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Inflation: What does it mean for you?

What is it, why is everyone talking about it, and why should you care?

Remember when shops closed in March 2020? And then they just… didn’t reopen? For like, a long time? Something about a pandemic?

That closure and others like it were necessary to keep people safe. But those closures also had expansive economic impacts that Canada is now attempting to recover from. 

To put it in a nutshell: in order to encourage strong economic activity within Canada, the Bank of Canada decided to leave the cost of borrowing money low. This meant people would  borrow—and crucially, spend—more money, keeping currency circulating in our economy. 

But choices like this one can bring on inflation, which can be a good thing or a bad thing. This post looks at what inflation is, what makes it happen, and what it means for us. 

What is inflation?

Our friends at Investopedia explained it simply when they wrote “inflation is the decline of purchasing power of a given currency over time.” No faff with those guys. 

Often, inflation is illustrated by imagining a grocery basket full of eggs, bread, and… wine. (This “basket” has to include a variety of products and services to be a good measure of inflation, and is often represented by the Consumer Price Index, or CPI.) This basket we’ve got will cost us $10, say. 

When inflation increases at a nonoptimal rate (i.e., when there’s too much inflation), the cost of goods rises. We might return to the grocery store to purchase the exact same basket of goods only to find the cost is now $15. 

This means that our power to buy goods, per unit of currency, has diminished. This is how inflation “erodes” the real value of cash, and cash holdings or savings, over time. 

Economists have been expecting an uptick in inflation; its absence is in part what encouraged the Bank of Canada to take the actions it did and leaving interest rates low. 

But this choice, and a variety of other factors, means we could see a rise in the rate of inflation in the next several years.

What causes inflation?

There are three general types of inflation: demand-pull inflation, cost-push inflation, and built-in inflation. An optimum level of inflation is actually a good thing, because it encourages economic activity and employment. 

Demand-pull inflation happens when an economy is well stimulated, and consumer demand for products actually outpaces the production capacity for those goods. As a product becomes more scarce, its price can rise. A classic example of  supply and demand.

Cost-push inflation is the opposite. This happens when the cost of production rises, and that cost is passed along the supply chain to the consumer with the ultimate price increase of said product. 

Built-in inflation is related to what can be called the wage-price spiral. When consumers see the cost of living rise—even a little—they assume it will continue and demand higher wages to compensate. These higher wages are reflected in the cost of production, which, again, drives prices, and so on. 

In Canada, we’re seeing bits of all of these types of inflation. This article itself could be considered a product of built-in inflation. Here we are, telling you that based on our research, increased inflation could occur in the next few years; this could drive you to change your behaviour. 

Similarly, as the Bank of Canada keeps the cost of borrowing low, consumers will likely continue to spend, potentially driving up prices. And ongoing problems in the global supply chain—remember when the big boat got stuck?—could force higher production costs down the supply chain onto the shoulders of consumers. But only time will tell!

What does inflation mean for me?

Inflation can have several impacts on the average consumer, both positive and negative. If inflation falls, it means your purchasing power grows. If it rises, it means your purchasing power falls. 

Inflation is always a possibility, and there are a few things you should be aware of. There are a myriad of potential impacts of inflation, but here are three you might find more likely to impact you. 

Consumer purchasing power may fall

Your wine, coffee, eggs, bread, furniture, car, rent, and imports (for example) may cost more than they do today. Some experts say it’s possible to insulate your savings against inflation by not holding cash, but rather other instruments like equities. Holding specific financial products may help counteract the erosion caused by inflation, but every scenario is different. 

Talk to a financial  advisor or broker if you’re worried about your holdings. 

Borrowing costs may increase

To counteract inflation, the Bank of Canada may opt to raise interest rates. If you have a variable interest rate on a personal loan, student loan, line of credit, or mortgage, this may impact you, as the interest rate on your balance owing may increase. Talk to your bank or broker if this concerns you. 

Spending may increase

When interest rates climb and inflation gets out of control, people tend to withdraw from the market. Worried about the economy’s future, they feel they should save what they already have. 

But in the early stages of inflation, oddly, the opposite tends to happen. 

With continued inflation in the forecast, consumers often actually increase their spending. This makes sense: the value of the dollar will likely fall, but the real use-value of a pair of new running shoes with room to grow for little Tommy or a new coat for wee Jimothy that’ll fit until  he’s older stays the same. The idea is to buy now, when prices are lower, investing in goods that won’t themselves lose value. But this increase in spending can actually drive inflation, as in the demand-pull scenario. 

Inflation: we can’t avoid it. That’s why it’s important to have a good understanding of economic trends like these so we know how to best respond and adapt as our economy recovers in unpredictable ways.