Why do prices keep going up?

EPISODE SUMMARY

Inflation is the story of the day so in this episode, Jordan Arndt and Evan discuss some possible reasons why inflation is so bad right now and what we can do about it.

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TOPICS IN THIS EPISODE

1. Inflation - how does it happen
2. Slowing down inflation 
3. Central banks and monetary policy 
4. What can we actually do about it as investors and citizens  

OTHER EPISODES

27. Will you Have any Guaranteed Sources of Income in Retirement 

45. Why you Should Care About Rising Interest Rates


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Transcript

Evan Neufeld: Hello, and welcome back to the Canadian Money Roadmap podcast. I'm your host, Evan Neufeld.  Today, we're looking at inflation and why prices are going up? How does inflation happen? How can it be fixed? And what can we actually do about it?  All right, joining me again today is one of my fellow advisors here at Enns and Baxter Wealth Management, Jordan Arndt. Thanks for coming!

Jordan Arndt: Awesome, thanks for having me, glad to be back.

Evan Neufeld: All right, let's talk about inflation. I know it's on everybody's mind a little bit, but the general idea of inflation is just that there is a general increase in prices for goods and services. So right now I'm not sure what the most recent inflation calculation was, but it's getting close to 5%. Is that true?

Jordan Arndt: I think it was 5.1% here in Canada, the last numbers and I believe it's over 7% right now in the United States.

Evan Neufeld: So inflation is measured as a percentage, but where does that precentage come from? Okay, so it's 5%, but if you look at something really specific.  I've seen things like bacon going up like crazy. There's a lot more than 5%. So how is that 5% calculated? Where does that come from?

Jordan Arndt: Where's it come from? So you may have heard the acronym CPI, which stands for consumer price index. That's one common measure that you'll hear for inflation and what that is, is just a basket of selected goods and services.  It’s not every good and service that exists. And it's used to measure just the general level of prices. So 5% being the average amongst that basket, like you said, bacon maybe is out here and something else will be lower. And it'll average out to that inflation number that's being reported.

Evan Neufeld: Right. And it's not done on an even weighted basis, right. Because look at things like gasoline, it's like, are you spending more on gas than bacon? Yeah. Okay so it has a higher weighting within the CPI. So it is supposed to be a relative estimation for how consumers have had their lives impacted by changes in price.

So some things that are maybe problematic with the CPI is that it doesn't really account for how consumers will behave as it relates to substituting. So if you can see something, okay, let's stay on bacon. Maybe let's say it's up 30%. Is everybody going to keep buying bacon if it's up that high? No, they might try something else or just not buy it. So your individual inflation rate is more representative of what you're actually buying, as opposed to what the national CPI is indicating. And especially those who are taking public transit, your inflation rate is going to be different than someone who's looking to buy a used car, which is really tough to find these days.

And then filling it up with really expensive gas. So keep those things in mind when we're looking at inflation too, because some people might have extremely high inflation rates and some people might have really low inflation. think you 

Jordan Arndt: Yeah. I make a good point there Evan, just in that if it's 5% today, that doesn't mean your spending is going up by 5% and my expenses are going up 5% as well.  However, it's a good indication of where prices are headed in general. 

Evan Neufeld: Right. Okay, so let's call it 5% ish right now. Where is it typically in a what kind of range is typically expected. 

Jordan Arndt: Inflation is not inherently bad here in Canada. Our central bank is the Bank of Canada and they target 2% over the last 30 years or so, I think it's been around 1.8%. So they've done a pretty good job of keeping it around that 2% goal and target. However, if you look at, you know, an inflation graph, it's been above 2% for awhile and then below 2%. But it averages out over that 1.8% over time or has been anyway.

