NEW YORK (
Why This Is ImportantAs a refresher, inflation in the U.S. is calculated by the Bureau of Labor Statistics (BLS) in a measure called the Consumer Price Index, or CPI. It is used by the Federal Reserve to justify its money printing policies, by the federal government to calculate cost-of-living adjustments (COLA) for the entitlement programs (e.g., Social Security), and to set the interest rate on inflation-adjusted bonds known as TIPS. Indirectly, the CPI influences interest rates, the stock market, and a host of salary and pension negotiations each year. If the CPI is too low, even by a single percent, the impact is in hundreds of billions of dollars. And from a financial planning standpoint, the impact is just as dire. If you are putting away money for a child for college, the rate of inflation you apply to the tuition has an enormous impact on the amounts you'd need to put away. In 18 years, a current $40,000/year tuition will become $66,000/year at a 3% rate of inflation, but $107,000/year at a 6% rate of inflation. The same logic and results apply to retirement planning. Further, the cost estimates surrounding the current health-care debate in the U.S. are founded on inflation projections that draw upon prior CPI readings for their baselines.
It is vitally important that our assessment of inflation be as accurate as possible.Unfortunately, the CPI understates inflation, which is much higher (worse) than we're told. Understanding exactly how this is accomplished will help clear your mind and lead to more certainty in your decisions.
Caveat EmptorEvery country fights its last battle, and in the U.S., unlike Europe, the prior enemy was deflation, which ravaged the land in the 1930s. Seeking to avoid that fate repeating itself, the U.S. Federal Reserve routinely justifies the continuation of its massive money printing experiment (which goes by the all-too-fancy title "Quantitative Easing") by citing an apparently low rate of inflation, as provided by the BLS. Here's a recent example of such justification at work:
Recent data show consumer price inflation continuing to trend downward . For the 12 months ending in November, inflation excluding the relatively volatile food and energy components--which tends to be a better gauge of underlying inflation trends--was only 0.8 percent, down from 1.7 percent a year earlier and from about 2-1/2 percent in 2007, the year before the recession began. (Source)A 0.8% yearly rate of inflation ( ex food and energy, of course) that is trending downwards certainly makes inflation sound like a non-issue and supports the idea of dangerous deflation lurking nearby. Indeed, the Fed is right, after subtracting out the items that are most responsible for keeping everybody alive and comfortable (food and energy), the rate of inflation as reported by the BLS seems to be locked in a mortal tailspin -- as long as you only look at the narrow range marked by the red line below: (Source) Well, the average person would be well within their rights to wonder what all the fuss is even about. After all, inflation is now within 0.06% of its ten-year average, and unless you are calculating the trajectory of a newly launched Mars probe, 0.06% is not really that big of a deal. But the Fed is terrified of it. Backing up this view is the BLS, which provided us with these data for December 2010: (Source) According to the BLS, the average household experienced an exceedingly tame rate of inflation of only 1.5% between December 2009 and December 2010. That is, what used to take $100 to buy in 2009 requires $101.50 in 2010; only a dollar-fifty more. Once we strip out food and energy, the cost index plummets, requiring only 80 cents more than a year ago to buy the same basket of goods and services. The only problem with this view is that it is utterly, provably, and demonstrably wrong. I can reveal how with one relatively simple example.