause stock prices to dip. With that said, stocks are generally considered to be safe investments when inflation is concerned. 

Why is inflation good? Why is inflation bad?

A low, stable rate is expected and beneficial in any economy. But when inflation is high and unpredictable, it’s bad for the economy. Unfortunately, Canada is in a precarious situation moving through 2022, which is why everyone is talking about it. 

Can you protect yourself from inflation?

Inflation can have many effects on an economy aside from just financial. However, there are ways to protect your finances. Here are 3 ways, according to Investopedia

  • Invest in stocks. The best stocks to invest in are those with products and services that can easily be increased in price. Commodities like oil, grains and metals have strong pricing power in times of inflation and will continue to profit during economic downturns. Look for stocks like these to shelter your money. In addition, stocks are generally profitable in the long term. Even if your portfolio suffers during tough economic times, it should recover in the long run. 
  • Invest in real estate. Buying property is a good way to park your money during unpredictable economic circumstances. This is not true when you purchase property with the intention to resell it for profit. Housing prices can be affected by inflation in the short term which means buying property for profit is not wise. The intention should be to hold it for a few years while the economy stabilizes. Plus, everyone needs a place to live! Another important thing to consider is high property costs in regions like Toronto and Vancouver. If you cannot afford a property, purchasing one will not protect you financially. There are also arguments that Toronto and Vancouver real estate may actually be a liability since the market prices are climbing so rapidly. 
  • Don’t park in savings, unless the rate is right. If the interest you earn on your savings is not higher than inflation, you’re losing money. This phenomenon is often called the “worst tax” because it usually goes undetected. If your savings rate isn’t 5% or higher right now, you’re better off putting your money elsewhere.

Has the cost of living increased in Canada?

Yes, inflation has caused the cost of living to increase in Canada. Generally speaking, the rate is about the same as the cost of living rate. Canadians likely notice this on a daily basis, such as higher gas, grocery and utility prices. 

The importance of paying attention to inflation

Rising inflation is a sign of an unstable economy. Unfortunately, this is what Canadians are facing right now. Experts predict the high rate will continue through 2022 as well. For this reason, it’s important to pay attention to what’s going on. You should also prepare for the worst by re-evaluating your finances and investments. If you’re going to tweak anything, now is the best time. 

Inflation can be a complex topic to wrap your head around if you aren’t used to looking at numbers all day. In addition, the state of the Canadian economy is alarming which makes it challenging to make informed, objective decisions.

Your financial situation is unique, and we can help you find the best advisor for your needs. Just fill out our short questionnaire.

You’re in the right place for financial advice.

Getting started is easy, fast and free. Match to your perfect advisor now.

Get 12 Smart Questions Everyone Should Ask Their Financial Advisor

Download these questions plus more with the Advisorsavvy community newsletter – subscribe now and enjoy a wealth of knowledge.

Subscribe now and get 12 Smart Questions Everyone Should Ask Their Financial Advisor