Have you ever noticed that the cost of goods and services seems to go up every year, but the amount you get paid tends to stay the same? One word to define that phenomenon is inflation, and it can have a significant impact on consumers, especially when it comes to your purchasing power and making your money work as hard as it can.
Inflation is an economic term that means a sustained increase in the prices of goods and services over a certain amount of time. This results in a decrease in the value of currency due to a rise in prices across the economy. Inflation typically happens throughout the year, but there are a few ways to keep pace with it if you understand how it works. Below, we talk about how inflation works and some tactics to lessen the impact on your wallet.
Inflation in action
Inflation happens when your purchasing power decreases over time. For many people, inflation is subtle and not always obvious. For example, let’s say you buy the same amount of groceries every month. You’ve likely noticed your bills slowly rising over the years. There are many factors that affect pricing. For instance, how difficult it might be to find a particular product, the labour cost and raw materials, as well as sales competition are all components that affect whether inflation could be on the rise.
On the flip side, the cost to purchase goods can also decrease. This is known as deflation and is less common than inflation. “Many consumers dislike the idea of inflation since it can affect their ability to buy goods,” says Robb Engen, a fee-only financial planner and blogger at Boomer & Echo. “However, it can also be a good thing since it’s a sign of consumer demand and economic growth within the country.”
It’s important to also discuss fiscal policy when explaining inflation. The Bank of Canada sets the overnight rate, which determines interest rates. In turn, this affects inflation. When interest rates are higher, it encourages people to save and discourages borrowing. When this happens, companies may increase their prices slowly or even decrease them to encourage spending.
When interest rates are low, people are more willing to spend since the cost to borrow is cheap. With an increased demand for goods and services, prices go up.
How inflation is measured
To measure inflation each month, Statistics Canada tracks a long list of prices, also known as a “representative basket,” of goods and services. This tracking shows how much Canadians typically buy of these goods and services each month. The prices of these items then add up to a measure of average prices, known as the consumer price index, or CPI. While consumers may notice inflation when making their daily purchases, the consumer price index (CPI), as well as the wholesale services price index (WSPI), another indicator, are much more precise.
The CPI is the most common measure used to calculate the cost of living for Canadians. To calculate the CPI, the government includes eight components:
- Household operations, furnishings, and equipment
- Clothing and footwear
- Health and personal care
- Recreation, education, and reading
- Alcoholic beverages, tobacco products, and recreational cannabis.
Since this data is updated monthly and reflects what the average Canadian interacts with, it’s a clear picture of how much the cost of goods has changed year-over-year.
The WSPI is a bit more technical since it measures the monthly change in the price of wholesale services. The information is gathered quarterly and gets combined with other business service indexes to get a better idea of real output and productivity. This data is helpful to the Bank of Canada since it allows them to see where the economy is headed.
3 types of inflation and knowing the difference
While it may seem like inflation happens all the time, various factors affect prices. If you understand the causes of inflation, you can sometimes make different purchasing decisions to keep your costs down.
1. Cost-push inflation:
When production costs such as materials and labour increase, it’s known as cost-push inflation. Even though the demand for certain goods may not have changed, the cost increase since production costs has risen.
The increase in production costs can happen for a variety of reasons. For example, when the unemployment rate is low, there can be a labour shortage. To attract qualified workers, companies need to increase wages. Alternatively, a natural disaster could destroy a significant crop such as corn. Items that use corn as part of their production could increase in price as a result.
2. Demand-pull inflation:
Demand-pull inflation refers to supply and demand. Whenever there’s an increased demand for a product, costs can go up since consumers are willing to pay more. “When the pandemic started, there were a lot of homeowners that decided to renovate their homes,” says Engen. “As a result, the cost of lumber increased due to the increased demand.”
On the flip side of things, when supply exceeds demand, prices fall. That said, companies can choose to raise prices even if there are no supply issues if they think consumers are willing to pay more.
3. Built-in inflation:
Consumers have come to expect inflation to continue to rise. Because of that, they expect that their wages will also increase. Of course, this cause-and-effect creates a wage-price spiral that drives inflation forward.
Ways you could beat inflation
If your wages haven’t increased or you’re hoarding your cash in a chequing account, your money is actually decreasing in value due to inflation. Trying to beat inflation can be difficult, but there are ways to do it:
- Shop around: Changing your shopping habits is one easy way to keep your expenses down. For example, you could purchase things in bulk when they’re on sale, or you could switch to a cheaper brand. Alternatively, if a particular item has risen in price due to demand, you could choose to not purchase it.
- Build your savings: The last thing you want is to see your savings devalue. If you invest your money, you could potentially see it grow. A couple of low-risk options include a high-interest savings account or market-linked guaranteed investment certificates. There’s no chance that you’ll ever lose your principal investment, so they’re a good choice for risk-averse investors.
- Invest your money: For those looking to stay ahead of inflation, you could consider investing in mutual funds, as there’s potential for higher returns. Other low-risk vehicles include high-interest savings accounts (HISAs)and Guaranteed Investment Certificates (GICs).
A handy, interactive tool published by Statistics Canada can help you determine your own personal household rate of inflation based on the goods and services you consume. Knowing how you compare to the average Canadian household can help you make better decisions around more economic spending.
In the end, is inflation good or bad?
Any economist will tell you that too much inflation is bad for the economy. However, too little inflation can be harmful as well. The Bank of Canada targets 2 per cent inflation per year, since it’s what the economy can handle. Although you can’t control inflation, you get to decide how you spend your dollars.
Connect with a financial adviser from Coast Capital’s investment team to learn about savings choices that are right for you.