How the target inflation rate affects you

Next year, the Bank of Canada and the Ministry of Finance could move the national inflation target. Why would they do that? We’ll examine what it all means.

Inflation is the increase in the price of goods and services due to demand and the cost of production. Some is normal in a healthy economy as it encourages employers to raise wages and minimizes the effect of debt. But if there’s too much, people lose faith in their ability to buy things. Too little, and wages stagnate. Worse, deflation encourages people to put off spending, stifling economic growth.

Canada’s inflation target is where it’s been since 1995: 2%, though the Bank says between 1% and 3% is acceptable. The target is due for its regular five-year review in 2016. Generally, economists say countries that set targets tend to have more stable inflation.

By setting a target, the Bank is giving other market participants a guide by which to set prices for everything — whether it’s lawnmowers or bonds or salaries.

The target’s effectiveness comes from its credibility. Everyone has to believe the inflation target in order for it to work. That’s why it’s a big deal when the Bank thinks about changing it — which is exactly what it might do in 2016.

Canada’s total consumer price index (one of the measures of changes in inflation) is presently 0.8%. It’s ranged from -0.9% to 3.4% since the 2008 financial crisis. Despite how low it is, some have suggested the Bank should raise the target. If the Bank does, the economy gets more breathing room in case there’s another crisis, allowing the Bank to combat unemployment and low economic growth.

To follow that logic, let’s examine how inflation and interest rates work.

Where interest and inflation meet

The Bank’s main tool for keeping the economy running is the interest rate. Canada’s overnight benchmark lending rate, as set by the Bank, is currently at the bargain basement number of 0.75%. The Bank moves its target interest rate up or down to cool an overheating economy or stimulate economic growth, respectively.

That works like a seesaw: when interest rates are low, people and companies borrow money and use it to buy things or invest in their businesses. That extra money in the economy means more demand for workers, goods and services. All that demand pushes inflation up.

When interest rates are high, people and companies are more reluctant to borrow because the cost of paying back a loan is higher. Less money floating around means less economic activity, and the inflation rate goes down.

At first blush, raising the target inflation rate would therefore keep the interest rate low, doing exactly the opposite of what the economic commenters want.

But the Bank isn’t just thinking about today when it sets the inflation target, says Todd Mattina, chief economist at Mackenzie Investments.

“If the rate of economic growth and expected inflation started to pick up again, the Bank would have much more room to begin raising the overnight rate,” he says.

This is already happening in the U.S., where increasing employment and greater economic activity have many economists predicting that the Federal Reserve will raise interest rates later this year.

The Fed and central banks around the developed world will have to take long-term trends into account when setting interest rates. The real interest rate is the overnight rate minus the inflation rate. The real interest rate has been dropping as the population ages and productivity slows.

“That means the overnight rate will tend to stay at lower levels than it did in the past,” explains Mattina—unless the inflation rate pushes it up.

For instance, raising the inflation target from 2% to 3% means that even if the real interest rate is 0.25%, the overnight rate could be as high as 3.25%.

So, when the inflation rate eventually rises, the overnight rate will too. Otherwise, the overnight rate would stay closer to zero, leaving the central bank little room to re-jig should the economy need more stimulus.

Despite this possibility, raising the target inflation rate is a long shot, says Heather McOuatt, portfolio manager at Franklin Bissett Investment Management.

“The concept of higher inflation in Canada is theory at this point,” she says. “If we’re going to see 3% inflation, I would expect to see nominal growth rates around 5%. That’s quite a leap for me at this point, so I have a hard time reaching that conclusion in the medium-term.

“The 2% target has been in place for a couple decades now and it’s been working for us,” she adds.

Inflation, interest rates and your investments

“Higher rates of inflation will be detrimental to anyone who holds nominal assets,” says Mattina. Nominal assets are non-inflation-adjusted assets like government bonds and annuities. Higher inflation erodes the purchasing power of the money tied up in those products, so a senior who relies on her $1,000 monthly annuity, for instance, wouldn’t be able to buy as much with her cash as she used to.

Higher inflation also affects cash by diminishing its purchasing power.

But higher inflation is positive for equities and commodities. Their market values can rise as prices do.

Real estate and gold are good hedges against inflation, says Mattina. Gold is specifically a hedge against Canadian inflation, because it’s priced in American dollars. So as inflation rises here, gold’s value would be stable. In fact, he adds any assets that are dominated in a foreign currency would hedge against local inflation, assuming inflation is lower in the foreign country.