Canadas inflation rate slowed to 3.4% in Mayis it back to normal?
Inflation has been a hot topic since the COVID-19 pandemic, when governments gave out vast amounts of money to people and businesses to help them stay afloat during widespread shutdowns. And it is still talked about today, with Statistics Canada’s announcement on June 27, that inflation in May was 3.4%
For decades prior, inflation had been relatively steady at around 1.5% to 3% annually. Last year, however, due to the increase of money in circulation and pandemic-related supply shortages, inflation spiked to levels not seen since the early 1980s. Prices across many essential categories, especially food and housing, have become noticeably higher since early 2021, making life less affordable for most Canadians.
What is the inflation rate in Canada?
The Consumer Price Index (CPI), through which Canada tracks inflation, rose 3.4% year-over-year in May. That means the annual rate of inflation is once again trending downward, falling from 4.4% in April. The CPI had been gradually falling from its peak of 8.1% in June 2022, but the April 2023 reading of 4.4% represented a slight increase from the month before.
According to Statistics Canada, the May slowdown was driven primarily by a year-over-year drop of 18.3% in gasoline prices. Meanwhile, the largest contributor to the rise in consumer prices remains mortgage interest costs. Canadians with variable-rate mortgages see their mortgage costs increase with every jump in the Bank of Canada’s (BoC) benchmark interest rate, and many Canadians with fixed mortgage rates are now renewing their mortgages at higher rates. These two factors are contributing substantially to the rate of inflation.
What does inflation mean?
Inflation is the rising cost of goods and services, which leads to a decrease in the purchasing power of money.
Say you have $10. Last year, a can of tomato sauce cost $5, so you could afford two cans. But the cost per can has risen to $6.50, which means now you can only afford one. Over time, you’ll be able to purchase fewer and fewer things with the same $10 of income. When your income growth does not rise in sync with inflation, your purchasing power erodes and your standard of living decreases.
What is a good rate of inflation?
Some people may think we should aim for 0% inflation. However, most economists, the BoC and other central banks see some inflation as desirable and reflective of a healthy economy. The BoC manipulates the Canadian money supply, as well as interest rates, to maintain a target rate of 2% inflation—or between 1% and 3%.
Inflation lower than 2% suggests there is an excess of supply, which means the economy is struggling; this leads to less production and fewer jobs.
Inflation higher than 2% signals that the economy is growing too quickly. Typically, this means Canadians are earning too much income—between their jobs, government benefits and other sources—and snapping up goods so fast that there are supply shortages, and therefore rising prices.
Why is inflation so high in Canada?
One of the reasons inflation is so high in Canada is because the federal government and the BoC worked together during the pandemic to increase the amount of money in circulation. The federal government spent north of $500 billion on pandemic-related benefits in 2020 and 2021, largely financed with bonds the BoC purchased. Canadians’ savings rate skyrocketed and the median after-tax income increased 7% from 2019 to 2020, largely thanks to these programs.
Worried about deflation because of how many Canadians were losing their jobs due to lockdowns, the BoC decreased the key interest rate to a historic low of 0.25% to encourage investing and spending. At the same time, global events, such as the war in Ukraine and China’s COVID-zero policies, created supply shortages for commodities like grain and oil and reduced global production.
Excess money in the economy plus fewer goods equals rising prices.
When will inflation go down in Canada?
When the rate of inflation first started to climb, the BoC believed it would be short-lived. As late as July 2021, the BoC believed that inflation was temporary, and the cost of living would be kept under control as the economy reopened. In an op-ed, BoC governor Tiff Macklem predicted inflation would be back to 2% by the latter half of 2022, and he said that there was no reason to “overreact to these temporary price increases.”
Inflation has proved stubborn, however. After a year-long series of rate hikes that has brought Canada’s benchmark interest rate to 4.5%, the BoC expected inflation to drop to 3% in the middle of 2023, and its ultimate goal is to reach the 2% target.
How does inflation affect my investments?
Inflation erodes the profit you make on an investment.
Let’s say you purchase a stock that rises 5% in one year. Your “nominal” rate of return before factoring in any fees, taxes or inflation is 5%. But if inflation rises 2% that same year, your “real” rate of return is only 3%. It’s important to calculate your investment profit using a real rate of return so you can properly evaluate where to put your money. (Find out how inflation might affect your retirement investments.)
As a rule, it’s difficult to make a profit with any investment during times of high inflation—your purchasing power decreases faster than most investments can grow. But some investments are more resilient against inflation than others.
Stocks
Inflation can negatively affect the stock market, because rising costs and interest rates usually affect companies’ bottom lines. Investors are also psychologically hesitant to put money in the markets if they feel it’s too risky, which further contributes to market drops. But this scenario can also provide an opportunity to buy high-quality, large-cap companies at a slight discount.
Bonds
When inflation rises, bond prices fall, and vice versa. That’s why long-term bonds can be a tricky bet. A short-term bond, however, such as a one-year bond, can be a good place to park money during high inflation, until it’s clearer where inflation and interest rates are going.
GICs
Guaranteed investment certificates (GICs) may appear like a good deal during times of high inflation. In 2022 and early 2023, for example, you could get GICs with rates around 5%, higher than the 1% or so offered in recent years. That may sound great, but when you consider that inflation remained between 5% and 8% during that period, you could have a negative real rate of return. Nevertheless, GICs are a reasonable alternative for low-risk investors who would otherwise leave their money in cash. (See what the rates are like now, by clicking below.)
ETFs
Exchanged-traded funds (ETFs) are a basket of assets, usually stocks, bonds or a combination thereof. Canadian investors can choose from a wide range of ETFs, with varying levels of performance and risk. Broad-based market ETFs tend to be a conservative and easy choice for investors during all market cycles, if they are willing to hold for the long term.
What to expect in 2023
The BoC is determined to bring inflation back down to 2%, even if it triggers a recession in the process. Recent CPI readings indicate inflation is starting to cool, but with a strong job market and continued supply issues, the long-term outlook remains uncertain.
Frequently asked questions
The Bank of Canada (BoC) delayed taking action against inflation in 2021, when consumer prices first began to rise sharply. In March 2022, it began hiking interest rates aggressively to tame inflation. Between March 2 and December 7, 2022, the BoC raised its benchmark rate seven consecutive times, from 0.25% to 4.25%. As a result, inflation peaked at 8.1% in June 2022, and then it gradually began to fall through the remainder of the year.
On March 8, 2023, after a year that saw the BoC raise its key lending from 0.25% to 4.5%, the central bank hit pause. It hoped that interest rates were high enough to return inflation to its 2% target without increasing rates any further. However, on June 7, the Bank announced another increase of 0.25% to the benchmark rate. It continues to believe that higher interest rates are one of the best tools to bring the rate of inflation back to historical norms.
Read more about inflation:
- Compound interest calculator: How interest grows
- What does high inflation mean for your retirement savings?
- What the Bank of Canada’s latest overnight rate hike means for your finances
- A contrarian approach to inflation, interest rates and the markets
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