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Is the consumer price index the best way to measure inflation? I have heard it has limitations. Also, what kind of assets should I buy in an inflationary period? Thanks, M.A.
: Inflation can be
in myriad ways, including the much-maligned CPI, but it is best
by only two: an increase in prices or an increase in the money supply.
Either way, inflation leads to an decrease in purchasing power -- and trouble for consumers.
There are several different official inflation measures in the U.S.:
The CPI, which measures inflation as experienced by consumers in their daily living expenses.
The producer price index, or PPI, which measures inflation at the start of the production process.
The employment cost index, or ECI, which tracks inflation in the labor market. This is also known as wage inflation.
The Bureau of Labor Statistics international price program, which watches imports and exports for signs of prices creeping higher.
The gross domestic product deflator, or GDP deflator, which measures the change in prices of all new, domestically produced final goods and services in an economy.
Of all these, the CPI is the most widely cited inflation indicator. It tracks the weighted average of prices of a so-called basket of goods and services purchased by wage earners in urban areas. The CPI is used to calculate the cost-of-living adjustments for both government programs and private-labor agreements.
The Bureau of Labor Statistics is the government entity in charge of calculating and publishing the CPI every month. According to the BLS Web site, prices for the goods and services used to calculate the CPI are collected in 87 urban areas across the country and from about 23,000 retail and service establishments. Data on rents are collected from about 50,000 landlords or tenants.
After BLS data collectors obtain all these prices, the BLS classifies the expenditure items into more than 200 categories, and arranges them into the eight major groups: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services (which range from cigarettes to haircuts).
The BLS says government fees like water and sewerage charges, auto registration fees, vehicle tolls and sales taxes are also taken into account for the index.
Once the basket is collected, the prices of the items are compared to those of a base year to determine the extent of inflation. According to the BLS, most of the CPI indexes -- city and regional CPI's are calculated as well -- have a 1982-84 reference base, meaning the BLS sets the average index level for the 36-month period covering the years 1982, 1983, and 1984 equal to 100. The bureau then measures changes in relation to that figure. An index of 110, for example, means there has been a 10% increase in price since the reference period; similarly, an index of 90 means a 10% decrease.
One of the biggest criticisms of the CPI is that it does not include investment items, such as stocks, bonds, real estate and life insurance. These items are excluded because, according to the BLS, they relate to savings and not to day-to-day consumption expenses.
The CPI also takes heat as a benchmark for not adjusting for substitution effects. Furthermore, the CPI's fixed basket does not take into account changes in technology, which often leads to declines in price. Just tink about how quickly prices fall at your local Best Buy or Radio Shack. And the index can be greatly influenced in any given month by a movement in volatile food and energy prices, which is why economists often prefer to look at the "core rate" of inflation, a figure that excludes food and energy.
But despite all the criticisms, most economists will admit that the year-over-year change in the core CPI is the best measure of the underlying inflation rate. And that's why traders are on pins and needles whenever it is released.
As to your question about the best assets to hold in an inflationary period, just take a look at how commodity prices have skyrocketed recently. When people believe that inflation is on the rise -- meaning the dollar will lose its purchasing power -- they often turn to hard assets, especially precious metals like gold and silver, which will maintain their value.
Fixed-income securities, on the other hand, have a hard time competing in an inflationary environment. Inflation destroys cash and fixed-income investments. For example, if you are locked into a long-term bond paying 5%, it has a negative return if inflation reaches 6% or more. That's why retirees with big bond portfolios are extremely afraid of inflation