Canada’s inflation rate slowed to 5.2% in February. When will it return to normal?

For decades prior, inflation had been relatively steady at around 1.5% to 3% annually. Last year, however, due to the increase of money in circulation and pandemic-related supply shortages, inflation spiked to levels not seen since the early 1980s. Prices across many essential categories, especially food and housing, have become noticeably higher since early 2021, making life less affordable for most Canadians.

The Bank of Canada (BoC) delayed taking action against inflation early on, but then started to aggressively hike interest rates in March 2022. On March 8, 2023, after a year of hikes that saw the BoC’s key lending rate climb from 0.25% to 4.5%, the Bank hit pause, and it hopes to maintain the current rate for a while. 

What is the inflation rate in Canada? 

The Consumer Price Index (CPI), through which Canada tracks inflation, rose 5.2% year-over-year in February. That means the annual rate of inflation is now trending downward, falling from 5.9% in January, which was already much lower than the high of 8.1% in the summer of 2022. In fact, the February inflation rate represents the sharpest deceleration in the CPI since April 2020. 

However, food costs continue to rise at a faster pace than overall inflation. The cost of food purchased from grocery stores was up 10.6% in February, compared to a year ago. Food inflation has been in the double digits for seven consecutive months. 

What does inflation mean? 

Inflation is the rising cost of goods and services, which leads to a decrease in the purchasing power of money. 

Say you earn $10. Last year, a can of tomato sauce cost $5, so you could afford two cans. But the cost per can has risen to $6.50, which means now you can only afford one. Over time, you’ll be able to purchase fewer and fewer things with the same $10 of income. When your income growth does not rise in sync with inflation, your purchasing power erodes and your standard of living decreases.

What is a good rate of inflation? 

Some people think we should aim for 0% inflation. However, most economists, the BoC and other central banks see some inflation as desirable and reflective of a healthy economy. The BoC manipulates the Canadian money supply, as well as interest rates, to maintain a target rate of 2% inflation—or between 1% and 3%. 

Inflation lower than 2% suggests there is an excess of supply, which means the economy is struggling; this leads to less production and fewer jobs. 

Inflation higher than 2% signals that the economy is growing too quickly. Typically, this means Canadians are earning too much income—between their jobs, government benefits and other sources—and snapping up goods so fast that there are supply shortages, and therefore rising prices. 

Why is inflation so high in Canada? 

One of the reasons inflation is so high in Canada is because the federal government and the BoC worked together during the pandemic to increase the amount of money in circulation. The federal government spent north of $500 billion on pandemic-related benefits in 2020 and 2021, largely financed with bonds the BoC purchased. Canadians’ savings rate skyrocketed and the median after-tax income increased 7% from 2019 to 2020, largely thanks to these programs.  

Worried about deflation because of how many Canadians were losing their jobs due to lockdowns, the BoC decreased the key interest rate to a historic low of 0.25% to encourage investing and spending. At the same time, global events, such as the war in Ukraine and China’s COVID-zero policies, created supply shortages for commodities like grain and oil and reduced global production.

Excess money in the economy plus fewer goods equals rising prices. 

When will inflation go down in Canada? 

When the rate of inflation first started to climb, the BoC believed it would be short-lived. As late as July 2021, the BoC believed that inflation was temporary, and the cost of living would be kept under control as the economy reopened. In an op-ed, BoC governor Tiff Macklem predicted inflation would be back to 2% by the latter half of 2022, and he said that there was no reason to “overreact to these temporary price increases.”

Inflation has proved stubborn, however. After a year-long series of rate hikes that has brought Canada’s benchmark interest rate to 4.5%, the BoC expects inflation will drop to 3% in the middle of 2023, and its ultimate goal is to reach the 2% target.

How does inflation affect my investments?

Inflation erodes the profit you make on an investment.

Let’s say you purchase a stock that rises 5% in one year. Your “nominal” rate of return before factoring in any fees, taxes or inflation is 5%. But if inflation rises 2% that same year, your “real” rate of return is only 3%. It’s important to calculate your investment profit using a real rate of return so you can properly evaluate where to put your money. 

As a rule, it’s difficult to make a profit with any investment during times of high inflation—your purchasing power decreases faster than most investments can grow. But some investments are more resilient against inflation than others.

Stocks

Inflation can negatively affect the stock market, because rising costs and interest rates usually affect companies’ bottom lines. Investors are also psychologically hesitant to put money in the markets if they feel it’s too risky, which further contributes to market drops. But this scenario can also provide an opportunity to buy high-quality, large-cap companies at a slight discount. 

Bonds

When inflation rises, bond prices fall, and vice versa. That’s why long-term bonds can be a tricky bet. A short-term bond, however, such as a one-year bond, can be a good place to park money during high inflation, until it’s clearer where inflation and interest rates are going. 

GICs

Guaranteed investment certificates (GICs) may appear like a good deal during times of high inflation. In 2022 and early 2023, for example, you could get GICs with rates around 5%, higher than the 1% or so offered in recent years. That may sound great, but when you consider that inflation has remained between 5% and 8% since January 2022, you may actually have a negative real rate of return. Nevertheless, GICs are a reasonable alternative for low-risk investors who would otherwise leave their money in cash.

ETFs

Exchanged-traded funds (ETFs) are a basket of assets, usually stocks, bonds or a combination thereof. Canadian investors can choose from a wide range of ETFs, with varying levels of performance and risk. Broad-based market ETFs tend to be a conservative and easy choice for investors during all market cycles, as long as they are willing to hold for the long term.

What to expect in 2023 

The BoC is determined to bring inflation back down to 2%, even if it triggers a recession in the process. Recent CPI readings indicate inflation is starting to cool, but with a strong job market and continued supply issues, the long-term outlook remains uncertain. 

Read more about inflation:

• How might inflation impact your retirement plans?
• What does high inflation mean for your retirement savings?
• What the Bank of Canada’s latest overnight rate hike means for your finances
• A contrarian approach to inflation, interest rates and the markets