Inflation

Inflation can have a significant impact on the profitability of your business. It's a very good idea to learn how inflation works so you can find coping strategies.

Jovanka Charbonneau, Senior Economist, BDC, explains what inflation is, what causes it and its impacts on entrepreneurs.

What is inflation?

Inflation is a quantitative measure of the overall rise in prices of the goods and services we consume.

There are various measures of inflation in Canada. According to Charbonneau, “The best known one is based on the Consumer price index (CPI), which is calculated by Statistics Canada. This measure looks at how the price of a basket of goods fluctuates over 12 months.”

However, the prices of some goods and services are more volatile than others. That is why the Bank of Canada uses another calculation method: the core inflation measure.

“It’s a more statistically sophisticated method that follows three indicators,” says Charbonneau. “It removes highly volatile components from the calculation, such as energy and food, which could skew the overall result upward or downward. The core inflation measure therefore helps us understand the situation in greater depth and identify trends in the structural economic changes to better understand where the country is headed.”

However, inflation does not affect everyone the same way. According to the economist, “It very much depends on the person’s consumption habits. A vegetarian will experience less inflation than a person who eats a lot of meat. In addition, tobacco and alcohol prices are included in the inflation calculation but do not affect people who do not consume them.”

Are you curious to learn how inflation is affecting you? Statistics Canada has developed a tool to calculate one’s personal inflation rate.

2 key measures of inflation

How is inflation calculated?

Let’s take a more detailed look at the CPI, the measure best known to the general public and frequently mentioned in the media. To calculate it, Statistics Canada looks at the price fluctuation of a fixed basket of goods in terms of quantity and quality from one year to the next.

“This means that Statistics Canada is taking into account various aspects that fluctuate,” explains Charbonneau. “For example, in the cellular services sector, consumer habits have changed considerably and service access has been made much easier in recent years so it's normal that the price has been adjusted downward when you compare it with what we had before. The content of the basket of goods has also been adjusted. For example, in 2020 and 2021, people bought more to goods than services.”

To measure the CPI while taking into consideration all theses aspects, economists look at the average price increase of the goods and services of a basket of goods. For example, for June 2022, Statistics Canada announced a CPI increase of 8.1%. “This corresponds to the increase calculated between June 2021 and June 2022,” says Charbonneau. “For annual inflation, the average for 12 months of the year will be calculated.”

What are the causes of inflation?

Inflation is driven by the mechanisms of supply and demand. “For example, during the COVID-19 pandemic, demand was up in Canada and the rest of the world while supply was down because shops and businesses were closed for health reasons,” says Charbonneau.

She adds that this pressure was exacerbated by the outbreak of the war in Ukraine in February 2022. “This further reduced supply.”

So, when demand grows rapidly and supply cannot keep up, inflation goes up.

The central banks of countries have a role to play in controlling inflation. “But, since they cannot always accurately foresee what will happen, high inflation can still occur,” says Charbonneau.

The Bank of Canada has tried to keep inflation at 2% per year since the early 1990s, that is, after inflation peaked in the 1970s and 1980s.

“This way, we can maintain economic growth but in a stable and sustainable manner,” explains the economist. “For the first 30 years of this objective, the Bank of Canada was effective at controlling inflation.”

What is the relationship between inflation and interest rates?

With its monetary policy, the Bank of Canada can try to keep the inflation level at about 2%.

“Basically, the Bank of Canada adjusts its policy rate, which basically controls all the other interest rates,” says Charbonneau. “When the policy rate increases, financial institutions will usually also raise the interest rates that they offer individuals and businesses.”

Higher interest rates result in fewer financing requests because credit becomes more expensive. “This lowers demand so inflation can be controlled,” she says. “On the contrary, if the policy rate and the interest rates are lowered, then demand will build.”

What is the history of inflation rates in Canada?

