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Inflation: How It Affects Your Finances

June 10, 2020
7 mins
A woman holds up her coffee mug and stares out the window as she works on her laptop

Much of Canada’s economy has ground to a halt amid the COVID-19 pandemic. One of the effects of this has been a drop in prices for many items. Most notably, gas.

As a result of consumer prices dropping, Canada’s inflation rate went negative to -0.2% in April, according to Statistics Canada, which tracks the cost of goods and services through the Consumer Price Index.

While the world struggles to contain the virus, prices are expected to continue to drop. Unfortunately, so are wages.

Longer-term, though, experts are divided on what happens when the economy recovers. Will it lead to continued low prices, or could we see inflation?

What is inflation?

Inflation is a rise in the average price of a selection of products and services, ranging from items such as food and beverages to housing, clothes, transportation and recreational costs.

For consumers, it means your money may not go as far, although if higher wages offset it, it may end up being a wash.

In terms of your savings, inflation can sway the value of your portfolio, depending on what you hold. Most importantly, you need to guard against inflation eating away at how much your savings can buy in retirement.

But economists say a certain level of inflation is needed to boost spending instead of saving, to promote economic growth, which benefits everyone through its effects on jobs and people’s investments.

The Bank of Canada aims to keep inflation at about 2%, to keep the price of goods affordable for Canadians, while also giving the central bank the ability to adjust interest rates up or down to help boost or dampen the economy.

How does inflation work?

Inflation can happen when there is added demand for products and services, as consumers are willing to pay more for them. It can also occur when companies charge more to offset higher production costs, including wages.

Another contributor to inflation can be government action intended to boost spending, such as lowering interest rates.

Interest on your mortgage or other loans is based on the central bank’s target for the “overnight” interest rate. This target is the interest rate at which major financial institutions borrow and lend one-day funds among themselves, and it affects how much interest they charge for their loans to consumers.

The Bank of Canada uses interest rates as a way to try and stimulate or slow the economy.

For instance, the central bank lowers interest rates if the economy is slowing down to encourage businesses and consumers to spend by making loans cheaper to pay back with lower interest rates.

There is a general tendency for interest rates and the rate of inflation to have an inverse relationship. In simple terms, when interest rates are low, it can encourage people and businesses to spend, so the economy grows, increasing inflation. When interest rates are high, the economy slows, and inflation decreases.

How does inflation affect savings and investments?

Inflation cuts into people’s buying power. Because inflation affects how much a dollar is worth, or able to buy, the money you had put away in 2000 for, say, a down payment, may not be worth the same today. And the money you save today may not buy you as much in retirement.

The Bank of Canada has an inflation calculator that allows you to plug in an amount from a previous year and compare it to today’s value (unfortunately, you can’t estimate the value beyond now, as the rate of inflation is unknown into the future). For instance, if you bought a couch for $1,000 in 2010, it would cost about $1,170 today.

For investors, it can mean your holdings are worth more. Although if you have stocks in companies that can’t offset rising costs with higher prices, they may fall.

For those who invest in bonds, at low-interest rates, they can yield less than the rate of inflation. For instance, if inflation is 4% and bonds return 3%, you lose 1%.  That is because, in this scenario, the goods or services you will buy with that money will theoretically cost 4% more than they did at the time you invested in the bonds.

How is COVID-19 affecting the inflation rate in Canada?

The immediate effects of COVID-19 have shown an overall drop in prices. Though some increased, such as cleaning supplies and many grocery items because of demand.

Compared with April of last year, consumers paid less for transportation (-4.4%), clothing and footwear (-4.1%), and recreation, education and reading (-0.7%), Statistics Canada said. But food prices went up 3.4%, with some items up higher, such as rice (+9.2%), eggs (+8.8%) and margarine (+7.9%). Gas prices fell 39.3% on a year-over-year basis in April, the most significant year-over-year decline on record.

While the price drop may benefit consumers in certain areas, the decrease in value and lack of demand for sectors such as the auto industry, real estate, retail, travel and hospitality have had a major ripple effect on the economy, affecting jobs and investments. Canada officially entered into a recession in the first quarter of this year, according to the C.D. Howe Institute. Economists generally expect a recovery to take a couple of years.

The government has been spending unprecedented amounts to prop up individuals and businesses. And to help the economy recover from the effects of the pandemic, the central bank has put a plan in place that includes lowering the overnight rate by a cumulative 150 basis points since early March to 25 basis points. The hope is that lower rates will encourage spending when the recovery gets underway, once lockdown measures are lifted.

Since the nature and fallout of this crisis are so unique, experts are divided about the future of the inflation rate in Canada as the pandemic drags on.

Propping up your personal finances

Credit reporting agency TransUnion has been conducting weekly surveys about how the pandemic has affected Canadians’ finances. The latest report shows 59% percent of respondents saying their income has been negatively affected. The impact is higher among millennials, though, with 72% saying they are negatively affected.

There are some emergency measures available for people immediately impacted. If you have lost a job or income, or have a small business affected by the pandemic, there are government relief programs available. A few of the aid measures include the Canada Emergency Response Benefit (CERB), the Canada Emergency Student Benefit (CESB), and the Canada Emergency Wage Subsidy (CEWS).

But longer-term, because of the uncertainty around how the pandemic will end up affecting the economy and your financial situation, it’s a good idea to get proactive around your spending and budgeting. Being prepared can include cutting costs, planning your purchases and building an emergency savings plan.

As for savings and investments, most advisors suggest diversification as a prudent strategy at any time to balance safe, predictable returns against more risky high growth options. This is still solid advice during times of uncertainly such as COVID-19. For instance, fixed-income products, like bonds and GICs, offer safe and more predictable returns, especially while stock markets are seeing big swings and scary dips. Conversely, despite the greater risk, when stocks and equity funds are in dips, some investors believe these securities offer more significant growth potential than fixed income products.

In addition to balancing a well-diversified portfolio, advisors suggest not locking in losses in investments by “panic selling” now when the market is in a period of uncertainty, and, if possible, avoid raiding your retirement fund to cover expenses.

Christina Varga

Christina Varga is a writer and editor. As a former Globe and Mail editor who assigned many, many articles on personal finance, and as a writer on the topic, she is interested in arming readers with the knowledge and tools to navigate to a better place in their money management.

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