Have you ever had the feeling that in the past couple of years, your expenses and cost of living have been constantly increasing, and you can't help but think that the Canadian dollar doesn't seem to go as far as it used to? Well, it's not just your imagination. This is actually due to inflation.

To help you understand more, in this article we’ll look at:

• what inflation is

• what causes it

• the potential effects on your finances.

How high inflation erodes the value of your money

Inflation is a phenomenon where prices gradually rise, resulting in a decline in the purchasing power of your money over time. This happens due to the acceleration of consumer prices across the entire economy, making things less affordable for people.

For instance, back in 1980, the average cost of a movie ticket was only $2.89.

However, by 2019, this had surged to $9.16.

If you had saved a $10 bill from 1980, it would have bought two fewer movie tickets in 2019 than it would have nearly four decades earlier.

The logic behind rising prices

It's essential to note that inflation doesn't apply to just one item or service. It refers to the general increase in prices across an industry or sector, such as the automotive or energy business, and eventually the entire economy of a country.

An increase in inflation can be caused by many things. That includes supply shortages and rising demand, like we saw with lumber. Or it may be a sharp rise in production costs, including raw material and wages.

Consumers often end up paying for these rising costs. For example, when the price of oil rises there is an almost immediate increase at the gas pump.

Some possible consequences of high inflation include:

Increased costs for businesses: High inflation can increase the costs of goods and services for businesses, which can lead to higher prices for consumers and reduced profits for companies.

Decreased investment and economic growth: High inflation can make it more difficult for businesses to plan and invest for the future, which can lead to reduced economic growth.

Increased unemployment: High inflation can lead to increased costs for businesses, which may lead to reduced hiring and increased layoffs.

Currency depreciation: High inflation can lead to a decline in the value of a country's currency, making exports more expensive and imports cheaper.

Investment strategy in a high inflation environment

Inflation can influence a company’s cost structure and impact corporate earnings, which in turn results in increasing or decreasing its stock market prices. For example, if a company experiences rising input costs due to inflationary pressures on raw materials or wages, its margins may shrink. Investors may re-evaluate their investments in such companies, leading to a decline in stock prices. Conversely, companies in sectors that can pass on increased costs to consumers, like certain utilities or companies with strong pricing power, may fare better during periods of rising inflation with increased stock prices.

During severe inflation, it can be beneficial to invest in assets that tend to hold their value or may even increase in value during times of high inflation. Consider these investing ideas during severe inflation:

Real estate: Property values can increase as the cost of living goes up, making real estate a potentially profitable investment during severe inflation.

Commodities: Commodities such as gold, silver, and oil can also increase in value during times of high inflation as their prices are often tied to the overall rate of inflation.

Inflation-protected securities: Treasury Inflation-Protected Securities (TIPS) are issued by the US government and provide a return that is linked to the rate of inflation.

Foreign currencies: Foreign currencies or assets that may benefit from a weaker domestic currency caused by inflation.

How can we control inflation?

What happens if prices continue to rise uncontrollably? In such situations, the central bank will step in to prevent further inflation.

In Canada, the Bank of Canada is responsible for promoting the country's economic and financial well-being. One of its key roles is to manage the supply of money in the economy by using monetary policy to maintain stable and low levels of inflation.

Tighten policy: When longer-term inflationary issues arise, the central bank may take measures to tighten policy, control inflation, and restore balance to the economy. However, if the Bank of Canada restricts monetary policy to control inflation, it could lead to a decline in demand. In addition, a rise in interest rates can strengthen the dollar, which can hurt the nation's trade strength since foreign buyers would have to pay more for exports. This could result in a decline in the value of global corporate sales and profits for Canadian corporations, causing equity and bond prices to drop.

Loosen policy: On the other hand, a deceleration or decrease in consumer prices, known as deflation, can indicate slow economic activity. Moreover, it may lead to a long-term drop in demand, resulting in lower wages, job losses, and reduced investment portfolios. In such situations, the Bank of Canada may stimulate consumer spending and promote economic recovery by lowering interest rates.

