How to manage inflation

Inflation is a rise in prices of goods and services. Typically, over time, it reduces the purchasing power of our currency, the Canadian dollar. For example, 20 years ago, C$1 could buy a 9-inch apple pie, but now that same dollar will only buy 20% of the same pie. This type of decrease in purchasing power of the Canadian dollar is mostly an accumulative result of inflation over the years.

The inflation rate is regarded as normal if it is between 1 to 3%, when it is measured over a 12-month period. If the inflation rate is higher than 4%, it is considered high or abnormal.

The Bank of Canada uses the consumer price index (CPI), which represents changes in prices as experienced by Canadian consumers. It measures price change by comparing, through time, the cost of a fixed basket of goods and services. CPI uses various formulations, to assess if inflation occurs and how wide it has spread across the sectors of economy.

There are 3 main causes of inflation. The first cause is an excess of cash or savings in the hands of people competing for the same goods and services. This pushes those prices up. As of now, it is estimated that Canadians have $200 to $300 billion in savings.

The second cause of inflation is a surge in demand in the economy. Canadians who were not able to enjoy high-contact services during the height of COVID-19—services not accessible online that require a service provider—are now demanding for more of those types of goods and services. This pent-up demand causes higher prices as employers are having a difficult time finding qualified workers and offering competitive salaries. This increase in labour cost results in higher consumer prices.

Downward shocks in supply is the third cause of inflation. This means there are fewer goods and services, so the providers of goods and services can ask for higher prices. The war in Ukraine has caused uncertainly in the supply chain and this has led to a shortage in oil, gas, and food, which has led to higher global prices of our daily products.

In addition, Bank of Canada is also to be blamed for having kept its policy interest rate so low (at 0.25%) for far too long, causing excess borrowing and a very hot house market in Canada’s big cities. Young Canadians are priced out of large cities such as Toronto.

The Bank of Canada raises interest rates to control high inflation. Rate hikes will impact variable mortgages where rates are linked to commercial banks’ prime rates. When the prime rate is below the “trigger rate,” monthly mortgage payment remains unchanged. But the proportion of each payment that goes towards paying down the outstanding mortgage goes down because interest expense takes a bigger share of the payment. This means longer time is required to pay down the mortgage loan.

Once the prime rate hits the trigger rate, homeowners will be forced to make higher mortgage payments every month. If high inflation persists for long time, fixed mortgage rates will be adjusted to higher level and cause higher monthly mortgage payments.

The hardest hit are low income, people with disabilities, and young college students because their consumption patterns usually are narrower than the rest of the population and they are more directly affected by inflation. So, they are spending a higher proportion of their income on food.

People in their midlife are also affected by variable mortgage rates, bills, and groceries.

Older adults and retirees whose incomes are solely tied to pension payments are also greatly affected.

Spend money rationally and avoid unnecessary purchases.

Reduce debt such as car loans and home mortgages.

Invest in defensive-sector stocks such as consumer staples, energy, health care, and utilities.

Invest in precious metals such as gold and silver bullion, exchange traded funds (ETFs), or high-interest savings with a laddered strategy. For example, divide cash into baskets of equal amount and every time the Bank of Canada raises interest rates, invest in guaranteed investment certificates (GIC) using only fund from one basket.

Make good use of coupons offered by suppliers.

Make purchases using your debit card to avoid overspending.

It is hard to say if any group would “profit” from inflation, but some would bleed less than others. For example, energy companies will earn higher incomes as demand for oil and gas is not as severely impacted by rising prices. Companies in consumer staples sector, such as Walmart and Proctor & Gamble, would probably be less impacted by inflation if they can control their supply chains and production costs.

Commercial banks would have more room to spread between the interest rates charged against borrowers and the interest rates paid out to depositors.

As is often said in economics, there could be a soft landing or a hard landing. With a soft landing, everything works out fine; inflation gets back to the normal range of 1 to 3%, the economy is growing at its potential rate, unemployment rate remains low or even down, and stock market is doing well.

With a hard landing, the inflation rate is contained to the normal range but along with a recession in the economy, unemployment rate goes up, or stock markets go down, or a combination of all 3. And these are the “gives” by ordinary Canadians to get back to normal prices.

There had been soft landings and hard landings. To quote from the July 13, 2022 press conference opening statement by the governor of Bank of Canada, “The path to this soft landing has narrowed because elevated inflation is proving more persistent.” Fingers crossed that Bank of Canada will deliver a soft landing although the bank faces many risks including not having a solid understanding of the nature of work in the wake of COVID-19.

Housing prices are reported going down, indicating that people are responding in an expected fashion to the 1% increase in the policy rate of Bank of Canada. So there is this hope that high inflation rates won’t be permanent. Bank of Canada expects the inflation rate to fall by the end of 2022, and the economy returning to normal by the end of 2024.