The truth about inflation

Whether we’re rich or poor, thrifty or overextended, inflation is as inevitable as death or taxes. But how high IS inflation? Is the Consumer Price Index a reliable guide? And what is the impact of underestimating inflation?

In an effort to gauge how much you need to save and how far your money will go in the future, most financial planners will run projections based on 3% or occasionally 3.5%, or even 2.5% annual inflation rates. However, as we'll see, this can put investors at serious risk.

The dirty secret behind inflation is that it is a lot steeper than we are led to believe.  There is a good reason why those 2 or 3% cost of living raises don’t seem to keep pace with the economy... they're not.

 Truth be told, inflation is a moving target. But that's not the only reason why our dollars seem to keep shrinking.

The truth of the matter is that we have been blatantly and systematically lied to about inflation. By constantly changing the way inflation is measured, the government ends up deluding the public as to the true effect on our pocketbooks. This is good for politicians, but dangerous for us, not only because we underestimate our need for money in the future, but also because we are ultimately being fleeced.

 The Bureau of Labor and Statistics, or BLS, defines the Consumer Price Index (CPI). Measurement of the CPI is critical because it is the index used to regulate prices and to calculate changes in wages and pensions. Financial planners also use these indicators as a way to predict future costs.

 The problem with this pricing methodology is that it paints an inaccurate portrait of inflation. The CPI measures inflation by how much the price of a “basket of goods and services” used by consumers changes over time. But the basket itself actually changes.

 For example, if a family downgrades from beef to chicken because the price of beef has drastically increased, the comparison doesn’t reflect the true inflation rate. But when beef rises, the Consumer Price Index does just that it changes the items that get measured, because that's what consumers do - they may substitute something lesser when prices rise.

 To quote Investopedia, “Substitution, the change in purchases by consumers in response to price changes, changes the relative weighing of the goods in the basket. The overall result tends to be a lower CPI.”

 Not only that, but some important expenditures are left out. For instance, the actual price of purchasing a house is not factored in, only an estimate of what it might cost to rent that house. Since house prices rise in value faster that the CPI rates, the CPI can’t accurately reflect a true cost of living increase.

 Statistics from the US Census Bureau show that average home prices rose by over 1600% between 1963 and 2013, from $19,300 to $319,275. However, by using the government’s CPI inflation calculator, $19,300 in 1963 adjusts upwards to only $146,930 in 2013 money. This is reflects less than HALF of the actual appreciated cost of a home over this period!

Perhaps even more disturbingly, we can see on a Truth Concepts financial calculator that the actual difference in rate required to inflate a property to $319k instead of $147k was the difference between 4.14% to 5.77%.

There are many reasons the government underreports inflation.

  • A low inflation rate does wonders for a politician’s popularity.
  • By skimping on cost of living raises for Social Security and government employees, an over-extended budget can be balanced.
  • It throws up a smoke screen that obscures government and Federal Reserve policies that actually make inflation worse.

 

Posted on January 18, 2016 and filed under Banks, Investments, Risk, inflation.