Understanding Inflation

It's always good to start with a definition, even if you lived through the double-digit inflation of 1974-75 and the early 1980s and know what inflation is firsthand.

Here, then, is that definition, courtesy of Webster's:

in·fla·tion

A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services

Now let's bring that back down to the real world.

Everything in the world changes with time. Seasons shift, people grow older and prices move up and down - in some cases with each tick of the clock. We humans have a compulsion to label things, so when prices persistently go up, we call it inflation. When prices go down, we call it deflation.

The tricky bit to remember is that with rising prices, we get a corresponding decrease in purchasing power. For example, a candy bar that cost $1 in 2003 would cost roughly $1.15 today - or to think of it another way, if you only wanted to spend $1, that same stale candy bar would be slightly smaller today. In order just to stay even - to have the same basic wealth - you're source of cash flow (investments, paychecks, lottery winnings) has to at least keep pace, or you're literally becoming poorer, no matter what the numbers in your bank account look like.

Measuring Inflation

To make sure we're comparing apples to apple, U.S. inflation (and deflation) is calculated based on a specific basket of things consumers actually buy every day - captured in the Consumer Price Index (CPI), published in the U.S. by the Bureau of Labor Statistics.

In practice, what we refer to as the CPI is really the CPI-U: The CPI for All Urban Consumers, which is a basket of goods and services commonly purchased by urban households. The CPI-U is designed to represent the average, real-market experience of 87% of the households in the U.S. When headlines talk about the CPI, what they usually mean is the CPI-U.

Another oft-headlined index is the Core CPI - the CPI-U without the items in the basket that are directly food- and energy-related. Why would anyone remove food and energy? After all, I know that my oil, gas and grocery bills make up a very large part of my household budget.

Well, since the CPI is watched as a yardstick for monetary policy by many economists and policy makers, the idea is that food and energy are subject to short-term microeconomic supply-and-demand shocks, and are thus too volatile to be a good yardstick for assessing the impact of monetary policy. (In other words, food and energy prices change too quickly.) But since most of us live in the real world - not the monetary policy theme park - we typically refer to (and journalists report on) the CPI-U, and not the core CPI.

Included in the CPI are things like food, beverages, housing, apparel, transportation, medical care, recreation, education, communication and other goods and services. Also included in the basket are all the little taxes and fees that make this nation great - things like auto registrations, water and sewer taxes, etc. Income and Social Security taxes are not included. (To learn more, visit the CPI's home at the Bureau of Labor Statistics. It's great nightstand reading.)

There's a third set of inflation indexes we should be paying attention to as commodities investors, however, and that's the Producer Price Indexes [PPI]. The PPI, instead of measuring what consumers spend, measures the actual amount that producers receive for their goods. Here's how the BLS describes it:

PPIs measure price change from the perspective of the seller. This contrasts with other measures, such as the Consumer Price Index [CPI], that measure price change from the purchaser's perspective. Sellers' and purchasers' prices may differ due to government subsidies, sales and excise taxes, and distribution costs. (PPI FAQs Bureau of Labor Statistics)

Besides highlighting the difference between purchasers and consumers, the main differences between the two indexes is that the PPI is only domestic, and it removes the entire retail service sector from the equation, both of which can be seen as "noise" if you are trying to understand nuts and bolts U.S. economics. The CPI, with its consumer perspective, collects data on anything that is bought by consumers, and includes imports, as well as sales and excise taxes. PPI is just the price the producer gets for its good.

The differences between the PPI and CPI are consistent with the different uses of the two measures. A primary use of the PPI is to deflate revenue streams in order to measure real growth in output. A primary use of the CPI is to adjust income and expenditure streams for changes in the cost of living. (PPI FAQs Bureau of Labor Statistics)

There's some belief among economists that because the PPI is less volatile, and that it may in fact be a better longer-term measure of shifts in the economy. But that is a subject we'll leave to the economists. From a commodities perspective, since consumers don't directly consume #2 Field Corn and Crude, the PPI is one step closer to the actual industrial transactions that drive commodity prices.

Money Math

Just knowing what the CPI is doesn't tell you anything about inflation - to get that information, you must look at the change in the index between two specific dates. It is a simple matter to subtract the CPI on some starting date from your end point and divide by your starting date, then multiply by 100 to get a percentage. Or, more simply: [(X-Y)/Y]*100. If you don't want to do the math yourself, there are a number of calculators out there that will do it for you.

Since 1918, inflation has danced all over the place - reacting to the whims of war, productivity improvements, monetary policy, international trade and other economic forces. Most of the recent history of U.S. economics has dealt with wide swings in inflation. It has really only been in the last 15 years or so that we have experienced average annual inflation rates of less than 4% - rates that most policy makers would target as optimum. The last time the U.S. experienced extended time at such stable inflation levels was in the early 1960s.

