Imagine that you’re selling lemonade. It’s a hot day and there’s a big demand for a long, cold glass of you’ve got. You can probably charge two bucks a glass and get away with it. Yup, thirsty people won’t think twice about shelling out for a little lemony relief. And if you’re down to your last glass or two, someone may offer a premium, coughing up an extra fifty cents to grab a glass. So, when supply is low and demand is high, prices jump. Of course, if your next-door-neighbours all decide to set up their own lemonade stands, you’re going to have to practically give it away to get it off your hands. And if the weather suddenly changes, a cold wind blowing the leaves and your customers’ thirst away, nobody is going to pay a red cent for your lemonade.

What’s true for lemonade is also true for money. When there’s more money than stuff to buy, prices go up. When there’s more stuff than money, prices go down. Inflation is the measurement of the changes in prices of all that stuff.

Enter interest rates. The lower the interest rates, the less it costs to borrow so there’s money to buy stuff.

Think of interest rates as the price of money. The central bank is in charge of deciding the cost of money overall, so it is the central bankers who set the interest rate. When central bankers raise interest rates, they make money more expensive and so the demand for it goes down. The less money available to buy stuff, the more pressure there is on prices to come down. That’s why higher interest rates lead to lower inflation.

Of course, if the central banker decides to raise interest rates to fight inflation, that means that the economy is going to slow down. After all, if nobody has the money to buy TVs, then the company that makes TVs is going to make fewer, so they’re going to lay off some TV builders, who then won’t have the money to buy food, never mind TVs. And that’s why the interest rate/inflation dance is such a precarious one.

Whenever there is news about the changes in the central bank rate, most people’s eyes glaze over. We know if rates go up, that’s no good for borrowing. But that’s about all we know.

At the turn of the new century, our central bank, the Bank of Canada, introduced a new system of eight “fixed” or pre-specified dates each year for announcing changes to the official interest rate it uses to implement monetary policy. Since the rates could no longer be changed on any day in response to an economic ill wind, this was seen as a good way of stabilizing interest rates. Central banks in Europe and the U.S. Federal Reserve also use this system. Of course, the central bankers reserved the right to make a change off schedule under extreme circumstances.

The Bank of Canada sets interest rates with the objective of keeping inflation between 1- 3%, with an optimal target of 2%. So when the inflation rate hit 3.1% last July (over July 200&), it was the biggest jump we’d seen since September 2005. Then in August, inflation jumped again by 3.5%. Ooops.

Of course, the central bank’s decision has an impact on our ability to borrow money. And while many a lender has been holding the line – not raising rates – to keep customers coming through the doors, those days are drawing to a close. Expect to see higher interest rates as lenders themselves find money is tight and they must pay more.

When rates go up, it isn’t all bad news. Only the borrowers suffer. The savers jump up and down clapping their hands because their deposits are working that much harder. While, typically, periods of high interest rates are associated with periods of high inflation, as with everything else, things will change again. If interest rates jump way up, you should consider buying investments that will hold those higher rates for as long as possible.

Start your research on various interest-based investments now. Learn about options like mortgage-backed investments (don’t laugh), the various types of bonds, and mutual funds that are based on fixed-income investments. Figure out what TIGRs and STRIPS are. Learn the language of investing — including all the stupid acronyms — so you’re ready to take advantage of what comes next.

We are leaving the age of rampant borrowing. Who knows what age we’re entering next. As with everything else in life, the changes are painful. But the opportunities are great. Get focused. Know what you want. Get educated. Take advantage of what the future holds. Become an OWAP…. an Optimist With A Plan!

The big news of late is how much more expensive it is to a) eat, and b) get around.

These are pretty basic needs. Most of us can’t walk everywhere we need to go and even if we could, the cost of fuel is pushing up the goods and services that have to be transported to the stores where we buy them. Eating… well… that just goes without saying.

So why does the consumer price index make it look like we’re in such fine shape? Inflation, while pinching us at the gas pump and in the supermarket, doesn’t seem to be reflected in the numbers we hear on the news. That’s because there are a lot of things that make up the Consumer Price Index (CPI) basket including:

1. Food – 18%
2. Shelter – 27.9%
3. Household operations and furnishings – 10%
4. Clothing and footwear – 6.6%
5. Transportation – 18.3%
6. Health and personal care – 4.3%
7. Recreation, education and reading – 10.4%
8. Alcoholic beverages and tobacco products – 4.5%

The products in the basket are weighted based on their common usage – those are the percentages. The weights determine the impact that a particular price change will have on the overall consumer budget.  For example, a 5% rise in the price of milk would have a much greater impact on the average budget of consumers than a 5% increase in the price of tea, because people spend on average more money on milk than they do on tea.  The weight for Canada assigned to milk (0.69%) is greater than that of tea (0.06%).  Without weights, price changes for all commodities in the CPI basket would be given equal importance in the calculation of the All-items index. Here’s one of the problems: according to their own documentation the current set of weights refer to household expenditures for 1992. 

