Inflation: What and Why

Unless you are older than 60, you likely cannot remember a time like this. The 1970s to early 80s was the last time we saw inflation making daily headlines and adversely impacting everyone’s ability to buy groceries. As we have all seen for the last few months, both in the media and every time you go to buy anything, the price of everything is going up and is well above the Bank of Canada’s target rate of 2% at closer to 8%/year.

What is Inflation, and how is it calculated?

Before we seek to understand why this is, let’s first stop to understand what it is. Simply put, inflation measures how much prices increase over time.

Statistics Canada is responsible for calculating and publishing Canada’s Consumer Price Index (CPI), which represents the nation’s official monthly inflation rate. But what exactly are they measuring? They measure the change in the price of a particular basket of goods that represents what the average Canadian household needs to buy every month to live. This includes eight major components: food, shelter, household operations, furnishings and equipment, clothing and footwear, transportation, health and personal care, recreation, education and reading, and alcoholic beverages, tobacco products and (believe it or not) recreational cannabis.
One thing that may surprise most people is that the basket of goods measured every month is not exactly the same. It may not include the same items or amounts of the existing items from month to month. While this may surprise many and lead others to accuse them of fixing the numbers, there is a very simple and practical reason for this: We don’t buy the same basket of goods, on average, every month. We pay more to heat and cool our homes in the winter and summer, travel more and differently at different times throughout the year, and what we buy changes frequently. After all, how much hand sanitizer were you buying in 2019 vs 2020 vs today?

All of this effort leaves us with an estimate of what, on average, prices went up buy, which can be revised at later dates if new information becomes available. But for the average household, CPI of 8% means you are paying about 8% more for basic lifestyle needs than you were the year before.

Now there is a problem with this approach when looked at by any household. No one is the average. We are all similar too, but different than what they consider average, and this can mean that every individual experiences inflation very differently than others. We don’t all buy the same things based on preferences, life stage, location, religious background etc. People who commute spend more on transportation than people living in the city riding a bike. Young families worry about the cost of diapers, whereas the average couple in their 50s doesn’t. Jews and Muslims don’t care about the increasing price of pork. That is all to say that inflation is deeply personal, so while 8% may have been the average, odds are it was something different for you entirely. Now that doesn’t mean it’s irrelevant. It just means that CPI is a general indicator of what your inflation looks like, but not the actual number.

What causes inflation?

The simplest understanding of inflation is that there is too much money changing too few goods. That is to say, economics teaches us that if supply and demand are out of equilibrium that prices will increase. While this is true, that is a gross oversimplification of what we see now. What we are instead seeing is shifts in supply and demand caused by simultaneous supply and demand shocks.

Before covid happened, the world ticked along the manufacturing and buying of goods at a relatively predictable rate, from distribution channels that were relatively slow to change, supplied by well-developed supply chains.
Then covid happened, and almost overnight, what we bought, who we bought it from, and where we got it from all changed almost overnight. The disruption of this shockwave cannot be overstated. The very laptop I am typing this on may have come from Apple. Still, the supply chain that created it came from dozens of component manufacturers, who in turn sourced their materials from dozens more materials manufacturers, and so on and so on, back to the raw materials being extracted from the earth and the supply chain that made it possible to extract that resource at all. In the end, the manufacturing of this laptop depended in part on the ability of a company to pump oil, refine it, create the materials to make plastic, and so on.

Disruption to one component of a supply chain is one thing. A disruption to everyone’s supply chain is unprecedented in modern times. All of which translates into higher costs of everything along that supply chain and the end product. Worse yet, this was a series of supply chain shocks as various countries and regions all reopened, closed, and opened repeatedly. At the same time, the consumer panicked about different items every month. How many people are still using toilet paper purchased in 2020?

This sort of instability for businesses means only one thing: higher prices.

On the other side of the equation, at least in Canada and the US, we had people’s cash deposits building up and consumer debt going down due to lower spending and government spending and stimulus plans. Why is this bad? Because that cash in part represented deferred consumption. Couldn’t travel in 2020 and 2021, so you planned on travelling in the summer of 2022? Well, good luck finding a cheap price on a rental car, because again, too much money was chasing too few goods.

What doesn’t cause inflation, despite many’s claims, is corporate greed. While many companies may report all-time high profits, this is largely not due to price gouging. If inflation pushes prices higher, that doesn’t mean their profit margin changes. If they did try to increase them, in a competitive market, their competitors would undercut them, and the gouger would be forced to drop them back to normal. By way of example: While your groceries may cost 8% more than they did last year, Loblaws still only makes about two cents profit for every dollar spent.

How inflation gets fought

There is only one cure for inflation, and that is for a new equilibrium price to be hit and for the shocks to stop to allow one to be hit.

Ultimately, it all comes down to us as consumers needing to spend less and save more. This is why Central Banks increase interest rates to fight inflation. Increasing rates makes saving more attractive and borrowing to spend more costly. Both, over time, have the impact of reducing the amount of money looking to purchase goods and services. Does this work? Well, in time. There are a few problems with this approach.

First, it takes time for all but those living at the margins to change their consumption habits. Habits are “sticky” and hard to break. When it comes to spending, they often don’t break until someone feels some form of pain and consciously seeks alternatives.

Secondly, interest rate increases do not address supply shocks. But then again, they are not suppose to.
Lastly, Canada is a small country and not big enough to dictate global prices like the US consumer can. So why not let the Americans fight inflation and sit back with a low rate, which is largely what Europe is doing? Because that would crush our currency vs the US dollar, just like what has happened to the Euro. Given that we import a lot more on average from the US than Europe does, this would be far worse for us than them.

In the end, inflation may not be a force of nature, but the way it hits people’s pocketbooks may it can be as devastating. Right now, the only thing people should be doing is looking at their spending and cutting out excesses if they are struggling. One thing you should not be doing is treating this as temporary and waiting to see what things are like next year, no matter what people are telling you. Things could be better, or they could be worse, but it doesn’t mean they will be cheaper.

Manuel Luis/MS