Evan Neufeld: So the rate that we're seeing right now is quite a bit higher than typical and more than we want.  So you might've heard this term being used in headlines in particular, but the term transitory. Have you heard that Jordan, that inflation is going to be transitory? I have heard that term. Yeah. The stupid thing about that term, that kind of drives me nuts is that there's no definition of it. Right?  So some people look like geniuses and other people look like idiots when they use the same term saying, oh, don't worry about it. This inflation is transitory. And then the next month inflation is still at 5% more than it was last year. It was like, oh, it's not transitory. It's like, well, I think transitory just has the meaning that it's eventually going to come back down to normal levels under normal conditions. And it could be argued that right now, due to the pandemic, due to emergency government spending, virtually around the world and increases in money supply by central banks, this is nowhere close to normal.  And so I think it's pretty reasonable to say that inflation is not normal and until other types of economic conditions normalize, I don't know if we can really expect inflation to follow suit yet. What do you think?

Jordan Arndt: Yeah, no, I don't disagree. Define normal? 

Evan Neufeld: Yeah, there's no normal, it doesn’t exist.

Jordan Arndt: I laugh at that or, you know, laughs the wrong word, but I 

Evan Neufeld: It's optimistic normal. 

Jordan Arndt: Normal seems to never happen or, you know, maybe we'll get closer to normal, but then something else will happen in the future that kind of deviates off that. And I think that's where the transitory part comes in is that it won't be. It's 5% today but it won't be 5% forever on a month by month rolling basis sort of thing. It might go up. It might go down, you know, but it'll move, I guess. Economic conditions change and as monetary policies changed and all these sorts of impacts that are on inflation. So it's not a permanent, it's not a static measure I guess.

Evan Neufeld: Okay. So we're kind of dancing around how does inflation happen there? Maybe let's go back and look at the textbook answer and maybe we can re-evaluate how that fits where we are in the world today.

Jordan Arndt: So I guess taking a look at the textbook answer that you might see for inflation is, is how does inflation happens? An increase in the money supply would be the root cause. This can play out in the economy in a variety of ways. I think it's important to just quickly touch on too, what exactly is money supply again. Just pulling kind of a textbook answer here, but money supply is really the value of the total amount of money in circulation.  So that's cash, coins and balances in bank accounts. It can be defined the federal reserve, which is in the United States to find it as a group of safe assets that households and businesses can use to make payments or hold short-term investments. So it's not what's in your RRSP necessarily. But it's, what's in certain bank accounts and cash that is available.

Evan Neufeld: It's not stocks or bonds necessarily, there's short-term bonds like 30 day or 90 days, but that type of thing would be closer to money supply, but yeah, it's what's in your bank account. So as that goes up, inflation happens when there's too much money chasing too few goods. So what is that actually then? This is a supply and demand problem.  This is Econ 101, right? So if the demand is too high for a set supply, then the price is just going to go up. And that's kind of what we've seen right now. So when people have more money, they're probably going to spend more, but what if they don't actually have more money and they can just access more credit?So even if you don't have the money in your pocket, how does the prevailing interest rate effect supply and demand, as it relates to goods and services. Right?

Jordan Arndt: So when interest rates are low, as we think about what the period we've been in recently, where interest rates have been typically quite low, your payment on that is therefore going to be less, your interest costs are going to be less and therefore you'll be able to borrow or spend more.

So if interest rates are low, perhaps using a mortgage as an example, if your interest rates are low, your payment is lower and therefore you can afford a house that is potentially worth more given your cashflow and salary and all that. As interest rates rise, then I think we can see where that goes, right.  As that goes up, your cost of borrowing go up as well. It makes it harder to service those loans and the interest on it and therefore spending will go down accordingly. Assuming your cashflow has also not increased at this same rate. 

Evan Neufeld: Yeah. So that's kind of the tricky thing to see here, right? Because one of the prevailing things, and I don't want to jump too far ahead of our order of operations here, but a lot of people are calling for an increase in interest rates to slow down demand.

But if we're looking at how this current inflation is happening, I think a really good argument can be made for it being more so on the supply side. Right? So if you look at computer chips, that's a perfect example. Now in our current world, computer chips exist in virtually everything. And so let's jump ahead a little bit.

So if you're looking for a used car, it's been particularly difficult to find a used car. And in some cases, really specific vehicles like trucks, they've been really tough to find. And if you listen to Ford and Toyota and Honda, and why can't they produce more vehicles to kind of fill this vehicle demand well it’s because they don't have computer chips.

