Understanding Inflation and Its Impact on the Economy
Prices tend to rise over time, and this is often a sign of economic activity—better known as inflation.
What Is Inflation?
Inflation measures the rate at which prices for goods and services increase over a given period. Many factors influence price changes, including the availability of products, labour costs, raw materials, and competition. At its core, inflation is about supply and demand. When demand for goods and services outpaces supply, prices tend to rise more rapidly.
How Inflation Is Measured
Statistics Canada tracks inflation using the Consumer Price Index (CPI), which measures the price changes of a representative "basket" of goods and services that Canadians commonly purchase. Since everyone has different spending habits, inflation affects individuals differently. For example, if fuel prices rise, those who drive daily will feel a greater impact than those who rely on public transit.
Although CPI is the most widely used inflation measure, it is an average and does not reflect everyone's exact experience. However, governments, businesses, and financial institutions use it to adjust wages, pensions, and other financial planning tools.
The Effects of Inflation
Inflation plays a crucial role in the economy, but extreme levels—whether too high or too low—can cause problems.
- High Inflation: Rapidly rising prices reduce purchasing power, meaning consumers can buy less with the same amount of money. It can erode savings, making it harder for retirees and fixed-income earners to maintain their standard of living. Businesses also struggle as costs rise unpredictably, leading to potential layoffs and slowed economic growth. In extreme cases, such as Zimbabwe's 400% inflation rate in 2024, hyperinflation can cause currency devaluation and economic collapse.
- Deflation: While falling prices might seem beneficial, prolonged deflation can signal economic distress. Reduced consumer spending leads to declining business revenues, job losses, and an overall economic slowdown. If people expect prices to keep falling, they may delay purchases, further worsening the economic downturn.
Canada's Approach to Inflation
To maintain economic stability, the Government of Canada and the Bank of Canada agreed in 1991 to target a low, stable, and predictable inflation rate—aiming for around 2%, within a 1% to 3% range. For decades, inflation remained near this target until the COVID-19 pandemic disrupted supply chains and led to an 8% inflation surge in 2022. This sudden spike significantly affected Canadians, particularly those on fixed incomes.
To combat inflation, the Bank of Canada raised interest rates to slow economic activity and balance supply and demand. This strategy helped reduce inflation, reinforcing the importance of maintaining predictable price levels.
How Interest Rates Control Inflation
The Bank of Canada adjusts its policy interest rate to manage inflation:
- Raising interest rates: Encourages saving and discourages borrowing, slowing down demand and curbing inflation.
- Lowering interest rates: Stimulates borrowing and spending, boosting economic activity when inflation is too low.
Since monetary policy takes time to influence consumer behavior, the Bank focuses on sustained inflation trends rather than short-term fluctuations.
Why Stable Inflation Matters
A stable inflation rate of around 2% helps businesses and consumers make informed financial decisions. When inflation expectations remain steady, wages, production costs, and pricing strategies align, creating a balanced and predictable economic environment. This stability is essential for long-term investments, including mortgage lending and real estate markets.
At Lendworth, we closely monitor inflation trends to ensure that our mortgage lending strategies remain competitive and adaptable. Whether interest rates are rising or falling, our goal is to provide borrowers and investors with well-structured financial solutions tailored to economic conditions.