Therefore, it is clear that controlling inflation is a double-edged sword. Striking a balance between economic growth and low inflation is a delicate issue that every central bank in the world must carefully consider.

Note that moderate inflation is not necessarily a bad thing

In terms of economic growth, inflation is not inherently a negative factor, but only becomes problematic when it reaches excessively high levels.

When inflation is kept within reasonable limits, it can actually benefit the economy by boosting corporate profits and employment rates. By raising prices, companies can increase their profits, which in turn can lead to higher levels of investment and job creation. Thus, moderate inflation can help to stimulate economic growth.

However, determining what constitutes "moderate" levels of inflation can be difficult. This is where the Consumer Price Index (CPI) comes in as a crucial indicator.

CPI: An economic indicator that measures inflation

The Consumer Price Index (CPI) is one of the most widely used measures of inflation, used to gauge changes in prices as perceived by Canadian consumers. This economic indicator calculates price changes by comparing the cost of a fixed basket of goods and services over time.

Over the 43-year period from December 1980 to December 2023, Canada's average annual inflation rate was 3.08%, meaning that the value of money depreciated by 3.08% each year.

For example, if you were to put $50,000 under your mattress today, and inflation averages 3% per year, its present value would be significantly lower if you pulled it out after 10 years, at only $37,000. If you waited 20 years, it would be worth even less, at only $27,000 at present value, and so on.

The components of CPI

The CPI basket of goods and services consists of eight major segments and involves the evaluation of the cost of over 700 products on a monthly basis.

As the components of the CPI are constantly changing, the impact of a price change in a given aggregate is determined by the weight of that aggregate in the CPI basket. Shelter, transportation, and food as representing approximately sixty-two percent of Canadian household budgets, are given greater weight in the index. Therefore, if there is an increase in housing prices, it is highly probable that the data will result in an increase in the CPI.

Where can I get CPI data?

The numbers are released near the 19th day of each month within the Consumer Price Index press release by Statistics Canada at 8:30am eastern time.  

The data released in a given month typically pertains to the previous month's information. For instance, on March 19th, the inflation rate for February is usually released.

Investors tend to pay attention to both the year-over-year and month-over-month changes in the CPI data, as these indicate changes in comparison to the previous year or month.

The CPI helps central banks make decisions

It should be noted that the CPI is a closely watched indicator by central banks worldwide, with each bank having its own set of standards for maintaining inflation rates in their respective countries.

For instance, the Federal Reserve considers an inflation rate of approximately 2% to be the most ideal. Similarly, the Bank of Canada also aims to maintain a target inflation rate of 2%.

As a result, if the central bank detects that the CPI is too high, they will typically implement a tight monetary policy to curb inflation, as was the case in 2022.

CPI data is very important for stock markets

While stock prices are driven by multifaceted factors such as company performance, market sentiment, and global events, CPI data can also have significant short-term and long-term effects on the stock market.

In the short term, the stock market may experience fluctuations around the time CPI data is released, influenced by investor expectations and sentiment. For instance, if investors anticipate that CPI data for the current month will exceed the actual CPI data, the unexpected data may trigger monetary policy actions by the central bank, such as interest rate hikes or cuts, causing the stock market to rise or fall after the release of CPI data.

In the long run, changes in CPI can impact different sectors of the economy differently. For example, sectors that are sensitive to changes in consumer spending, such as retail and consumer discretionary industries, may be more directly affected by inflationary pressures. As CPI rises, the demand for goods and services in these sectors may increase or decrease, leading to positive or negative shifts (respectively) in stock prices within those industries.

As we’ve shown here, inflation can erode your purchasing power and thus when inflation rises it is important to have a portfolio to diversify your assets and offset inflation. Sign up and start using the moomoo app today to check macroeconomic data and assets for investment.