So Ford was creating F-150’s without all of their electronic components until they had them. And they're sending these vehicles back through the production line once they received them. So they've got these parking lots full of vehicles that are half done. Just because they can't get computer chips.  So why can't they get computer chips? Well, there's many reasons I'm sure, but one of the main ones was that the companies that were producing them, they largely had to shut down during COVID just like everybody else. But then with a huge increase in demand for consumer electronics. So you've got three kids at home and they all are doing school online.

Everybody needs a device and you're doing work from home and you need a better webcam and all these different things to, to exist in our work from home world while everybody needs more consumer electronics. What do those things need? They need computer chips more than the Ford F-150 does. So as a set supply of products goes to a different type of good.  The other ones suffer as a result. And so even though demand for vehicles hasn't necessarily gone up like, everybody needs a car now that it's COVID, it's like, no, it's just the supply of cars is so much less as a result. So I would argue that current inflation that we're seeing is maybe more to do with supply chain issues than it is an increase of aggregate demand.

Jordan Arndt: That's a great example Evan, and I think as we think back to COVID too, when it first hits, you know, we're stuck at home, unfortunately lots of people maybe lost their jobs through that time. However, there were lots of people that were still working and so they were still bringing home a normal salary.  But we're stuck at home and so we couldn't go out and spend money at restaurants or we couldn't travel, or we couldn't go to a movie or, you know, some of those things that we typically spend with our discretionary dollars. So instead those were redirected towards other things. And I think this is another area where inflation can rise. And so maybe you're stuck at home. You started looking at that deck that you're wishing you would rebuild.

Evan Neufeld: This is what I did by the way. 

Jordan Arndt: But lots of people were in the same boat you know, back to May 2020 or in and around there when COVID was kind of first peaking, lumber starts going through the roof and then sales were crazy because everyone's stuck at home and they're looking at their house projects.  And so some of those dollars that you maybe would have spent elsewhere are now being redirected towards say a home improvement project or building that fence or building that deck that you've been thinking about. You had the dollars to spend, you couldn't spend it on something else that you've substituted it now.  Let's just use lumber in this example, as that happens, the increase in demand also increases and therefore prices tend to tend to go higher. 

Evan Neufeld: Yeah. And so when it happens in a really concentrated way with very specific products, that's when supply chain issues can happen really fast, because a lumber mill, for example, it doesn't have unlimited capacity. Like they have a set amount of capacity that they can use to produce lumber and that was a real problem for a long time. So everybody wants to build a new deck, a new fence or new homes because interest rates are so low. Well, yeah, the cost of everything is all those inputs and it's going to go up.

Jordan Arndt: Back to your supply chain example too, with the computer chips. It's not a switch that gets flipped on and off and on and off, you know, maybe demand increases for something, lumber overnight. Production can keep up and supply is limited. And then that doesn't get fixed overnight either. So with the computer chips, that's not all of a sudden they can't catch up. You know, we're feeling maybe some of the trickle down effects of that here. Almost two years later, really. 

Evan Neufeld: Okay. So if we're looking at inflation as being caused, potentially by increased demand, due to extra money supply, but also potentially by wacky spending behaviors, creating supply chain problems.  And there's a million other examples we could give there, but if it's both supply and demand, how do we actually fix this? Well, the first one that has been yelled from the rooftops is we got to increase interest rates. And so that means the cost of borrowing is going to go up and the cost of existing debt is going to go up.

So when that happens, as we've already mentioned, the average person isn't going to be buying nearly as much as they would have, especially if it's fueled by debt. Hopefully not on credit cards, but things like lines of credit and basic loans or even vehicle loans and things like that are probably less likely to happen. It kind of staves off demand a little bit, and then supply can potentially catch up.What are your thoughts there?

Jordan Arndt: I'm wondering if you can explain a little bit too, you know, I think a lot of people are wondering where does rise in interest rates come from? Some of this talk about change in money supply or rising interest. Is the government making that decision? Who's controlling those decisions.

