Inflation and interest rates were prominent in the headlines this week. On Tuesday, Statistics Canada reported that Canada’s inflation rate reached the central bank’s 2% target in August, down from 2.7% in July. This makes it the slowest rate of increase since 2001. The following day, the Federal Reserve announced a 0.50 percentage point cut to its benchmark interest rate, the first reduction in four years. This decision was partly based on the US central bank’s confidence that inflation will soon reach the policymakers’ goal of a 2% annual rate.
With all this attention on inflation, many people are asking what inflation really is and what it’s even based on. If you’ve noticed a bit more room in your spending habits lately, here’s why now might be a perfect time to invest.
How Is Inflation Measured?
The Consumer Price Index (CPI) is the most widely used measure of inflation. It monitors the prices of approximately 700 goods and services across Canada and reports monthly changes. The CPI provides insight into the average household’s spending on a typical basket of goods and services, categorized into eight major groups.
Interestingly, Statistics Canada has recently added hand sanitizer, face masks, and disinfecting wipes to the Consumer Price Index.
The inflation rate is calculated by comparing prices from different time periods. For example:
- In year one, a basket of goods and services might cost $100
- In year two, that basket costs $103, an increase of $3
- That results in an annual inflation rate of 3%
But Why Do Prices Go Up?
Prices generally rise when demand exceeds supply. For example, increased interest in home renovations during the pandemic combined with supply chain issues drove lumber prices to historic levels. Similarly, out-of-season fresh fruits and vegetables cost more due to their scarcity. Manufacturers may also raise prices if their production costs increase, passing these costs onto consumers.
Inflation and Interest Rates
The Bank of Canada targets a 1% to 3% inflation over the long term, a level that supports economic growth and predictable price increases.
If inflation is higher, it could lead to unstable price increases, causing people and companies to worry about their expenses, their purchasing power, how to make ends meet, and potentially dip into savings.
Central Banks around the world manage the economy and inflation through two major ways:
- Fiscal policy – government decisions regarding taxes and spending
- Monetary policy – increasing or decreasing the money supply and interest rates
To spur on the economy, as in the case several years ago, lower interest rates have led to more borrowing and spending. We’ve seen this in the Canadian housing market lately with more homebuyers purchasing homes, some for more than they can afford in normal times due to extraordinarily low rates, often resulting in financial troubles later. On the other hand, as seen in the last few years, when inflation rises, interest rates are increased to encourage savings and reduce spending, slowing the economy and inflation.
Why It Matters?
On a personal level, when prices go up but your income stays the same, your purchasing power decreases because you can’t buy as much as you used to. Imagine you spent $100 on groceries in 2001. By 2021, those same items would cost you $143.52. However, if wages increase, this can lead to higher manufacturing costs, which leads to higher prices and higher inflation.
Inflation and Your Household Spending
Inflation causes money to lose value over time, meaning your money doesn’t stretch as far. Rapid inflation can significantly impact your finances and purchasing power, affecting both essential and nonessential household expenses. While most central banks typically target an annual inflation rate of 2%-3%, sudden increases can force people to re-prioritize spending out of necessity or caution, especially retirees on fixed incomes.
When inflation rises quickly, it’s crucial to review and adjust your household spending, prioritizing essential living expenses like groceries, transportation, and housing. If inflation affects multiple areas, you may need to revise your budget to accommodate these changes. Creating a cashflow analysis and a balanced budget, something I offer my clients, helps manage income and expenses to meet your goals.
As you review your cashflow analysis and budget, always prioritize essential daily living expenses. Once you’ve accounted for essential expenses, you can then decide how much to allocate elsewhere. This is where savings for retirement, often years away, can get derailed and take a back seat to more immediate needs.
Saving For Retirement
When inflation is high, the purchasing power of your money decreases. This means that the same amount of money buys fewer goods and services than before. As prices rise, you may find that a larger portion of your income is needed to cover essential expenses resulting in less money available for discretionary spending and savings. High inflation can make it challenging to set aside funds for long-term goals such as retirement, as immediate needs take precedence. However, reducing savings now can significantly delay your retirement later.
Conversely, when inflation is low, your purchasing power is higher. Prices for goods and services rise more slowly, allowing your income to stretch further. This means you can buy more with the same amount of money, leaving you with more disposable income.
With lower inflation, like what we’re seeing now, it’s the ideal time to take advantage of this opportunity to allocate funds towards savings and investments, including retirement accounts. The stability provided by low inflation helps in planning and achieving financial goals, as you can better predict and manage your expenses.
Reassessing Your Financial Strategy
With inflation now on the decline, the cost of daily living is coming down, potentially freeing up more of your household budget. This is an excellent time to reassess your financial strategy, including your investment savings, to ensure you are on track for retirement. Consider increasing your RRSP contributions now to give them time to grow and keep up with inflation. The current decrease in living costs gives you more flexibility in your budget, making it a prime opportunity to catch up on your savings and ensure your investments are aligned with your goals. By allocating more funds to your RRSP, you can take advantage of the lower cost of living to boost your retirement savings, making sure you have a comfortable and financially secure future.
Are you saving enough to afford the life you want in retirement? Or should you take advantage of this perfect time of financial breathing room to put more in your RRSPs and other investments now to give them time to grow? Reach out to me to set up a meeting and ensure your savings are on track to meet your goals, so you can enjoy the retirement you want.
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