Inflation lately has been pretty tame. Still, the possibility that it could raise its ugly head again, eating away at our spending power and standard of living, is always in the back of our minds. That’s why it’s important to understand inflation to better protect ourselves from its potential impact. Knowing these myths about inflation is a good place to start.
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In spite of this seemingly easy-to-tame animal, economists have an awful track record of predicting inflation. Because we like our forecasts to be precise, we gravitate to specific numbers. Though Vanguard’s economic modeling may be less emotionally appealing, it is far more useful and illustrates just how difficult the CPI is to predict. Over the next decade, Vanguard predicts that there is a 90 percent probability that the annual CPI will increase between zero and 4 percent. It also means that there is a 5 percent chance it will average less than zero (deflation) and another 5 percent chance it will be more than 4 percent (high inflation). Why does it matter? With 4 percent annual inflation, spending power in 10 and 20 years will be 68 percent and 46 percent, respectively, of what it is today.
With deflation, high-quality fixed-rate U.S. government bonds would likely be the best protection. Stocks and real estate would be the best protector against high price increases. Gold may not be as attractive as many think in a high-inflation scenario.
Myth two: The CPI excludes food and energy. I’ve heard this one countless times, usually in the context that the government is manipulating inflation. The Consumer Price Index for All Urban Consumers (CPI-U), the all-items index, increased 1.7 percent from October 2013 to October 2014. The all-items index includes eight major expenditure categories: food and beverages; housing; apparel; transportation; medical care; recreation; education and communication; and other goods and services. The BLS also publishes a CPI-U for all items less food and energy, widely referred to as the “core” CPI. Because food and energy are more volatile, the core CPI is a more stable measure of underlying inflation.
Thus, when you see the CPI reported, it includes food and energy. With the recent and happy trend of declining oil prices, you may see lower increases in the CPI than the core CPI. The October core CPI, released on Nov. 20, was up by 1.8 percent for the past year. In the past month, the core CPI was up 0.2 percent while declines in energy brought down the total CPI to 0.0 percent. You can see more about how the CPI is calculated at this BLS FAQ page.
Myth two and a half: My personal inflation is much greater than the CPI. I’ve certainly felt this regularly with my health care costs for the last couple of decades, and with having a kid who will soon be going to college. I often stew over skyrocketing health care and education inflation.
But I spend little time being grateful for price declines. Consider this Radio Shack newspaper advertisement from a 1991 edition of the Buffalo News. Thirteen of 15 items in this ad can now be replicated using just about any smartphone ... and done with much higher quality. Yet, the 13 items back then cost $3,055. Research by the late Stanford communications professor Clifford Nass demonstrates that we have a tendency to remember negative experiences much more vividly than positive ones. We process good and bad information in different parts of our brains. Negative emotions involve more thinking, and we process the information more thoroughly. In short, bad has a stronger impact than good.
Personally, this makes me feel a bit better, yet I still can't shake the belief that my own costs are way above the CPI. Perhaps this is just a human bias.
The next time you hear someone give you a compelling reason for why inflation will be either very high or low, don’t you believe it, and definitely don’t act on it. Putting all one’s money in gold or even bonds is foolish. A better approach is to be prepared for either high or low inflation.
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Next, understand the difference between the total CPI and the core CPI. Having a better understanding could help you better gauge what your spending increases may be. Finally, the next time you get a whopping increase in a monthly bill, take a look at your smartphone or other technology in your house; it’s possible this may make you feel a bit better. I emphasize the word “possible.”
Author’s note: Thanks to Steve Cichon at TrendingBuffalo.com for finding this ad.
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