# Guide to inflation: Price changes, the pandemic and your pocketbook

Inflation is simple to describe, but its effects—and how it’s measured—are surprisingly complex. At the most basic level, inflation is an increase in the price of goods and services over time, and an inflation rate is a measurement of how much prices have changed. This uncomplicated explanation, however, disguises the challenges in defining and measuring the changing cost of living.

## 100 years of measuring changes in consumer prices

In Canada, we’ve been assessing inflation for more than a century. In 1910, the Department of Labour (now part of Employment and Social Development Canada) began publishing average retail prices for a basket of household essentials. The basket contained 29 food items, five kinds of household fuel, rent—and even laundry starch.

Canadians had good reason to want a way to track changes in the price of goods and services they used every day, as prices could and did change rapidly. In 1917, the yearly price change was an astonishing +17.9%, and over the four years of the First World War, the cost of living nearly doubled as inflation rose by 48.3%. Disagreements between workers and firms about how to adjust wages to account for changes in the cost of living were also a major source of labour unrest.

Today, inflation in Canada is measured using the Consumer Price Index, or CPI, which gauges increases and decreases in the cost of a “representative” basket of goods and services with more than 700 items. By tracking how Canadians actually spend from month to month, the CPI measures changes in the price of goods and services, not variations in the cost of maintaining a certain standard of living.

To create the CPI, each month Statistics Canada researchers fill a virtual shopping basket, add up the total cost, and determine overall price changes from the previous month. Calculating the rate of inflation is straightforward: If, in one year, the cost of the basket of goods and services is \$100, and in the following year, the same basket costs \$102, the inflation rate is 2%. You can see the changes in the inflation rate going back to 1914 using the Bank of Canada’s inflation calculator

Today, the CPI basket has nine major components: food, shelter, transportation, household expenses, furniture and appliances, apparel, medical and personal care, and two “catch-all” categories of “sports, travel, education and leisure” and “alcohol, tobacco and recreational cannabis.” Statistics Canada has created a CPI visualization tool that shows the makeup of the components and how prices change, both nationally and by region.

The items in the basket are periodically reviewed and adjusted to match what Canadians are actually buying. For example, during the Second World War, households could no longer purchase car tires, silk stockings or bananas, so these were taken out of the basket (to be replaced when they became available again); firewood was removed in 1940 as more modern methods of household heating had taken hold; and in 2017, videotape rentals got the heave-ho.

In addition to the consideration of price changes, all of the items in the basket are “weighted” in accordance with how much of a typical household’s budget is allocated to that item. This means increases in items that aren’t a very big component of household spending, such as haircuts or lottery tickets, affect the index less than changes in the price of items that are a bigger share of household spending, such as groceries or transportation.

## The many uses of the modern Consumer Price Index

The CPI “is a simple and familiar measure of price changes,” according to the Bank of Canada. Employers use it to make cost-of-living adjustments in wages and salaries, and governments use it to regulate income taxes and social benefits such as the Canada Pension Plan and Old Age Security payments.

The Bank of Canada also has a mandate to keep inflation, as measured by the CPI, within a target range. Since 1993, the Bank and the federal government have agreed that the Bank will adjust its interest rates to maintain year-over-year CPI growth within a 1.0% to 3.0% range.

“Low, stable and predictable inflation is good for the economy,” the Bank notes, “and for your finances. It helps money keep its value and makes it easier for everyone to plan how, where, and when they spend.” These goals are shared with other governments around the world. Last month, for example, the Bank of Jamaica released a reggae song promoting inflation targeting, featuring “the low, stable and predictable inflation dancers!”

## Controversies in the CPI

The CPI is not without controversy, however, and one of the most disputed aspects is how the index treats the cost of shelter.

The cost of housing prices is excluded from the CPI, although runaway housing costs have characterized the last decade in Canada’s major cities. Real estate prices are excluded because they incorporate the cost of both current and future shelter, while the CPI only includes current costs. For renters, the CPI includes the cost of rent, insurance, and maintenance and repairs carried out by the tenant; for homeowners, costs such as mortgage interest and property taxes are included, but the price of the house itself is not.

This technical explanation provides little comfort to Canadians watching as the price of housing soars in Canada’s largest cities even as the “official” CPI remains low. This tension hit a flashpoint in mid-August, when Statistics Canada announced that yearly inflation had risen by just 0.1% from July 2019 to July 2020. This finding didn’t square with many peoples’ experience of yearly price changes—especially in the months since the COVID-19 pandemic started.

## How the COVID-19 pandemic changed the way we spend—in ways that official inflation doesn’t measure

The mismatch between Canadians’ experience of changes in the cost of living and the official inflation numbers was exacerbated by the COVID-19 pandemic, which, as noted by economist Justin Wolfers in the New York Times, “has made life more expensive in ways the official bean counters aren’t capturing.”

Since February, the pandemic has changed the ways that people spend. For example, we’re buying more essentials, like groceries, causing their prices to rise, but buying fewer airline tickets and less gasoline and clothing, meaning those prices have dropped. And, until recently, there were some items, like haircuts, that we weren’t buying at all.

The pandemic also changed where and how people shop, such as by increasing the amount we spend on grocery delivery, which typically charges a premium although the underlying cost of the food may not have changed.

What’s more, as Wolfers points out, the quality of many goods and services has fallen during the pandemic—whether that’s restaurant meals now eaten out of styrofoam containers at your dining-room table or university courses delivered via Zoom—creating a hidden form of price increase that the CPI doesn’t incorporate.

The decrease in the availability of goods and services, from toilet paper to bread flour, also acts to bring your desired standard of living further out of your reach, as you have fewer options for achieving the standard you’re aiming for. And all of these changes hit lower-income households harder, as they spend a greater proportion of their income on necessities like food.

Taken together, these changes mean that Canadians’ lived experience of rising costs may be inadequately captured in the official measurement of inflation.

## Restoring the relevance of the CPI

At the end of August, the Bank of Canada announced it would consult directly with Canadians about inflation, including through an online survey for individual Canadians that’s open until October 1. The Bank’s consultations are part of a review of its inflation-targeting approach, which is set to renew in 2021. For its part, Statistics Canada is reportedly working on an interactive CPI that will allow consumers to choose their own weightings, instead of relying on the overall weightings for all households.

In announcing the consultations, senior deputy Bank Governor Carolyn Wilkins said: “It’s critical that we measure inflation as accurately as possible so Canadians have confidence in our target.” The Bank’s findings are expected to be published in a report in the coming months.

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