From 1990 to 2020, inclusively, the average annual inflation rate was 1.92%. However, since 2021, the annual inflation rate has exceeded 5%.Source: Bank of Canada, Inflation Calculator This link will open in a new window. Should you be concerned? Here’s what you need to know.

The consumer price index

Inflation is an increase in the prices of goods and services. The Bank of Canada uses the consumer price index (CPI) to measure it. This index is derived by calculating the increase in the price of a basket of goods and services that is intended to be representative of the public’s consumption habits. This basket contains approximately 700 items drawn from all areas of consumption: food, shelter, transportation, clothing, recreation, etc.

Since not everyone consumes exactly the same goods and services, the inflation rate represents an average. In fact, inflation may affect some people more (or less), depending on the products and services actually consumed.

The annual inflation rate has not always stayed close to 2% per year

For example, from 1970 to 1990, the annual inflation rate varied considerably, but it averaged 6.90%#1. In 1993, the Bank of Canada adopted an “inflation target” in order to keep inflation at a much lower and predictable rate. For 2022-2026, the Bank of Canada is targeting an annual inflation rate of 2% within a range of 1% to 3%.

How does inflation affect your finances?

Inflation increases the prices of goods and services. It will therefore erode your purchasing power if your income does not keep pace. The following tables show these impacts in figures.

Price of a $1,000 asset over time based on the annual inflation rate

The above table shows that, for example, at an annual inflation rate of 5% and after 20 years, the price of an asset that was initially $1,000 will rise to $2,653.

Number of years 2% annual inflation rate 3% annual inflation rate 4% annual inflation rate 5% annual inflation rate 6% annual inflation rate
1 year $1,020 $1,030 $1,040 $1,050 $1,060
10 years $1,219  $1,344 $1,480 $1,629 $1,791
20 years $1,486 $1,806 $2,191 $2,653 $3,207
30 years $1,811 $2,427 $3,243 $4,322 $5,743

Impact of inflation on $5,000 of non-indexed annual income

The above table shows that, for example, with the annual inflation rate at 5% and after 20 years, $50,000 in non-indexed annual income will provide the equivalent of $18,844 in purchasing power.

Number of years 2% annual inflation rate 3% annual inflation rate 4% annual inflation rate 5% annual inflation rate 6% annual inflation rate
1 year $49,020 $48,544 $48,077 $47,619 $47,170
10 years $41,017 $37,205 $33,778 $30,696 $27,920
20 years $33,649 $27,684 $22,819 $18,844 $15,590
30 years $27,604 $20,599 $15,416 $11,569 $8,706

If inflation continues at an annual rate of 5% and your income does not change, in only 14 years you will lose half of your purchasing power. If inflation were running at 2%, this would take 35 years.

End of the warning

Purchasing power after having invested $1,000 per year for 25 years

Annual inflation rate 2% expected rate of return 3% expected rate of return 4% expected rate of return 5% expected rate of return 6% expected rate of return
2% $25,000 $28,451 $32,495 $37,243 $42,825
3% $22,077 $25,000 $28,415 $32,410 $37,094
4% $19,614 $22,103 $25,000 $28,379 $32,327
5% $17,528 $19,658 $22,128 $25,000 $28,345
6% $15,752 $17,584 $19,701 $22,153 $25,000
7% $14,233 $15,816 $17,639 $19,744 $22,178

Looking at the above table, you can see that when the inflation rate is equal to the rate of return, investing only allows you to maintain your current purchasing power. In other words, the return you earn only allows you to offset the effects of inflation on your purchasing power. If you earn an annual rate of return that is less than the inflation rate, the money you invest loses some of its purchasing power over time.

Would you like to test other rates of return or inflation, or a different investment horizon? 

How inflation affects your savings (in French)

Don’t forget taxes on investment income

The return to be used in the above example is the after-tax return. If you need to pay tax on your investment earnings, then you will earn less. In order to pay less tax (or no tax) on your investment income, you can invest in a registered plan such as a TFSA.

What is the main way that inflation is controlled, and what are the impacts on your portfolio?

One of the ways that the Bank of Canada can help control inflation is by raising or lowering its key interest rate, in order to ensure a certain balance between the overall supply of goods and services produced and the demand for them. This increases borrowing costs (through higher interest rates), thereby slowing consumption. When this occurs, demand is said to be decreasing. This is because it costs consumers more to borrow. On the other hand, new investments in debt securities can now deliver higher yields, encouraging consumers to invest or save more. When demand slows, prices tend to fall.