Of course, to follow these figures, you have to accept the government's measure of inflation ... something lots of people are loath to do. CPI measures are imperfect for a variety of reasons, and many believe that they fundamentally understate experienced inflation. Some argue that these understatements are deliberate - after all, huge amounts of government spending are tied to CPI: Social Security cost-of-living adjustments, many government contracts, etc. A lower CPI means the government saves money. And since it controls how the CPI is calculated, it's a bit of "fox guarding the henhouse." Matt Hougan explored these issues a few years ago in the Journal of Indexes.

Still, the CPI is the best measure that most people agree on; it's what's used in most financial planning exercises, and it's what we have to work with here. For investors, then, the question becomes: What really causes inflation and the changes in the inflation rates, as measured by the CPU? And therein lies cocktail party arguments that could last decades.

A Tale of Two Theories

The first fairly obvious and unhelpful theory is the classic, "too much money chasing too few goods." This theory is that there is literally too much money in the system, combined with high demand for scarce goods which results in sustained rising prices.

Where does this "too much money" come from? Well, at a micro level, this can come from shifts in labor pools and employment trends. Let's say that a giant company moves in to your small, isolated town, complete with busloads of employees. Its first corporate act is to send those busloads of employees to the supermarket to buy carrots. And let's suppose that it is mid-February and there is a limited supply of carrots, and the mayor has, in her great wisdom, banned the importation of carrots to her hamlet (perhaps her brother owns the local carrot monopoly). All of these new people are in competition for the scarce carrots and will "bid up" the price of carrots. Same supply, more demand - prices rise.

A second theory focuses on cost pass-throughs. As producers compete for their own scarce inputs - wages and materials - their costs rise. They have to pass these costs out to the consumers by raising prices. A good example of this is what happened in the summer of 2008 with energy prices: As oil prices rose, refiners passed the costs through to the consumers via high gasoline prices. There was no real scarcity of gasoline - no rationing or epic lines - instead it was expensive oil that was responsible for the rising price.

These are overly simple microeconomic explanations. Macroeconomists focus on the literal money supply - not the "too few goods" part, but the "too much money" part.

Here's an excerpt from the Library of Economics about money supply and how it relates to inflation:

An increase in the supply of money works both through lowering interest rates, which spurs investment, and through putting more money in the hands of consumers, making them feel wealthier, and thus stimulating spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, especially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

The reality is obviously that all of these are intertwined, and assessing (much less predicting) inflation is a huge challenge. Still, it's critical to commodity investors, because inflation - both experienced and expected - has a huge impact on commodity prices.

Commodities and Inflation

Gold

When you talk about commodities and inflation, the first thing that comes to mind is Gold with a capital G. Here at HardAssetsInvestor.com, we even put it in the headline: The Special Case for Gold. Gold is unique in commodities, as it is traded largely based on perception and policy, and less on actual industrial supply and demand. That perception is largely about gold's ability to buck inflation: Gold bugs start every argument with a fundamental belief that gold holds its purchasing power.

The World Gold Council uses the following illustration: Gold was at $20.67 an ounce in 1900, which is equal to gold at $503/oz in 2006. They state:

In the two years to end-December 2006, the actual price of gold averaged $524. So the real price of gold changed very little over a century characterized by sweeping change and repeated geopolitical shocks. In contrast, the purchasing power of many currencies has generally declined.

In other words: Currencies devalue, but gold soldiers on. All well and good if your timeline was the past 100 years, a time when gold's role as a government-sanctioned store of wealth steadily eroded. But in the shorter term, even the World Gold Council admits, "Experience has shown that gold can deviate from its long-run inflation-hedge price."

This is where the opposing view steps in. Commodities expert Larry Swedroe voiced this side of the argument here at HardAssetsInvestor.com quite well:

"Let's assume that to provide a hedge against future inflation an investor decides to purchase gold at the end of 1980 with the price at $641 an ounce. Over the next 27 years (1981-07), inflation rose at an annualized rate of 3.4%. If gold were an effective hedge against inflation, its value at the end of 2007 should have been at least $1,528. Yet, it was worth just $833 (an annualized return of just under 1%). In other words, an investor in gold experienced a reduction in purchasing power of 2.4% per annum, or a cumulative loss of purchasing power of about 55%. For an investor who was unlucky enough to purchase gold at its peak of $850 an ounce on January 21, 1980 (as some undoubtedly did), the inflation-adjusted price would have had to have been in excess of $2,300 by the end of 2008."

So gold is not exactly an inflation hedge, then, is it? At least over the short term, as suggested in this article on InflationData.com, gold may work more as a crisis hedge (flight to safety) rather than an inflation hedge.

Not Gold: Energy

If gold is not the perfect inflation hedge, then what is?

Once we step away from the special case of gold, it's important to realize that commodities are the ultimate inputs into the inflation equation. All else being equal, we would expect a steadily appreciating commodities market to cause price inflation.

