By MoneySense Editors on September 16, 2024
Estimated reading time: 7 minutes

Guide to inflation: Price changes, the pandemic and your pocketbook

By MoneySense Editors on September 16, 2024
Estimated reading time: 7 minutes

This guide will help you understand what inflation is, how it's calculated, and what it means for your personal finances.

Photo by Clem Onojeghuo on Unsplash

Inflation is simple to describe, but its effects—and how it’s measured—are surprisingly complex. At the most basic level, inflation is an increase in the price of goods and services over time, and an inflation rate is a measurement of how much prices have changed. This uncomplicated explanation, however, disguises the challenges in defining and measuring the changing cost of living.

100 years of measuring changes in consumer prices

In Canada, we’ve been assessing inflation for more than a century. In 1910, the Department of Labour (now part of Employment and Social Development Canada) began publishing average retail prices for a basket of household essentials. The basket contained 29 food items, five kinds of household fuel, rent—and even laundry starch.

Canadians had good reason to want a way to track changes in the price of goods and services they used every day, as prices could and did change rapidly. In 1917, the yearly price change was an astonishing +17.9%, and over the four years of the First World War, the cost of living nearly doubled as inflation rose by 48.3%. Disagreements between workers and firms about how to adjust wages to account for changes in the cost of living were also a major source of labour unrest.

Today, inflation in Canada is measured using the Consumer Price Index, or CPI, which gauges increases and decreases in the cost of a “representative” basket of goods and services with nearly 700 items. By tracking how Canadians actually spend from month to month, the CPI measures changes in the price of goods and services, not variations in the cost of maintaining a certain standard of living.

What’s included in the CPI?

To create the CPI, each month Statistics Canada researchers fill a virtual shopping basket, add up the total cost, and determine overall price changes from the previous month. Calculating the rate of inflation is straightforward: If, in one year, the cost of the basket of goods and services is $100, and in the following year, the same basket costs $102, the inflation rate is 2%. You can see the changes in the inflation rate going back to 1914 using the Bank of Canada’s inflation calculator.

Today, the CPI basket has 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 recreational cannabis. Statistics Canada has created a CPI visualization tool that shows the makeup of the components and how prices change, both nationally and by region.

The items in the basket are periodically reviewed and adjusted to match what Canadians are actually buying. For example, during the Second World War, households could no longer purchase car tires, silk stockings or bananas, so these were taken out of the basket (to be replaced when they became available again); firewood was removed in 1940 as more modern methods of household heating had taken hold; and in 2017, videotape rentals got the heave-ho.

In addition to the consideration of price changes, all of the items in the basket are “weighted” in accordance with how much of a typical household’s budget is allocated to that item. This means increases in items that aren’t a very big component of household spending, such as haircuts or lottery tickets, affect the index less than changes in the price of items that are a bigger share of household spending, such as groceries or transportation.

The many uses of the modern Consumer Price Index

The CPI “is a simple and familiar measure of price changes,” according to the Bank of Canada. Employers use it to make cost-of-living adjustments in wages and salaries, and governments use it to regulate income taxes and social benefits such as the Canada Pension Plan (CPP) and Old Age Security (OAS) payments.

The Bank of Canada also has a mandate to keep inflation, as measured by the CPI, within a target range. Since 1993, the Bank and the federal government have agreed that the Bank will adjust its interest rates to maintain year-over-year CPI growth within a 1.0% to 3.0% range. The Bank’s rates influence the prime rates of banks and other lenders.

“Low, stable and predictable inflation is good for the economy,” the Bank notes, “and for your finances. It helps money keep its value and makes it easier for everyone to plan how, where and when they spend.” Governments around the world share these goals.

Controversies in the CPI

The CPI is not without controversy, however, and one of the most disputed aspects is how the index treats the cost of shelter.

The cost of housing prices is excluded from the CPI, although runaway housing costs have characterized the last decade in Canada’s major cities. Real estate prices are excluded because they incorporate the cost of both current and future shelter, while the CPI only includes current costs. For renters, the CPI includes the cost of rent, insurance, and maintenance and repairs carried out by the tenant; for home owners, costs such as mortgage interest, home insurance and property taxes are included, but the price of the house itself is not.

This technical explanation provides little comfort to Canadians watching as the price of housing soars in Canada’s largest cities even as the “official” CPI remains low. This tension hit a flashpoint in mid-August 2020, when Statistics Canada announced that yearly inflation had risen by just 0.1% from July 2019 to July 2020. This finding didn’t square with many people’s experience of yearly price changes—especially in the months since the COVID-19 pandemic started.

How COVID-19 changed the way we spend—in ways that official inflation doesn’t measure

The mismatch between Canadians’ experience of changes in the cost of living and the official inflation numbers was exacerbated by the COVID-19 pandemic, which, as noted by economist Justin Wolfers in the New York Times, “has made life more expensive in ways the official bean counters aren’t capturing.”

Beginning in February 2020, the pandemic changed the ways that people spent. For example, we bought more essentials, like groceries, causing their prices to rise, but buying fewer airline tickets and less gasoline and clothing, causing those prices to drop. For a while, there were some items, like haircuts, that we weren’t buying at all.

The pandemic also changed where and how people shop, such as by increasing the amount we spend on grocery delivery, which typically charges a premium although the underlying cost of the food may not have changed.

What’s more, as Wolfers pointed out, the quality of many goods and services fell during the pandemic—whether that’s restaurant meals eaten out of styrofoam containers at your dining-room table or university courses delivered via Zoom—creating a hidden form of price increase that the CPI didn’t incorporate.

The decrease in the availability of goods and services, from toilet paper to bread flour, also acted to bring Canadians’ desired standard of living further out of reach, as we had fewer options for achieving the standard we aimed for. And all of these changes hit lower-income households harder, as they spend a greater proportion of their income on necessities like food.

Taken together, these changes mean that Canadians’ lived experience of rising costs may be inadequately captured in the official measurement of inflation.

The CPI and the Bank of Canada’s rate changes

COVID-19 brought the global economy close to a standstill. In response to pandemic-related “negative shocks” to the Canadian economy, the Bank of Canada cut its benchmark rate three times in March 2020, dropping from 1.75% to 0.25%. By early 2022, however, rapidly rising inflation prompted the Bank to start hiking its rate, which it would do 10 times between March 2022 and July 2023. Canadians didn’t see rate relief until June 2024, when the Bank cut its rate from 5% to 4.75%. Two more quarter-point cuts followed in July and September 2024, and as of press time, cuts are widely expected when the Bank makes its next scheduled announcements in October and December.

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About MoneySense Editors

MoneySense editors and journalists work closely with leading personal finance experts in Canada. Since 1999, our award-winning magazine has helped Canadians navigate money matters.