Evan Neufeld: Yeah, that's a good question. And it's actually really complicated, but the Bank of Canada is where interest rates are set and the Bank of Canada has nothing to do with the government. Well, maybe I'll be careful there, but they're designed to be independent of the sitting government and so that they can make decisions that work in tandem with fiscal policy and that's how the government spends money. But the Bank of Canada controls interest rates and the supply of money by printing it and issuing bonds to raise money for spending of the government. So the way that trickles down into the economy and to the average person is that the bank of Canada actually lends money to consumer banks.  And so that's referred to as the overnight rate and so the overnight lending rate is what your bank can actually receive money to give to you. Right? So as the bank of Canada raises interest rates, the trickle-down effect is that the interest rate that your bank can charge you for your mortgage, for your line of credit and so on and so forth will then go up accordingly.

Right? So if they're borrowing, costs go up, and if you're borrowing costs go up. Now, the problem that I have and the beef that most people have with banks is that on the other side, the way that a bank works is that they take in deposits from you and I, and then they lend it out to you via mortgages, lines of credit, credit cards and so on and so forth.  And the differential between what they pay you to park your money there and what they charge you to lend it out to you. Again, that's the bank's profit margin in simple terms, I guess. Right? So you say, okay, well, if interest rates go up or my interest rate on my savings account, going to go up, I'm going to say maybe temper your expectations. They're a little bit, these are for-profit businesses. I'm not here to poopoo the banks, but this is just how it works. If interest rates go up 0.25%, don't anticipate an immediate increase in your savings account interest rate by 0.25%. It might come, it'll be slow if anything, but that's kind of how that works.  So this is a roundabout way of saying how interest rates actually trickled down to us as consumers. 

Jordan Arndt: So what I'm hearing is that here in Canada, the central bank is the bank of Canada. They can control the monetary supply, both the size and supply of it.  Ultimately what they're seeking their mandate is to have stable prices. Like we talked about at the start there and an inflation rate of you know, approximately 2% is the target and they want that through high employment. And that's not 0%. There always be some level of unemployment, but they want that to mean, you know, the general working population to be relatively employed.

So, I guess what I'm hearing is through all that, how can inflation be fixed? Well, here in Canada, the bank of Canada is going to be a large player in controlling that and working towards bringing that down from our 5% current level to something that is more in line with their targets. 

Evan Neufeld: Yeah, for sure.  And so what they're looking at now is not just supply chain issues, but the employment is a factor there. And so coming out of COVID, unemployment was really high. And so to raise interest rates in that environment means that anyone that's unemployed and has debt, it's a double-edged sword there or kicking people while they're down in a way.  And so even for businesses that want to grow, they can't afford to grow in the right way because they can't borrow money to expand operations quick enough. And so they look at measures of the economy including employment, but also GDP growth and manufacturing, all these different things. In addition to supply and demand problems and inflation when it comes to raising interest rates.  Because that little thing of interest rates has a massive impact over everything in the economy.

Jordan Arndt: Yeah. They're not looking to slam the brakes on overnight, you know, inflation maybe is a little bit high. I think we'll see that maybe come down over time. It's not going to be an overnight 5% this month and 2% next month.  It's likely something that I think will ebb and flow as we move back towards the target.

Evan Neufeld: Okay. So now what can we, as investors and as consumers actually do about inflation? I hope you've got a silver bullet here Jordan! 

Jordan Arndt: Of course, I think not to make this sound too simple, but you know one way that my family has seen the impacts of inflation here quite tangibly is in our grocery bill.  We noticed it last month here in January, that our groceries were quite a bit more expensive than they typically have been. And that's just a direct result of goods and services raising in price. So what can we do about that? I guess one simple way, we're still eating, we haven't chose to skip meals.  But, substitution is a relevant strategy. I guess, that you can think about. And I think this is where a budget comes into play or something where really understanding your cash position, you know, what can you afford with your salary and your sources of income and taking a critical look on that?

It's maybe not the silver bullet that we want to hear, but you know, maybe it is a tough time if inflation is high, maybe it's a tough time to do the deck now, or it's a tough time to do that extra trip. And so I guess it might still be okay, but really taking a critical look at, at you know, your spending and your budget and how that fits in with your sources of income and just making sure those are aligned as opposed to letting them maybe get misaligned. 