Impact of higher interest rates on mortgage loans

A few years ago, Katia took out a mortgage. This loan is now coming due, and she has to renew it at an interest rate that is 1% higher than what she has been paying. Here is the extra cost to her:

  • Remaining mortgage balance: $250,000
  • Expected time left to pay off the mortgage: 20 years
  • Current interest rate: 3%
  • New interest rate: 5% (2% more than the current rate)

Katia will need to spend $3,093 more per year than she would have if rates had not changed (for a total of $61,859 between now and complete repayment of her mortgage loan).

What if the rate increased by 3%?

She would have to pay $4,738 more annually than she does now (for a total of $94,767 from now until complete repayment of her mortgage loan). Katia could choose to pay back her loan over a longer period of time instead. However, she would end up paying more interest this way.

You can test various scenarios using the calculator :

How changes in interest rates can impact your mortgage

Impact of higher interest rates on the price of a fixed-rate bond

When interest rates rise, the prices of bonds generally fall. To better understand this, consider the example of Marie-Pier.

Marie-Pier pays $1,000 to acquire a bond that will pay her $30 of interest per year for 10 years, independent of what happens to market interest ratesIn general, the interest on a bond is paid twice per year, so the bond will pay $15 every six months. To keep our example simple, we are assuming that the bond pays $30 per year..  The expected rate of return is 3% ($30/$1,000).

Now let’s assume that immediately after she buys the bond, economic conditions change and the interest rate offered on similar investments rises to 5%. An investor can now buy a bond that will pay $50 of interest per year rather than $30. Marie-Pier can no longer sell her bond for $1,000. What investor would buy it, when there are similar bonds for sale that pay more interest than hers?

The market value of Marie-Pier’s bond therefore falls to approximately $850, since the investor who pays to acquire it will obtain interest payments of $30 per year, in addition to receiving $1,000 when the bond matures ($150 more than the price paid). This gives the investor approximately a 5% annual return on his investment, or the same return as if he had bought the new bond.

Since the market value of bonds adjusts in response to changing interest rates, Marie-Pier cannot profit from the higher interest rates. She must be satisfied with $30 of interest per year. And even if she wanted to sell her bond for $850, there can be no assurance that she would find a buyer. Bonds cannot be sold as easily as stocks, because they are not traded on a stock market.

Other investments are also sensitive to rising interest rates. This includes strip bondsA stripped bond is a bond on which no periodic interest is paid.
The investor earns a return by purchasing the bond at a lower price than the price paid at maturity. For example, the investor can pay $750 for a bond with a value of $1,000 at maturity. 
, debenturesA debenture is a fixed-income investment, similar to bonds, except that debentures are generally not backed by specific assets. Also called unsecured bond. and fixed-rate preferred sharesA preferred share is a share that normally gives holders the right to receive a dividend before the dividends for holders of common shares are calculated.
Dividends can either be fixed or calculated according to a specific formula. For example, the dividend will be $0.3125 per quarter for the first five years, then adjusted every five years according to the rate for five-year Government of Canada bonds plus four per cent.
It is possible that holders of preferred shares will receive a dividend, but that holders of common shares will not.
. The value of these investments also tends to fall when interest rates rise. Here is more information:

  • For bonds, strip bonds and debentures
    If you hold these securities to maturity, you will not suffer a loss unless the issuer defaults on its payments. You will continue to earn the rate of return that was set initially, even though similar bonds will be offering higher rates of return. So, in the above example, Marie-Pier would be able to hold her bond to maturity, receiving her $30 in interest payments per year and then, when the bond matures, recovering her $1,000 investment.
  • For preferred shares
    In the case of preferred shares, they have no maturity, so you cannot avoid a loss by waiting for a maturity that does not exist.

But be careful! The more distant the maturity of a fixed income investment, the more its value will fluctuate when interest rates change. The following table provides estimates of the impact of interest rate increases on the price of a bond.

Declines in the value of a bond offering an annual interest rate of 3%, should rates change

Number of years until the bond matures Drop in bond value following a 1% rate hike Drop in bond value following a 2% rate hike Drop in bond value following a 3% rate hike
5 years -4% -9% -13%
10 years -8% -15% -22%
25 years -16% -28% -38%

Note: The above figures are approximate.

Impact of inflation on so-called safe investments and liquidities

During periods of inflation, even safe investments carry the risk of negative returns. Consider the example of Pascal.

Pascal has invested in a guaranteed investment certificate (GIC) that has a 5-year maturity and pays a 3% annual return. This means that he is certain to receive a 3% return. But be careful! If the annual inflation rate is 5%, Pascal will incur a loss on his purchasing power of 2% per year.

You must therefore be sure to build a portfolio – possibly with the help of an authorized representative, – that reflects your investor profile.