The price of groceries, gas, housing – it’s all increasing at a rate that hasn’t been seen since before the turn of the millennium.
So inflation (a topic those who grew up in the 70s know well) is back in the news.
According to Statista, inflation in 2022 was 6.8%, more than double the rate of the previous three decades, hovering around 1-3%. To find a higher inflation rate than 2022, you’d need to go back to the early eighties.
That means millennials and Gen Z have never faced an inflation rate like we saw in 2022.
It’s no wonder everyone’s talking about inflation.
What is inflation?
To quote the Bank of Canada: ‘Inflation is a persistent rise in the average level of prices over time.’ To put that plainly, everything gets more expensive over time.
That’s why you could get 20 McDonald’s hamburgers in the 70s for the price of a single burger today.
It’s not just burgers either. Because inflation is a measure of the rise of the average levels of prices, that price increase is reflected in everything we purchase.
And that increase has been occurring for decades.
How inflation works
At first glance, inflation doesn’t seem to make sense. Shouldn’t prices default to staying the same?
Perhaps if the economy was still, prices would stay the same. But in the current economy, our wealth is not static.
In fact, our economy is, generally speaking, growing. And the purchasing power of the average Canadian is growing along with it.
That extra money in our economy is increasing demand. That increase pulls on a fundamental lever of capitalistic economies – the law of supply and demand.
The principles of supply and demand are simple:
- When supply is greater than demand, prices decrease.
- When demand is greater than supply, prices increase.
And as our purchasing power continues to grow, demand is increasing.
That sets off a waterfall effect:
- The economy grows and Canadians grow in wealth
- Demand increases as Canadians’ purchasing power does
- Sellers increase prices to keep up with demand
These three factors combined are what generally cause inflation.
How is inflation measured?
Following just one benchmark (like the cost of McDonald’s hamburgers) to measure inflation does not work. The price of burgers could spike or drop based on a variety of temporary conditions. For example, a drought could cause the price of wheat to increase, pushing the price of buns higher, thus increasing the price of your hamburger.
This price increase would reflect the effects of the drought, but it would not reflect the general inflation of the cost of living.
To make sure inflation is more broadly applicable, the Bank of Canada (BoC) bundles together a variety of products and services in a ‘basket’ that generally reflects the average Canadian’s cost of living.
This basket includes products like:
- Medical care
- Personal care supplies
- Transportation services
The price of each product or service is then added together and averaged out. Each month, the price of this basket is calculated and then compared against the previous month’s price.
This creates the Consumer Price Index (CPI), which is how the BoC measures inflation.
Is inflation bad?
On the surface, inflation seems bad because it makes everything more expensive over time.
However, it’s important to remember that inflation occurs because the purchasing power of individuals has increased. That is to say, more people in the economy have more disposable income to spend.
So while we may not like that inflation occurs, it is a sign that the economy is doing well.
And for the most part, when the economy is doing well, so are you.
What about deflation?
Deflation is the opposite of inflation. The BoC defines deflation as ’a persistent fall in the average level of prices over time.’
Essentially, deflation means consumers are buying less than industry is producing, leaving retailers and service providers to lower prices to encourage more people to buy.
This typically indicates a higher unemployment rate, which means consumers are unable to purchase as much as they could in the past.
So while decreasing prices seem positive, it reflects a flagging economy.
The dark side of inflation
While inflation isn’t ‘bad’, it can harm the economy. Wild swings in the rate of inflation, like what we saw during the pandemic, create uncertainty.
- First, the rapid change in prices makes it difficult to run a business. You don’t know how much your suppliers are going to charge you month to month, or how much your employees will need to survive.
- Second, this rollercoaster makes it difficult for the average citizen to plan their finances or create a budget. For example, if you don’t know how much lumber will cost next year, it makes it much more difficult to plan for building or purchasing a new home. After all, it might be much more expensive to buy a house tomorrow if the price of lumber suddenly spikes. In short, it’s never clear if you should spend your money now, or save it for the future.
Because of this chaos, the economy suffers.
In the end, it’s not so much about the rise or fall of prices, but how predictable the rate of inflation is.
For that reason, the BoC does its best to control inflation.
How the BoC controls inflation
Back in the nineties, the BoC and the government decided the best rate for inflation was between 1% and 3%. And it’s been successful at keeping the inflation rate there since (except for during the pandemic).
The BoC has been able to do this by raising or lowering interest rates.
When inflation is too high, the BoC raises interest rates, which causes consumers to stop spending money. This will inevitably decrease demand, which will naturally lower pricing.
If inflation is low, however, the BoC lowers interest rates, which allows consumers to better leverage debt to purchase, thus increasing demand.
Why did inflation increase so quickly in 2022?
The Bank of Canada has a great track record for controlling inflation. So, why did inflation spike seemingly out of control in 2022?
- Increased demand: The government of Canada released money to those in need to make sure the country wouldn’t enter a recession. Pair that with historically low interest rates, and Canadians were spending much more than usual.
- Decreased supply: government lockdowns and plant closures decreased the supply of almost every product over the course the pandemic.
Together, the spike in demand combined with a decrease in industry’s ability to supply goods caused a drastic increase in inflation.
The good news is, 2024 is looking a lot more manageable, with inflation predicted to drop to 2.43%.