Evan Neufeld: Yeah. I would just want to be careful not to, in full agreement with you here, not to rush out now to do those projects before inflation gets worse, because as inflation gets worse, the prospect of interest rates going up that much more will become a reality. And so if you're increasing your consumer debt to spend more, do the big trip, all that kind of stuff now, the long-term cost of that might actually be significantly more than you really anticipate. So as investors, another thing that we can take a look at are some typically inflation resilient asset classes, so things that people would often talk about are real estate and commodities, even gold or Bitcoin.

The problem that I've seen with a lot of these, let's talk about those last few first was like gold and Bitcoin. They haven't done well at all in this current environment of rising inflation. And so this is the highest inflation increase we've seen since the eighties and those asset classes have declined.

So what are we to think of those? I'm like, okay, maybe conventional wisdom is not so wise all the time. Right? So beyond that things like real estate is another way that people look at inflation resilient assets. And one of the main reasons there, it's not that real estate always goes up in value and it could be argued that as interest rates go up, fewer people are going to be able to afford homes.

And so prices might actually go down, but in a lot of cases, people see it real estate as inflation resilient because they have so much debt on it at a fixed dollar amount. And so if inflation goes up, meaning cost go up and hopefully your income goes up accordingly, but your debt is fixed at that same rate.

That's kind of how real estate ends up inflation protected in a way. It's less so on the value of the asset more than it is the fixed value of the debt. I'm sure I could get some pushback on that and I'd be okay too, but that's one way to think about it. 

Jordan Arndt: Yeah. The challenge I see too with real estate is that depending, I guess where you are in life, if you're young and you just recently bought a house and now your house is appreciating quite quickly, that seems great.  However, that’s only because you only realized the value in that when you come to time to downsize or to liquidate that asset. So yeah, there are some benefits for sure, to how your house appreciating, but let's say you wanted to move or upgrade or something. Well, if your house has appreciated, so has the house that you want to buy as well.  So you're kind of just getting into a more expensive asset that as that goes. So I guess that's with real estate too. A word of caution that maybe you're not, you're not going to realize that value necessarily until later in life. 

Evan Neufeld: Yeah. Then as investors here, looking at just the, the difference between stocks and bonds in general, we could talk about this for weeks and write books on this and whatever, but equities would largely be considered a better hedge against inflation than bonds would be.

The main reason there is that companies that's, that's what stocks are. They're just companies. They will change their pricing accordingly with inflation. And in many cases, even beyond the rate of inflation think of a company like Disney where they can raise the price of their park entry fees, way higher than the prevailing rate of inflation.  And so rising inflation doesn't really mean a whole lot when you can pass along those increased prices to consumers. I'm not an advocate for price gouging by any means. That's just the reality of things is as prices go up, sometimes those companies can benefit as a result. And if you're an owner of those companies then your impact against inflation, won't be as much.

Jordan Arndt: Let's compare that maybe to the opposite, or bonds and why those maybe aren't a good hedge against inflation. If you own a bond at let’s just say one, 1% rate today and rates are rising well in the future. If someone else can, can buy and purchase a new bond at 2%, for example, well, now your 1% bond doesn't look as good.  And so if we are going to be in a period of rising rates here, The bond you're holding today might not look as good as the bond that someone is able to purchase tomorrow. And therefore, perhaps not as good of a hedge against inflation as something that can like equities rise with inflation. 

Evan Neufeld: Yeah and that the bond component, we call the whole category  fixed income.  So fixed income has really impacted directly by rising interest rates. And so I know this is an inflation topic here, but it relates very specifically to interest rates as well. So exactly Jordan as you said, if interest rates go up, current bond values go down. So prices and yield kind of go on a bit of a teeter-totter that way.  So shorter term bonds are probably going to be less of a problem because you can roll over your bond into a new one at a higher rate, much more frequently, but the longer the duration of your bonds are as a 30, 40, 50 year bonds. Those are going to be pretty difficult for the owners of those bonds in a rising interest rate enviroment.