With housing prices having skyrocketed in the last decade, me’thinks the numbers could be a little off. Housing is eating way more than 28% of our budgets in many parts of the country. Ditto the fact that while some costs have risen dramatically affecting everyone’s budget, others have fallen, affecting only some people’s budgets.

The costs of computers, TVs, software, audio equipment, clothing, appliances and new cars have gone down, offsetting the increases in things like food and gas, to make inflation appear less dramatic than most of us are actually feeling in our wallets.

And while the price of a box of yogurt may appear to have remained stable, food manufacturers are dealing with the increases in costs not by raising their prices, but by reducing the amount they put in the box. So quantities are going down, while prices seem to remain stable. (Have you noticed that your food containers hold less food? Check it out.)

Ultimately, as the costs for covering our Essential Expenses rise, less and less will be available to spend on the bottom half of the CPI basket of goods. The problem with that is a vicious cycle: we don’t buy TVs or cars and the manufacturers have to lay off the workers who build them; then people laid off don’t have the money to keep body and soul together.

This would have started a long time ago had so many people not had credit available to buy the things they really couldn’t afford. We’ve been buoyed by a credit bubble that’s burst in the U.S., Australia, and elsewhere around the world. Don’t let the pundits fool you. We’re in deep doo doo and we’d better learn to live on what we make FAST.

There is no doubt in my mind that we will see increases in unemployment across the country as we come to terms with our new economic reality. The really sad part is that we might be able to hold on with one income in our family, if we didn’t owe money to every Tom, Dick & Harry. With our debt loads having reached record levels, we don’t stand a hope if we don’t get ourselves in the black. And SOON.

The economy, like the stock market and life itself, is a cyclical thing. Where we are today is not where we will be in six months, a year or a decade. But if we don’t have the tenacity (and the emergency fund) to hold us through the bottom of the cycle, the cost emotionally and to our families’ sense of well-being can be devastating.

So, what’s it going to be? A new TV? A better cell phone? Or the peace of mind that comes from knowing you can weather the economic storm that may or may not be just around the corner?

Some of the people who watch the show who don’t make a ton of money are often dumb-struck that a couple can be making $100,000 a year or more and still be in debt. “Where’s the money going?” they ask. “How can you make that much money and still need to use credit?” they wonder. “How much would they have to make to not go into debt?”

There a couple of problems with the way people look at their money. The first is that many people think of the money they earn in GROSS dollars – that’s before taxes. But if you make $100K and pay 30% in tax, you’re left with $70K. “That’s more than enough,” you say. Maybe. But if all your thinking is based on $100,000, then you’ll be in the hole $30K every year and you’ll never understand why.

So we think of our incomes in GROSS dollars. But we think of our expenses in NET dollars. Yup. And that adds to the problem. Can you see why?

The other thing that adds to the problem is that $100,000 doesn’t buy what it used to. According to the U.S. Federal Reserve, between 1960 and 1990, money lost a whopping 77% of its buying power. That means if you paid a buck for something in 1960, you’d have to come up with about $4.40 to buy it in 1990.

So did incomes rise four-and-a-half times over the same period? Not on your life. Which means a $100,000 income doesn’t buy all the bread and butter it used to. But it still sounds like a lot of money, right? So we still THINK it should buy everything we need. There ya go: another gap between perception and reality.

If $100,000 doesn’t buy all it used to, how come we have more stuff than ever before? That’s easy. We’re using credit. Gobs and gobs of the stuff. We’re borrowing against the equity in our homes. We’re using lines of credit in record numbers. And we’re carrying more plastic than ever before. And we’re giving no thought to how we’re ever going to pay back the principal.

Sure, we’re careful to make our minimum payments. We don’t want to ruin our credit histories, after all, and limit our access to even more credit. But a suggestion that someone pay more than the minimum is met with a laugh… ha ha.. it must be a joke. Who’d be silly enough to do that?

The media has also been lying to us. They’ve been telling us we’re rich. We’ve lots of money in terms of home equity, after all. And that’s money in the bank.

Well, it’s not. It can evaporate – as it has in the U.S. – even more quickly than it grew. And since you have to sell your home to use your equity as money, you better have a nice rock picked out that you can crawl under when the caca hits the fan and you HAVE to sell your home to pay for all those toys you put on your credit card.

It’s time for us to grow up and act like adults. We can’t keep operating under the delusion that just because the amount of money we make sounds like a lot, that we can buy whatever we want whenever we want. And we can’t keep talking about our income in gross dollars while we spend in net? We have to come to terms with the reality of our money and our lives. If we put only $100 in the bank, then we can spend only $100 – at the most. (We should save $10.) And we can’t put $100 on a credit card if we don’t have $100 in the bank to pay it off IN FULL when the bill arrives.

People who aren’t aware of how much they make, how much they spend, and how much their debt is costing them in terms of money and life’s energy expended are not heading anywhere good. It really doesn’t matter how much we make. What matters at the end of the day is what we do with it and how truthful we are with ourselves.

Have you ever thought about how much money it would take to make you happy? Is that net or gross?

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