An economist explains: What is inflation?

To mitigate the effects of inflation on your grocery bill, consider comparison shopping or cutting back on certain products (Getty Images/Joos Mind)

Inflation is something that everybody is talking about and, while we all understand its impact on our wallets, it can be hard to understand exactly what it is. A number of factors have contributed to the recent rise in inflation. COVID and the subsequent supply chain disruption and labour shortages have driven higher prices for staples such as furniture, cars, gas and food, while the Russia-Ukraine crisis has had an additional impact on oil and gas prices. There could also be spikes in processed food because of the diminished wheat production in Ukraine and Russia.

From March 2021 to March 2022, inflation was tracking at 6.7 per cent. “The last time inflation reached these rates was 1991, where it stayed high for eight months,” says David-Alexandre Brassard, chief economist, CPA Canada.

The average inflation rate in 2020 was 0.7 per cent, it was 3.4 per cent in 2021 and it's forecasted to be around 5.3 per cent for all of 2022. “It means that we’ll have two years of inflation that will be significantly higher than the two per cent long term target of the Bank of Canada,” explains Brassard.

To help explain these rising costs, here are some basics on what inflation is, how to reduce its impact and what we can expect to see in the months to come.

WHAT IS INFLATION?

Inflation is based on the Consumer Price Index, Brassard explains. “Statistics Canada tracks an average basket of goods and services that people buy and estimates how the price of that basket fluctuates over time.”

The basket of goods used in calculations includes eight components:

• Food
• Shelter
• Household operations, furnishings and equipment
• Clothing and footwear
• Transportation
• Health and personal care
• Recreation, education and reading
• Alcoholic beverages, tobacco products and recreational cannabis

Each category contains multiple goods and services. For example, transportation will include the cost of buying or renting a car, as well as the cost of gasoline or public transportation. The basket of goods and services must be updated frequently to account for the changes in consumption patterns of Canadians.

“An increase in prices of certain goods and services can impact multiple categories either directly or indirectly,” says Brassard. “The increasing cost of energy for example will impact transportation and shelter directly and can drive up transport prices for imported goods across multiple categories.”

HOW DEMAND AND SUPPLY IMBALANCES DRIVE INFLATION

There are two sides to the inflation equation: demand and supply.

Demand refers to the volume of consumption and how people are buying the goods and services they want. “With COVID, the demand side switched away from services. People were travelling and dining out less, and spending their money on goods, housing and renovations, creating a higher demand for certain goods,” Brassard explains.

“On the supply side, it moved the other way,” he adds. “With labour shortages, absenteeism from COVID and supply chain disruptions, there was, and still could be, less supply than demand. Higher demand and lower supply drives prices up.”

WAYS YOU CAN FIGHT INFLATION

As consumers see prices increase, they may try to reduce consumption.

“That’s not always possible,” acknowledges Brassard. “Components such as food and gas might be hard to cut back on. You could eat out less or reduce gas usage by working remotely, but not everyone is in a position to do that.”

There are a number of strategies that are gaining traction with consumers facing challenging times. “As people experience financial distress, they are turning to online reused goods markets and co-ownership. The sharing economy can also offer options to consumers,” Brassard says.

Some ways to minimize the impact of inflation at home include:

• Reduce consumption of items that have risen the most, such as meat and dairy.
• Cook more to reduce consumption of processed food and eating out.
• Postpone renovation plans. “Construction prices right now are very inflated. This is something you could hold back on, if possible,” advises Brassard.
• Try to extend the life of durable goods such as appliances, furniture and cars as much as possible. “It’s cheaper to repair than buy new ones,” he says.
• Take advantage of the resale marketplace for second-hand goods and consider renting or sharing items that are used infrequently.
• Comparison shop to find the best prices and seek out coupons for groceries
• Drive less where possible.

LOOKING PAST 2022

Brassard is hopeful that inflation may not remain as high after 2022. “Central banks are starting to increase interest rates in an effort to slow down inflation. Increasing rates makes it more costly to borrow so it becomes advantageous for consumers and businesses to hold money rather than spend it. This, in turn, reduces pressure on the demand side.”

While hyperinflation and rapid price increases are often discussed, he believes that scenario is unlikely. “Hyperinflation is defined as when inflation reaches 50 per cent month-over-month. That means your $1 apple in September will cost $1.50 in October. We are miles away from that possibility.”

Canada has room to raise interest rates and control inflation, he notes. “Right now, rates are low and that’s a good thing. In fact, inflation in Canada is close to two per cent lower than the U.S. Looking at Russia can offer some perspective on Canada’s inflation position. Their prices have increased 16.7 per cent from March 2021 to March 2022 and the central interest rate starts at 17 per cent.”

LEARN MORE

Take a deeper dive into inflation’s causes and history. Plus, get tips for resetting your finances and what to budget if you’re looking to buy your first car.