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  • Writer's picturePatricia A. Stewart | CFA

This Is How Rising Interest Rates Hurt Your Purchasing Power

The global economy shut down and tumbled into a recession during the early days of the 2020 pandemic. To prevent an economic catastrophe, central banks around the world lowered their interest rates to essentially zero. Low interest rates make it cheap to borrow which, in theory, helps stimulate the economy.

There is a downside to this, though. Sustained low interest rates can supercharge the economy and lead to runaway inflation. To combat an overheated economy, central banks do the opposite—they raise their key lending rate, making it more expensive to borrow which cools economic growth.

Why Are Interest Rates So High?

In January 2020, the inflation rate in Canada was 2.4%. By March it had fallen to 0.9%. In March of 2020, the Bank of Canada stepped in to avert a recession and lowered its key lending rate an unprecedented three times, from 1.75% to 0.25%. It held it there until early 2022.

Those lower rates helped tame inflation and prevented a sustained recession in 2020, with the annual inflation rate coming in at 0.7%, which helped supercharge the economy.

In 2021, the annual inflation rate increased to 3.4%. Central banks around the world saw inflation rising but thought it was just temporary and decided there was no immediate need to step in and raise rates. The last thing they wanted to do was derail the fragile economy.

By March 2022, Canadian inflation had climbed to 6.7%. That same month, the Bank of Canada raised its overnight lending rate to 0.50%. It raised it two more times in April and May, bringing it to 1.50%.

Unfortunately, it takes months for monetary policies to work its way through the economy. Inflation continued to climb and in June 2022, it hit a 40+ year high of 8.1%. That’s when the Bank of Canada got even more aggressive, hiking the overnight rate an astonishing one hundred basis points to 2.50%. It raised it three more times in 2022, taking the lending rate to 4.25%. Canada’s inflation rate in 2022 was 6.8%.

The Bank of Canada is not done raising its rates either. Inflation is still stubbornly high and will require “much higher” interest rates. How much higher? Some see the central bank rising to at least 4.50% in 2023 before taking a pause. To put that number into perspective, 4.50% is an 18-fold increase in borrowing costs over the 0.25% from March 2020.

Canada’s inflation rate is expected to decline in 2023 to an average three percent. As a result, the first interest rate cut is not expected until 2024.

What Is Purchasing Power?

High inflation means the cost of everything has gone up. According to Statistics Canada, grocery prices have soared 11% year-over-year and fresh vegetables have gone up 13.6%. Unfortunately, wage growth is not keeping pace. As a result, Canadians are having to pay more with less.

Due to high inflation, the purchasing power of your money is less valuable, and, as a result, your money has less buying power tomorrow than it does today. If you found $100 on the ground 20 years ago, on paper, it’s still worth $100, but you can’t buy nearly as much as you could with it today as you could 20 years ago. When prices go up, your money buys less.

And that’s how inflation negatively impacts purchasing power. Inflation helps measure the increase in the cost of an item or service, while purchasing power looks at how much you can buy with a certain amount of currency.

Case in point: over the last 50 years, the purchasing power of $1,000 has decreased to $142.83. Meanwhile, an item that cost $1,000 in 1972 would, thanks to inflation, cost $6,834.82 in 2022.

What does all of this mean for the average Canadian?

Inflation is a kind of hidden tax that most Canadians don’t think about. It’s easy to see how inflation impacts the price of gas, groceries, and utilities, but its less obvious when it comes to creating retirement wealth.

Right now, the difference between the income generated in a typical savings account and the income needed to actually crush inflation has rarely been wider. As a result, investors are left looking for both a safe place to invest their money and generate strong returns.

Sharp Asset Management for Your Retirement Planning

Inflation remains high and purchasing, or buying power, has been reduced, eroding the value of your money and the amount you can invest. All the more reason to contact the private wealth management professionals at Sharp Asset Management.

Sharp Asset Management Inc. is an independent Portfolio Management firm that is 100% owner operated. Since we are a highly concentrated group of professionals, we are able to respond quickly to changing market conditions.

We are not affiliated with any financial institution, securities firm or mutual fund company; as a result, our investment decisions are unbiased. We do not earn any commissions or fees on investments we choose on behalf of our clients. To learn more about investing with Sharp Asset Management, contact us today.

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