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Question of the Week - April 25, 2016

Question of the Week - April 25, 2016

Guest Post - Monday, April 25, 2016

Where do we stand with inflation?

We last wrote about inflation in our November 9 blog post, so it’s time for an update. Measuring inflation can be either simple or complex, depending upon what is measured.

The Consumer Price Index (CPI) is the most commonly quoted figure—calculated using a basket of goods for urban dwellers (who comprise 90% of our population), as determined by the U.S. Bureau of Labor Statistics. The 10% of the population not included are those living in rural non-metropolitan areas, farm households, military installations, religious communities, as well as prisons and mental hospitals.

History of the CPI

The CPI was formed during World War I, due to the need for a consistent method for adjusting worker wages for cost of living increases in regions heavily affected by wartime production. It had to be a herculean effort to collect and tabulate this type of data in 1919, although we had simpler and fewer items to buy. A few earlier estimates were tacked onto to this series, and we now have data beginning in 1913.

As the economy became more complex and our consumer behavior changed, refinements have been made over the years to create more balanced baskets of goods. A big refinement was finding a way to treat real estate. The solution was to monetize what a home's rental value might be if you rented and didn't own it.

The CPI has never been perfect, and assumptions have been made over time in an attempt to 'smooth' data and remove any anomalies. For instance, new cars and appliances were temporarily removed from calculations during World War II, as these items weren't readily being manufactured because of the war effort. It's come to the point where the Bureau of Labor Statistics (BLS) publishes a 100+ page book describing their methodology in fine detail.

Components of the CPI

The CPI we see in the headlines (“headline” CPI) is comprised of roughly 40% housing/shelter, 15% transportation, 15% food/beverages, 10% medical care and the balance being a combination of recreation/education/clothing/etc. About 25% of the underlying components are related to food or fuel, which can be volatile in price. They are removed to smooth the impact of more stable components which are quoted as (“core” CPI). Of course, we all spend differently, so our basket of goods will vary among ourselves and change over different stages of life. Students, for example, are heavily affected by tuition costs, and seniors are more affected by price changes in medical care and pharmaceuticals. These costs have increased more rapidly than many other items in the CPI index. On the other end, technology products have benefited from dramatic enhancements in features over time—often at a cheaper cost.

In the past year or so, oil prices have depressed the headline CPI, keeping it close to 1% on a year-over-year basis. However, without energy’s influence, the core CPI has crept up just above 2%. But this can be deceiving when trying to look at the big picture year-over-year. If energy prices remain flat over the next several months, we could see headline year-over-year CPI fall into negative territory, but the core inflation could approach 1.5% by mid-year.

Inflation and the Economy

Low inflation has been both a friend and a foe for the large developed economies in recent years. On the one hand, price stability is a good thing for political stability and modest economic growth. It certainly beats the havoc a high inflation rate can wreck on a country and its economy.

>However, persistently low inflation is a byproduct of slow economic growth, and that appears to be the issue today. Policymakers at this point would gladly trade a bit of inflation for stronger economic activity—within reason. (Remember the 70’s?) Interestingly enough, though, world economic history has been marked by numerous multi-year and even multi-decade bouts of systematic deflation. These have often been brought about during periods of extreme technological innovation, particularly during the Industrial Revolution. During these times, the production costs for a variety of items dropped substantially, and consumers benefitted, often at the expense of laid-off workers. We continue to see that today, with technology and improved productivity holding the costs of goods and services down. As with many things financial, finding that Goldilocks inflation sweet spot between "just enough” and “too much”' can be elusive.

Inflation Psychology & a Cautionary Note

Inflation and deflation also have behavioral effects, which can perpetuate trends. (“Buy it now, as it will be more expensive tomorrow,” or “Why buy it now—it will be cheaper tomorrow.”) As humans, we place a high value on recent experience to affect our behavior and our predictions about the future, which we see reflected in periodic consumer sentiment measures. In fact, for many consumers, having a job with somewhat rising wages and cheap gasoline are two strong indicators for buying activity—notably big-ticket items like cars. On the other hand, higher inflation for medical care and tuition can become a burden and a hot political issue during the election season.

How inflation is measured, what is included, and over what time period it is measured can make inflation rates deceiving. It depends upon what you buy and your stage of life. Whatever measure you use, remember the rule of 72 in your financial projections and your investment management: Take the inflation rate and divide it into 72. That will tell you how many years it will take for prices to double.

Read our Weekly Review for April 25, 2016.

Read the previous Question of the Week for March 28, 2016.

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