Jordan Arndt: Let's touch on one perhaps good news scenario with inflation. How about how will those maybe claiming retirement benefits here in Canada, specifically? I'm thinking of old age security, OAS and CPP. How are those as a hedge against inflation? 

Evan Neufeld: Yeah. So Old Age Security that's again, the government benefit that you receive after age 65, depending on your income, but the vast majority of Canadians over 65 will receive it and the Canada Pension Plan and that's another benefit that you received, but you contribute to it during your working years. So if you've worked in Canada you will likely be contributing to the CPP. So the way that those programs are structured, as it relates to inflation is that they are index directly to inflation.

So, it's evaluated periodically. I believe it's every quarter, those payments are re-evaluated. So if inflation is 5%, well, then your payment's going to be 5% more. There's going to be a bit of a lag time between when inflation happens and when you see the increase. But the way that that structured is it makes sure that our seniors are not impacted as directly and they're not hurt by inflation potentially as much as wage-earners might be. 

Beyond old age security and CPP though, some people might be receiving defined benefit pensions across the country. These are becoming fewer and far between, but some of them might still have a cost of living adjustment or COLA. You might be seeing that on your pension statement every year, in many cases, they won't be directly tied to inflation, but if the pension is fully funded and in a really good financial position, they might be able to increase your payments over time.

So even if there is a cost of living adjustment, you might not see the full benefit, but with old age security and CPP, you will receive the full increase along with what the CPI is in.  Okay. That's a lot on inflation here. Maybe  just a quick summary here, Jordan. Again, what is inflation and how does it happen?

Jordan Arndt: As we talked about there, you know, inflation is just a general increase in prices for goods and services. It reduces the purchasing power of your money and it's often measured by something called CPI.  A good example of this is, let's say in 1970, a cup of coffee was 25 cents. That same cup of coffee today will cost somewhere around a $1.75. This is a good, simple example of how inflation can take effect. How does it happen? So textbook, increase in money supply has been kind of the root cause.  However, this plays out in in the economy in a variety of ways. In the case of COVID, for example, we're seeing a supply and demand tension, but also perhaps more money supply in the economy through CERB, rebates, credits, access to cheap loans, transfer payments. There's a number of ways that I guess money can be introduced into the economy by the central banks.

Evan Neufeld: Yeah. And how can it be fixed? This one is the million or billion or perhaps trillion dollar question here, but largely speaking, one of the fixes that could happen is by increasing interest rates. Likely to happen here over the next few months, but alongside that, the supply chain side of things that is related to private industry, and also just time as people's behavior changes, then the supply chain problems will eventually work their way out, but there's no immediate fix for inflation. If there was, they would have already done it. But this is something that needs to be monitored over time. And short little adjustments are largely better than huge sweeping adjustments. So look for the bank of Canada, the federal reserve, European central bank to just do incremental increases in interest rates and re-evaluate from there.

What we can do about it while we can stay invested. This isn't a perfect time to be an investor, this isn't a rising tide lifts all boats situation, but at the same time, interest rates really only need to be increased and inflation is really only a factor in a strong economy. So we're still in a strong economy with really high employment right now.  But there are some problems that I think will eventually get fixed through monetary policy and some government intervention here a little bit. And then just consumer behavior changing over time. OAS and CPP, seniors that are receiving these benefits won't have to worry as much as it relates to those benefits specifically, because those are indexed to inflation.  If you're a homeowner, I guess that it's good news. You might see an increase in the value of your home as it relates to this, but I'd be careful about looking for historically inflation protected asset classes, because in every circumstance of rising interest rates and inflation, the other underlying factors in the economy are different.  So I hate the “this time it's different thing” but every time it's different. So be careful about making huge swings in your portfolio. Maybe make a few tweaks here and there, but this is a good time to rebalance and make sure that your risk profile is in line where you want it to be over the long term.

Thanks for listening to this episode of the Canadian Money Roadmap podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal, and tax advisors before making changes to your financial plan. Evan Neufeld is a Certified Financial Planner and Registered Investment Fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.