What is inflation and what does it mean for your budget?

Inflation is dominating the news in the latter half of 2022, and for good reason. In June it reached 8.1% — its highest level in 39 years — and remained high through the fall, with economists unable to predict when it would come down. 

But what is inflation, exactly? How is it calculated and what does it mean for your finances? And what kind of impact could it have on your mortgage and other loans? Let’s take a look.

Inflation: a brief explanation 

Inflation is basically the increase in the cost of goods and services from one year to the next. In Canada, the most widely used measure of inflation is the Consumer Price Index (CPI). This is a “basket” of common needs that Statistics Canada uses to measure the increase in consumer costs.

The CPI covers eight areas of consumer spending:

1. Food
2. Shelter 
3. Household operations, furnishings and equipment
4. Clothing/footwear
5. Transportation
6. Health and personal care
7. Recreation, education and reading
8. Alcohol, tobacco and recreational cannabis

When the CPI increases, this is called inflation. When it decreases, it’s called deflation (though this hasn’t happened since the 1950s).

Inflation is normal in most global economies, but the level of inflation is what matters. The Bank of Canada (BoC) has an inflation target of 2%, which is the mid-point of its 1 to 3% range — the level of price increases that the BoC and Canada’s Minister of Finance have agreed upon as acceptable. 

What causes inflation? 

Typically, the reasons for inflation include an increase in the amount of money in circulation and a rise in the demand for goods and services. 

The current increases in inflation have some unique causes. The COVID-19 pandemic and Russia’s invasion of Ukraine are both contributing to rising prices. 

During the pandemic, lockdowns greatly reduced consumer spending, which meant Canadians saved lots of money. Since the economy reopened, consumers have been making up for lost time by buying lots of everything, thereby considerably increasing demand which, in turn, has brought about an increase in prices. 

At the same time, supply and transportation issues have reduced the amount of goods available. Many of the world’s goods are made in China, which has been pursuing a zero-COVID-19 policy, meaning it has had continuous lockdowns, leading to a reduction in the manufacture and supply of goods.

The Russian invasion of Ukraine has led to huge increases in the price of many consumer staples, such as wheat, corn and oil. A litre of gas at a Canadian pump cost an average of $111 in January of 2022, but that leapt up to a peak of $207.20 by June. In July, the cost of food in Canada rose by 9.2%, year-on-year.

Now that we have a clear idea of what is causing the current high rate of inflation, let’s look at what it means for your finances.

The impact of inflation on your budget and financial plan

For many Canadians, wages have not kept pace with inflation. By May of 2022, average wage increases for permanent workers rose by 4.5%, at a time when inflation was at 7.7%.

When your expenses increase more than your income, something has to give. Clearly, you still have to pay your mortgage or rent and other essentials, such as hydro, natural gas, food and insurance. So, what does that leave?

There are mainly two key areas that most Canadians can cut back on without going hungry, homeless or cold: entertainment and savings. However, if you stop contributing to your savings, your financial plan will quickly fall apart. Making any meaningful reduction in your savings could mean delaying your retirement, rethinking your kids’ university plans or going into debt to pay for large expenses. 

It’s easier — and less damaging to your overall financial plan — to cut back on dining out, concerts, live sports and entertainment. It will mean denying yourself some enjoyment, but a little short-term pain will make for a lot of long-term gain. 

What impact does inflation have on interest rates? 

The BoC raises and lowers its overnight interest rate, depending on how the economy is performing. The big banks and other lenders use the BoC’s overnight rate as a basis for how much they charge their customers when lending them money. 

When inflation is high, the BoC increases its overnight rate, with the goal of making borrowing more expensive to reduce spending, reduce demand and therefore bring prices down.

At the beginning of 2022, the BoC’s rate was only 0.25% — a low rate designed to promote spending and boost the economy. However, that rate shot up to 2.5% by June. As a result, the cost of borrowing for consumers increased considerably.

What impact has inflation had on mortgages and loans?

The good news for the majority of Canadian mortgage holders is that the Bank of Canada’s rate increases won’t have an immediate impact, since two-thirds of them have a fixed-rate mortgage contract. The whole point of a fixed rate mortgage is that you lock in an agreed rate, which won’t increase during the contract term (the most popular term being five years).  

If, however, you have a variable-rate mortgage, one of two things could happen. Either your regular mortgage payments will increase, in line with the increase in the interest rate, or the amount of money that goes towards paying off the principal of the loan (the amount of money you owe) is reduced. This means it would take longer to pay off your mortgage.

For example, if you had a $200,000 mortgage and had been paying 2% in interest at the beginning of the year, your monthly payments would have been around $1,010. If that interest rate increased to 4.25% in June, your monthly payment could have risen to as much as $1,235.

Fixed mortgage rates have also increased considerably in 2022, so when you come to renew your mortgage contract, you may find that you’ll have to accept a higher rate than the one you currently have.

If any of your other loans have a variable rate (such as a home equity line of credit or personal line of credit) the amount of interest you pay (and the minimum repayment) will likely increase in line with the BoC’s overnight rate increases.

How ACU helps its members survive high inflation

At ACU, we take a balanced approach when it comes to our lending practices. Our financial advisors understand the impact of borrowing money as interest rates increase. We’ll also help you balance day-to-day needs while keeping your payments current and your credit score in good standing.

An ACU financial advisor will help keep your budget and financial plan on track during periods of high inflation. We’ll look at your overall financial situation and find ways to maintain your savings levels while reducing expenditures. 

If you need a hand navigating the impacts of inflation, we’re here to help. Book an appointment online now.

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