Most of us can remember a time when our parents or grandparents told us how much something cost when they were our age. It might have been a loaf of bread. Or their college tuition. Or even a new home. Whatever example was used, one thing that’s almost certain is that it cost a lot less then than it does now. But those stories weren’t actually about bread, tuition or a home. They were about inflation. Inflation is the tendency of things to cost more over time.
When you hear about inflation in the media, you often hear about something called the inflation rate. The inflation rate is simply a measure of how fast prices have increased over the past year.
The challenge with determining an inflation rate is that not all prices change at the same rate or the same time. Some things cost a lot more than a year ago. Other things cost just a little more. And some things may actually cost less.
To make it easier to measure, the inflation rate is usually calculated as the annual change in price for a “basket of goods”. Generally, the basket includes a variety of common items that most people are likely to purchase over the course of a year. If that basket of goods cost $100 a year ago and it costs $105 today, we say that the inflation rate is 5%.
What causes inflation?
Very broadly, there are two main things that can cause inflation:
- Too much demand. Inflation can happen when there’s more demand for something than the economy can supply. For example, if there are more people who want to buy a home in your city than there are homes for sale, the price of homes will go up. Economists refer to this as demand-pull inflation.
- Increase in business costs. Inflation can also happen when the cost of producing something increases and a business has to raise prices. For example, if the price of jet fuel increases, the cost to operate an airplane goes up. This may lead an airline to charge more for plane tickets. Economists refer to this as cost-push inflation.
Is inflation good or bad?
To understand whether inflation is good or bad, we first need to define what we mean by good or bad. Let’s start by thinking about money.
When you get money, you essentially have two options for what to do with it:
- You can keep it. You could do this in many ways, such as putting it in a savings account, investing it, or paying down debt.
- You can get rid of it. You could also do this in many ways, such as spending it, donating it to charity or giving it to a family member.
To function properly, an economy needs a good balance of saving and spending. Too much of either can cause problems. So, when we think about whether inflation is good or bad, we need to look at how it impacts the balance between spending and saving.
Inflation can be good…
Most economists consider a little inflation to be good, because it encourages people to spend some of their money, but not all of their money. If you know that something will cost a little more in the future than it does today, you’ve got a small incentive to buy it sooner rather than later. This puts some of your money back into the economy – which helps to support economic growth.
For inflation to be considered good, it also needs to be stable and predictable. If consumers and businesses are reasonably confident about what prices will be in the future, they can plan their spending effectively and keep their finances healthy.
In fact, stable and moderately-low inflation is so important to a healthy economy that the Bank of Canada has set a target for inflation: It tries to keep the annual rate of inflation between 1% and 3%, with a target of 2%.
High, negative and unpredictable inflation are less desirable:
- A high rate of inflation makes things more expensive for everyone, particularly when incomes don’t keep up with prices. High inflation means we need to allocate more of our money toward spending and less towards saving. Overall, people can afford to buy less with the same amount of money, and this can weaken the economy.
- Negative inflation (deflation) may be a sign of underlying problems in the economy. People may be losing jobs and incomes may be dropping. Financial uncertainty may lead people to spend less. People may also delay buying things if they’re waiting for prices to go down even further. Left unchecked, deflation can lead to business closures and increased unemployment.
- Unpredictable inflation makes it difficult for people and businesses to plan their spending. If they don’t know what prices will look like a month or a year in the future, they may delay spending and put more of their money into their savings, to be prepared for the unknown. This reduction in spending can have a negative impact on the economy.
How does the Bank of Canada (try to) manage the level of inflation?
There are a few things the Bank of Canada can do to try to influence the inflation rate, but the primary one is changing the level of interest rates. The interest rates set by the Bank of Canada have a strong influence on the interest rates that your local bank charges for mortgages and loans, and that it pays on savings accounts and Guaranteed Investment Certificates (GICs).
When inflation is too high
Since high inflation can lead people to spend more and save less, the Bank of Canada will try to lower the inflation rate by raising interest rates. Higher interest rates can help to lower inflation in two ways:
- It makes borrowing more expensive. If it costs more to borrow money, consumers and businesses will borrow less, and consequently spend less as well.
- It makes saving more appealing since people can earn more in their savings accounts and GICs.
In short, higher interest rates can help tip the balance away from spending and toward saving.
When inflation is too low
Since low inflation can lead people to save more and spend less, the Bank of Canada will try to increase inflation by lowering interest rates. Lowering interest rates has the opposite effect to raising them:
- It makes borrowing cheaper, so consumers and business owners are more likely to borrow money to make purchases or expand their businesses.
- It makes saving less attractive since people will earn less in their savings accounts and GICs.
Lower interest rates can help tip the balance back towards spending and away from saving.
What should I do when rates are rising?
After an extended period of very low interest rates, rates have been increasing fairly rapidly toward longer-term norms. What you can do about this depends on whether or not you have debt.
If you have debt, you may want to direct more of your money toward paying down your debt to help reduce your interest costs. In general, it’s best to start with your highest-interest debt, which is often your credit card.
Next, look at paying down lower-interest debts, like your mortgage. Traditional mortgages generally have limits on how much you can prepay in a year, so be sure you know what your limits are. Some mortgages, like Manulife One, allow you to put as much money as you want toward paying down your line-of-credit debt – which makes it a great option if you want to pay down your debt quickly.
Finally, if you’re concerned that rates will continue to rise, you may wish to lock-in some of your mortgage debt at a fixed rate. If you have a Manulife One account, you can lock in a portion of your debt with a term sub-account.
If you don’t have debt, higher rates can be a good thing. The key is to put your money to work. If you’re still using a chequing account that pays very low interest, consider switching to Manulife Bank’s Advantage Account, a combined chequing and savings account that offers all the features you’d expect while paying a high rate of interest on every dollar. If you’re comfortable locking in your money, consider earning even more interest with a GIC.
Whatever your situation, it’s always best to have a conversation with your advisor to ensure your money is working toward your long-term financial goals.