the Wealthy Canadian

Stats Canada released the August inflation last week. I’ve already seen news headlines declaring the dramatic drop of inflation, and what it could mean for the Canadian economy. So I thought that I would briefly describe what inflation is and how it affects interest rates.

From academia…Definitions:

• inflation is the increase in cost of a good (or basket of goods and services) from one point in time to the next.
• deflation is the decline in this cost
• disinlfation is a drop in the inflation rate

In general when someone talks about inflation, they are referring to a change in the cost of something from one point in time to the next. Usually we are talking about how much something has changed price form 12 months ago. In that sense, inflation increases or decreases (negative inflation) or simply slows down. This notion of inflation is what is called the Consumer Price Index (CPI).

The CPI is actually what measures the cost of living. The cost of a basket of goods and services that comprise an average households’ expenditures are tracked. Since people, on average, spend more on food than clothing, food gets a higher weighting in the basket. Likewise, every item in the basket has a weighting related to the average spending habits of most people.

Unfortunately, some goods have very sporadic price movements. Things like energy can have drastic price changes from month to month. These drastic price changes could make the CPI look very erratic. That is why there are two measures for CPI, the total and the core.

CPI = the measure of the rate of change for goods and services.
Total CPI = the total basket of 600 goods and services that comprise an average households expenditures.
Core CPI = Similar to the total, minus the most volatile components.

For example the August measure of the Total CPI was 1.7% (things cost 1.7% more this year than last year). However, volatile goods like gasoline dropped in price in the month of August. Eliminating those volatile components we can see that prices rose 2.2% from last year as described by the Core CPI.

So we saw a disinflation of the 12-month Total CPI from 2.2% in July to 1.7% in August and a deflation in the price of gasoline from July to August.

What do we do with the inflation, or CPI numbers? The Bank or Canada uses these when determining what to do with interest rates.  On another post I’ll discuss how the Bank uses inflation in its monetary policy.