Inflation 101

Does the cost of groceries or gas seem high to you? If so, there’s a reason. In early summer 2022, inflation rose above 8%, the steepest increase in 39 years¹. To shed light on the issue, let’s look at the answers to some common questions.

What is inflation?

Inflation is a widespread and persistent increase in the cost of goods and services. This increase is usually expressed as a percentage on an annual or monthly basis. When the cost of living increases and money loses value, you get less for every dollar you earn. For example, here’s how the cost of ingredients for a family breakfast has changed in the past 26 years²:

Today, it takes more money to buy just 1 package of bacon than it took to buy all the ingredients 26 years ago!

Why is inflation going up?

There are several reasons for price hikes:

• If there aren’t enough goods or services to meet the demand, prices tend to go up. That’s why real estate prices soared in 2020 and 2021 when there were more interested buyers than available properties.
• When the cost of providing a good or service goes up, companies changes their prices to remain profitable. For example, higher prices at the pump affect the price of transportation and delivery.
• If the cost of living goes up and the unemployment rate is low, workers negotiate higher wages to keep up. However, this increases the expenses of companies that tend to adjust their sale prices accordingly, thus triggering a vicious cycle.

How is the inflation rate calculated?

The main inflation indicator is the consumer price index (CPI). It shows changes in the price of a “basket,” which generally represents household purchases of essential goods and services such as groceries, housing, transportation, clothing and other various items. These expenses are weighted based on their relative importance to represent fluctuations in the cost of living.

What are the negative impacts of inflation?

High inflation reduces your purchasing power; you need more money to eat, get housing, commute and live. This is especially hard for people whose income isn’t indexed (doesn’t increase with the cost of living), like retirees who receive a pension or withdraw from their savings.

Are prices expected to keep going up? Will they level off? Or go back down? Uncertainty about the future can disrupt plans to buy or lease a new vehicle, become a homeowner or change careers. Companies may be reluctant to invest in growth projects or acquisitions, since it’s harder for them to estimate production costs.

Inflation and interest rates: How are they related?

Central banks ues their monetary policy to boost or slow economic growth. For example, the Bank of Canada deems that when inflation is between 1% and 3%³, the economy grows at a sustainable pace.

To control inflation, the Bank of Canada usually increases the key policy rate which financial institutions rely on to set interest rates for their products, including variable-rate mortgages, lines of credit and business loans.

If you’re planning to buy a new car or home, note that when interest rates go up, so does the cost of borrowing. As a result, the lease or financing rate for a vehicle could be end up much higher than when the vehicle was ordered, leading to higher payments than expected. Some homebuyers may not be able to get a mortgage if their income is insufficient to pass the “stress test” at an even higher interest rate. The stress test proves that you can make payments at an interest rate that is usually higher than the one on your mortgage contract.

Companies may also find it more difficult to get financing. Growth often requires getting a loan to buy new equipment, open a new branch or acquire a competitor or partner, and this loan is then repaid using the additional income. However, the higher cost of borrowing undermines the profitability of these endeavours, perhaps causing them to be set aside.

Although sometimes unfortunate, these consequences work in favour of the central banks’ goal of slowing down economic activity to bring growth to the desired level.