In the past 30 years, inflation has been fairly stable at about 2% per year. “However, in the 1970s and 1980s, it frequently reached about 8% per year and even 13%,” says Charbonneau.

There were also periods of deflation, which means times of negative inflation.

“An example would be the 2009 crisis, but that period was short,” says Charbonneau. “High deflation is just as harmful to the economy as high inflation. When their products are worth less on the market, businesses have a lower profit margin and therefore less ability to invest in projects and hire staff.

History of inflation rates in Canada

How does inflation impact businesses?

Generally, inflation negatively affects businesses because it creates a great deal of uncertainty in terms of prices. It is no coincidence that the Bank of Canada tries to control inflation to keep it at around 2%.

“It’s much easier for businesses to plan their activities when they know what to expect in terms of costs,” explains Charbonneau. “When there is uncertainty—for example, when prices suddenly go up significantly, managing supply becomes difficult because all the inputs cost more.”

High inflation also puts upward pressure on wages. “Staff will ask for raises to keep up with inflation and this will add to the company’s cost pressure,” says the economist. “And if prices increase more quickly than disposable incomes, people will be forced to make choices so this will affect demand.”

In addition, inflation does not hit all people and businesses the same way. “For example, individuals who depend on a fixed pension income will be more affected by inflation so they will have to further reduce their demand,” she explains. “Businesses who serve this clientele will also more negatively affected by high inflation than others.”

Another thing to keep in mind is that, when inflation is high, interest rates are up. “Heavily indebted businesses will therefore see the costs of repaying their loans increase, which will reduce their profits,” says Charbonneau.

3 strategies for coping with inflation

When businesses are hard hit by inflation, many tend to pass the bill on to consumers.

“But be careful,” says Charbonneau. “Since some people are really affected by inflation, they may reassess their needs and try to reduce some budget items. By raising their prices, businesses could risk losing customers.”

However, there are a number of other possible strategies for coping with inflation.

1. Increase efficiency

To cope with inflation, your company should find better ways of using the human, material and technological resources available to it to increase its overall capacity. An example of this technique is reducing operational waste to increase the efficiency of operations and to thereby produce more without having to invest more.

Your company can also draw inspiration from consumers who are rethinking their spending. “You can review your company’s various budget items and shop for new and less expensive supply sources,” says the economist.

The costs of hiring your staff should not be underestimated either. One way to address this is to invest in employee retention such as by hiring a specialist in human resources management.

Automating certain processes may also be an option. A merger or acquisition could also help you to attain a critical mass and become more efficient.

2. Reinvest your profits

Your company can also dip into its profits rather than simply pass the bill from inflation on to the customers.

“Many businesses made record profits during the pandemic and, as a result, their cash flows increased more quickly than the historical average,” says Charbonneau. “They can therefore use these cash flows to fight inflation. For example, they can pay a debt that is costing a lot in interest.”

3. Review your service offering

Instead of simply considering how much to charge for your products and services, you could look at how and why you are charging a given price.

“It’s good to look at how you can adjust your service offering—for example, by creating partnerships with other companies to make life easier for your customers,” says the economist. “A hardwood flooring company could partner with an interior design office to jointly offer a range of products and services or even refer customers to each other.”

Other options could be considered, such as developing a less expensive product, increasing the quality provided for the same price, introducing a loyalty program or improving your after-sales service. According to Jovanka Charbonneau, “These are all considerations that can make a difference for part of your clientele.”

Why are inflationary expectations risky?

While inflation is a risk for businesses, inflationary expectations are even riskier.

“When consumers and businesses expect high inflation to continue for a long time, they change their behaviours,” explains the economist. “For example, if people expect that inflation will be 5% for the next five years, they will ask that their salaries be increased to that level.  This will have a long-term impact on business costs.”

This snowball effect complicates the Bank of Canada’s response. According to Charbonneau, “When inflation goes up, its response to avoid finding itself in that situation is usually prompt and aggressive so that the economy is not jeopardized.”

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