Unpacking inflation and interest rates

Do you remember the days of penny candy? I don’t, but I’ve heard it was once a thing. Now, I can’t imagine buying anything for a penny, a monetary unit we’ve entirely done away with given its worthlessness. That’s because prices keep going up, not only for candy but for everything we buy. This increase in prices is caused by inflation.

For a long time, inflation rates in Canada hovered around the 2% mark. That meant that prices didn’t increase extraordinarily quickly, given that price bumps were tied to this rate. But recently, this has changed, with inflation quadrupling to a high of 8% just one year ago. Now, Canadians are paying a lot more attention to how inflation and interest rates affect our spending power.

What is inflation? 

Inflation is a term that refers to how much the price of the things we buy is changing. There are many factors that can influence the rate of inflation, like availability of goods and how much they cost to make. 

Statistics Canada measures inflation rates by generating the Consumer Price Index (CPI), which identifies the rate at which prices are changing for average Canadians. It does this by tracking a fictional basket of goods typically purchased by Canadian households, and calculating price increases over time. These increases in the cost of goods indicate the rate of inflation. 

If you’re old enough to remember the 1970s, you’ll recall that inflation was high, nearing the 10% mark, and prices rose relatively quickly. Since the early 1990s, the Bank of Canada has been using economic control mechanisms to keep inflation rates lower, which is why prices have remained relatively more stable. While we might not be able to imagine buying penny candy, until recently we haven’t actually seen steep price increases because inflation has been hovering closer to 2%.

However, the last couple of years have been rockier, with inflation rising sharply. This has meant that Canadians have felt pressured to continue to afford the same commodities that were more affordable when inflation rates were lower. Since 2021, inflation rates have varied from as low as 1% to topping 8%, just like the notably high rates seen in the 1970s.

Inflation can feel like an elusive economic phenomenon, leaving you scratching your head as you try to make sense of where your hard-earned money is going. For instance, one of the highest rates of inflation seen recently has been in the grocery sector, where Canadians already spend a whopping 11% of their household income. This means that the same amount of income simply won’t stretch as far when it comes to feeding your family or buying other commodities you need.

Controlling inflation 

Inflation can feel a bit like a wild roller coaster ride, with no predictable course. But while its constant erosion on the purchasing power of our money isn’t exactly predictable, there are economic forces at play that are intended to control inflation rates in Canada.

An agreement between the Government of Canada and the Bank of Canada dating back to the 1990s has enabled the Bank to exert forces on our economy to maintain an inflation rate between 1% and 3%. It largely does so by controlling interest rates. As inflation has crept up recently due to market factors and the influence of the COVID-19 pandemic, we’ve experienced a number of interest rate hikes that have been instituted as a measure of inflation control. 

As the Bank raises or lowers its key policy interest rate, consumer activity is influenced, which is intended to keep inflation in check. As interest rates rise, Canadians tend to save more as their spending power is diminished. When rates drop, we tend to spend more money as our purchasing power is once again restored. Healthy economies avoid having both hyperinflation (very high rates) and deflation (very low drops).

Interest rate hikes

So this brings us to the interest rate hikes you’ve likely read about in the news lately. The Bank of Canada has been steadily increasing its interest rate in recent years. This is intended to have the effect of reducing our borrowing and spending, thereby keeping inflation from rising out of control. 

After peaking at about 8% a year ago, inflation rates are now closer to half that, at about 4%. The Bank of Canada has made clear its intent to continue to exert force through interest rate adjustments until inflation returns to the 2% range. That’s why we continue to hear about looming interest rate hikes. 

What does this mean for you? As interest rates continue to rise, compounded with inflation that remains higher than many Canadians have ever seen, your money simply isn’t going as far as it used to. You likely feel like it’s very challenging to stretch your paycheque to cover all of your expenses. 

One of the key areas where interest rates affect us are on the biggest purchase most of us will ever make: our homes. Even a small adjustment to the interest rate can have a significant impact on how much you’ll pay for your mortgage, even if you already largely own your home. That’s why financial advisors are carefully anticipating what the Bank of Canada will do next.

What can be done to manage inflation’s impact?

Inflation and fluctuating interest rates can make it a challenge to manage your finances and feel secure about your financial future. Partnering with a financial expert like our knowledgeable chartered professional accountants can allow you to navigate these complexities with confidence.

Our understanding of economic trends can assist you in creating inflation-adjusted financial plans and developing a budget that accounts for current rates. This will allow you to optimize your spending and reallocate resources strategically to mitigate the impact of rising prices. Tax planning services can also enable you to take advantage of available deductions, minimizing your overall tax burden and leaving more money in your pocket. You can read more about how to curb the impact of inflation here

MMT Chartered Professional Accountants have the expertise you need to analyze and understand complex economic data and develop effective strategies to protect your wealth. If you’re struggling with the effects of rising inflation and interest rates, as many Canadians are, contact us today. Invest in the guidance of a trusted advisor, and gain confidence in achieving your financial goals, even when times seem uncertain. 

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