Next week, the Bank of Canada will decide whether to lower interest rates or wait for (at least) another seven weeks.
The evidence that rates should fall is mounting.
Consider three of the Bank of Canada’s own core measures of inflation. These strip out volatile items, so they provide a decent indicator of where overall inflation is headed. As I illustrate below, all three show price rises below the Bank’s 2 percent inflation target in recent months.
Graphic credit: Janice Nelson.
At its last interest rate decision, it said that before lowering rates, it “will be looking for evidence that this downward momentum is sustained.” It now has that evidence.
Falling inflation is undoubtedly good news. And if rates fall, all the better. Despite this, the broader Canadian public is unlikely to feel much better. Many might question, or even outright reject, the data itself.
And they’ll have a point.
Not because the data is manipulated, to be clear. (I’m not peddling a conspiracy theory here.) But because our experience of inflation is worse than what the headline inflation statistics suggest.
Looking under the hood
To understand this, consider how the inflation rate that Statistics Canada reports each month is calculated. It includes roughly 1,200 items, each weighted to capture the average price change for the “average” household.
But there are big (big!) differences underneath this average that matter for how painful inflation feels for many—perhaps even most—Canadians.
If your spending isn’t average, then your personal inflation rate may differ.
Overall, Canada’s inflation rate for April was 2.7 percent. But if you’re a renter, I estimate you’re experiencing 3.2 percent inflation. If you own your home mortgage-free, your rate is 2 percent. If you have a mortgage, though, that rises to 2.9 percent. And if you’re lower income (that is, if you’re in the bottom fifth of the income distribution), then your inflation rate is 3.1 percent.
So even with inflation falling back to target, many might not feel it.
Psychology of price changes
But the psychology of inflation is about so much more than this.
People put more weight on items that they buy frequently or on items with large and unusual price increases. Food prices are particularly important. Most interestingly, the effect of price increases on our perception of where inflation is going may matter more than price decreases. So periods of rapid price hikes might lead us to think prices will keep rising even after they’ve stopped.
All of this is consistent with easy-to-perceive (or “salient”) price changes mattering much more than the broad basket of items that Statistics Canada tracks.
This matters. Since February 2020, rent is up 20 percent, food is up 23 percent, gasoline is up 30 percent, and mortgage interest costs are up 43 percent.
Graphic credit: Janice Nelson.
Over the past 12 months alone, rent is up 8 percent and mortgage interest costs are up 25 percent.
Not everything rose as much, of course. But these other items may not matter as much as the salient ones like food, rent, and so on, which have risen the most.
Price levels and affordability
My final point is a simpler one. Inflation represents a change in prices, and the strain on our budgets and the pain we feel at the point of purchase are more about price levels compared to some point in the past that we each have in mind.
A period of high inflation erodes the purchasing power of our income, and if inflation then falls to zero, that lost purchasing power does not return.
Food, rent, and transportation costs are up nearly one-quarter since the beginning of 2020. Average hourly pay, meanwhile, is up only about 15 percent. The purchasing power of wages in terms of food is therefore down by about 7 percent. In terms of gasoline, it’s down 12 percent. And in terms of mortgage interest costs, it’s down 20 percent.
The average family might “perceive” the purchasing power of their disposable income in terms of how much of these salient items they can afford.
If so, the current moment is unlike any other.
Across the whole of Canada’s postwar history, no year has seen a faster decline in the average family’s “food purchasing power” than 2022. The second-largest decline was 2023.
Graphic credit: Janice Nelson.
In fact, I estimate that the quantity of food that an average family’s disposable income can purchase has fallen back to levels not seen since 2005!
This shows why inflation feels much higher than headline statistics suggest and why they don’t capture the real strain that many households feel right now.
It may take years of solid income growth to recover. Unfortunately, Canada’s income and productivity growth have stalled.
So, even as inflation returns to normal, the affordability challenges that many of us experience—and therefore the pressure (and blame) that we put on governments—will continue for quite some time.
Trevor Tombe is a professor of economics at the University of Calgary, the Director of Fiscal and Economic Policy at The School…
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