Inflation is back, so what next?
It has been a long time since inflation has dominated news headlines.
In January 2022, Canada’s inflation rate hit a 30-year high of 4.8% after months of articles and analysts identifying it as the number one investment risk for 2022. What is inflation? In short, inflation is the decline of purchasing power of a given currency over time, reflected in the cost of living.
Inflation is typically measured by the Consumer Price Index (CPI), which examines the weighted average of prices of a basket of goods and services – such as transportation, food, and medical care. The opposite of inflation is deflation, which is when the purchasing power of money increases and prices decline.
Why is inflation increasing?
Anyone who owns a car will have winced at some point over the past 12 months, with gasoline prices up 33% during that period. Shelter and food have also seen significant increases.
Arguably, the most logical reason for this is the base effect. After prices dropped considerably throughout 2020 as many governments imposed lockdowns to try to curb the spread of COVID, any year-over-year comparison was always going to look scary. However, this doesn’t entirely explain why inflation is soaring. Supply chain issues are playing havoc with certain sectors. Lumber was in the news last year after prices in May hit record highs of more than US$1,600 per thousand board feet before collapsing and then surging again in early 2022. New car production has slowed due to the ongoing conductor chip shortage causing used cars and trucks to dramatically increase.
Central banks maintain that once these kinks have been worked out, costs will return to normal. But as the recent price increase in lumber and other industries show, it hasn’t proved that simple.
Labour issues have also played a role in the inflationary picture. In Canada, employment is back to near pre-COVID levels but the overall statistics obscure shortages in certain occupations. The structure of the workforce has changed and while the likes of business and finance have prospered, the sales and service industries remain badly under-staffed and negatively affected by the onset of remote working. Many businesses have had a difficult time hiring enough workers to satisfy demand and some argue that government benefits have hardly incentivised people. Whether this reverts to pre-pandemic levels, time will tell.
What does inflation mean for interest rates?
The inflation-interest rate axis is a fundamental tenet of central bank policy. Typically, in a low interest-rate environment as we have now, more people are able to borrow more money. Consumers, therefore, have more money to spend, the economy grows, and inflation increases. When interest rates are increased, consumers tend to save because returns from savings are higher, less disposable income is spent, the economy slows and inflation decreases.
Getting the balance right between the two allows the economy to grow successfully. With inflation persisting in recent months, speculation is therefore rife about when central banks will start hiking rates. Wait too long and inflation spirals out of control, raise them too soon and the economic recovery (and job gains) will be stymied, potentially causing stagflation (slow growth, high unemployment, and inflation) and even a recession.
Both the Bank of Canada and the Fed have already signalled they are close to hikes by beginning to taper off the stimulus programs that protected their economies during COVID.
Volatility, in whatever form it may present, is to be expected. A robust financial plan has volatility – whether from inflation fears or a housing market crisis – built into the plan. The history of financial markets is a study in uncertainty in the short term, but predictability over the longer term. We believe the best way to take advantage of the longer-term trends is by taking an evidence-based approach to investing. Taking the long view of financial markets allows you to stomach the short-term noise.