For the last two years, inflation has been at top of mind for Canadians. It is a tax on households. When prices rise, the purchasing power of each dollar earned falls.

This generates huge losses for the economy, as well as households on fixed incomes, and increases uncertainty, making it more difficult to plan for the future.

The real question in the minds of many economists is what the trend in inflation will be going forward, and when interest rates will begin to fall and bring relief to Canadians.

While this episode of inflation has created challenges for many, this is not the first time Canada has gone through such an experience; we have been here before.

Inflation in the 1980s and 1990s

Canada faced a serious inflation problem in the 1980s and 1990s when the consumer price inflation (CPI) index hit 13 per cent in 1980 and was still at seven per cent in 1991.

To solve this issue, in 1991, the Bank of Canada and the Minister of Finance agreed on a plan to bring inflation down to a target level. Initially, this was six per cent, but this was lowered to two per cent (within a one to three per cent range).

The Bank of Canada uses the overnight rate to control inflation. This rate determines the rates of government treasury bills, the bank rate and variable rate mortgages.

In August 1981, the Bank of Canada pushed this rate to well over 20 per cent — equivalent to a variable rate mortgage cost today of almost 23 per cent. In May 1990, the central bank increased the rate to almost 14 per cent. In both cases, the central bank brought inflation down, but at the cost of a serious economic slowdown.

The pandemic fuelled inflation

The inflation target was most recently renewed in December 2021. It was remarkably effective until summer 2021, when inflation exceeded the three per cent range and peaked at over eight per cent in June 2022.

The root cause of this inflation was not domestic like it had been in the 1990s. Rather, it was in response to the COVID-19 pandemic, which affected all major Western economies.

Canada was not alone in increasing its debt so citizens could stay home and limit the spread of infection. The Bank of Canada lowered the overnight rate to 0.25 per cent and intervened massively to buy the government’s debt.

Initially, it was believed these inflation increases would reverse as supply chain challenges resolved, so central banks were slow to react.

But this assumption proved false. As the pandemic receded, Canadians began spending the money they had stored away during lockdowns. With low interest rates, the prices of assets like houses and shares dramatically increased. The Russian invasion of Ukraine added another economic shock.

By this point, high inflation had started to become entrenched in the expectations of businesses, unions and individuals. As history shows, once inflation becomes entrenched in the economy, it is very difficult to reverse.

Taming inflation

The Bank of Canada, although slow to react, successfully reversed the increasing inflation trend with 10 interest rate increases between March 2022 and July 2023 and by increasing the overnight rate to five per cent.

Inflation fell to 3.1 per cent in October and November 2023, creating optimism about returning to levels that would assure the Bank of Canada that inflation had been tamed.

Despite core inflation remaining stubbornly above three per cent, this relative success allowed the central bank to hold the overnight rate at five per cent, increasing the possibility of lower interest rates.

This confidence was confirmed with the January CPI coming in at 2.9 per cent, just inside the Bank of Canada’s operating band.

It’s clear that central banks must act as soon as they can to prevent inflationary expectations from becoming entrenched in the economy. Once entrenched, the economy ends up bearing significant pain to reverse it — pain that is not spread evenly across the population.

Food and shelter costs

Interest rates and inflation are inextricably linked and they affect households in different ways. The CPI measures the rate of inflation on a basket of goods, but not all households consume every good in the basket, and not all prices increase at the same rate. Therefore, the impact of inflation varies across groups.

Younger, poorer households spend a disproportionately large portion of their income on food, which has seen major price increases over the last two years. Similarly, those commuting from the outskirts of metropolitan areas faced higher commuting costs when gasoline prices spiked.

However, the biggest anomaly is in housing costs, where increasing interest rates designed to lower inflation automatically translate into higher rental costs and imputed housing costs.

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In its January 2024 CPI report, Statistics Canada reported that rental costs increased by 6.2 per cent year over year, while food price inflation was still up 3.9 per cent.

Together food and shelter costs amount to 45 per cent of the CPI, but younger, poorer households have disproportionately suffered because their price index is skewed more toward food and shelter.

A waiting game

The impact of higher interest rates in Canada’s mortgage market depends critically on the maturity of someone’s mortgage and rent controls.

Many households with variable rate mortgages, or those renewing mortgages during this period of high interest rates, are struggling with significantly higher mortgage payments.

Additionally, those who know they will have to renew their mortgage in the coming year are taking steps to adjust to those increases.

In fact, approximately 20 per cent of mortgages held by some of Canada’s biggest banks are negatively amortized, meaning homeowner payments do not cover the monthly interest charges. So, each month, the amount owed on the mortgage increases. Needless to say, many are urgently hoping for interest rate reductions in 2024.

Right now, the Bank of Canada is waiting to see what happens to inflation in the coming months before deciding whether to hold the overnight rate where it is, decrease it or increase it. This decision hinges on whether it feels the underlying or core rate of inflation aligns with its target zone.

The central bank is well aware that signalling a reduction too early could feed into greater consumer spending and higher inflation. So interest rates could stay where they are for several more months. While shelter and food price inflation will moderate, don’t expect actual prices to revert back to pre-pandemic levels.

The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.