Energy - specifically oil - is a component of nearly everything in the CPI basket. So how's it look?

Source: CRB 9/30/83 to 6/30/08

The first obvious point here is that the CPI is a staggeringly stable number. While we read headlines that suggest wild changes in inflation, what we're always reading about is the amplified, implied annual inflation that a one-month change in the CPI implies. But the actual basket growth has been phenomenally steady over the last 25 years.

A good explanation of this chart (specifically, the relationship of oil prices and inflation) can be found at the Federal Reserve Bank of San Francisco. It concludes that high oil prices have a limited effect on core inflation in the U.S., although higher energy costs can get reflected directly in the CPI-U as consumers spend more money on gasoline, heating oil and the like - which is one reason economists prefer to remove energy and food from CPI discussions. This impact will also be seen in the core CPI if prices rise and remain high for a period of time - because businesses will need to spend more money on their materials and inputs, which will then be passed on to the consumer in the form of higher prices. The article then goes on to say:

However, once oil prices stabilize, the corresponding inflationary pressures will dissipate. As a result, both overall and core measures of inflation may decline, with the overall inflation rate likely to fall towards the lower rate of core inflation.

Well, surely the cost of food tracks inflation (and vice versa).

chart data from CRB 9/30/83 to 6/30/08

This time, we're looking at the Reuters CCI Oilseeds and Grains sub-index (soybean, wheat, corn) versus the CPI, as a general proxy for U.S. agriculture. The interesting thing to note here is once again we can see the slow growth of the CPI and the volatility of the agricultural commodities.

Most of the headlines about inflation and agriculture recently have stemmed from the jump in some local food prices and local food shortages in the first half of 2008. A combination of increased wealth in developing countries and higher demand for certain rice and grain corresponded to supply shocks brought on by bad weather and poor crop yields.

Do Commodities Work As An Inflation Hedge?

It's statistically inarguable that the effects of commodities on inflation - and commodities reaction to inflation in general - is muted at best. Logically, the demand for stuff will increase with population and global wealth, and the supply of stuff is ultimately limited. But this is the long-bull case for commodities we know so well, and while those increased prices will show up eventually in the inflation statistics, the CPI will remain the lowest volatility measurement we have over the long haul.

The bottom line is that we as investors are looking for a way to ensure that inflation doesn't ravage our investment portfolios - earning a 10% return looks great when inflation is at 2%, but it looks less attractive if it is at 11%. Do commodities help?

A study done by Merrill Lynch and reported on by the Financial Post back in April suggested that investing in commodities was - in general - a logical way to hedge against inflation.

"Commodities tend to move broadly in line with inflation-linked liabilities such as materials, wages and retirement benefits," Merrill Lynch said, adding that commodities can yield high returns in high-inflation environments.

On the other side of the coin is an article written by Dennis Tilley on IndexUniverse.com where he details why he believes you are better off investing in T-bills or commodity equities to offset inflation, rather than take your chances with commodities.

"There are better inflation hedges and ways to play the rise in commodity prices. Ultimately, the best exposure to commodities is through equities; our recommended equity portfolio offers plenty of exposure to energy and basic materials stocks and to asset classes with heavy exposure to commodity production, such as emerging market stocks. Although not perfect, TIPS and short-term treasuries also provide some protection against a commodity price spike."

The Sure Thing (Kind Of)

If all you are looking for is to hedge against inflation, there's an extraordinarily simple tool that removes all the guesswork: Treasury Inflation-Protected Securities, or TIPS. First available in 1997, these are bonds offered by the U.S. Treasury, available in $100 lots. Interest is paid every six months based on the inflation rate. If inflation increases, the interest payment increases; if inflation decreases, so does the payment. The interest payments are rolled into the principal until maturity. The investment is protected from deflation because at maturity, the amount paid is the greater between inflation-adjusted principal or original principal. You can find the latest auction data on TIPS on the Treasury Direct site. The yield on TIPS is essentially always less than the corresponding Treasury, but the inflation protection - if you're convinced inflation's going to be a bugaboo for you - makes up the difference with an iron-clad guarantee.

They're not sexy, but if all you want to do is protect your money, this will do the trick.

The catch, however, is that you have to believe the government's CPI statistics. If you do, then TIPS make all the sense in the world. If you don't, well, maybe gold or commodities - while not perfect - are about as well as you can do.

Comments

[secmaven:]

The CPI is a staggeringly stable number. Is there any other number out there, other than the speed of light, which meets this test? We can only conclude, and verity from personal experience, that the government created CPI is a managed number and therefore unreliable as a measure of actual inflation.

Jan 09 11:28 AM

[Brad Zigler:]

Try looking at the real-time monetary inflation indicator that's updated in the HAI daily blogs (here, for example, www.hardassetsinvestor...)


On Jan 09 11:28 AM secmaven wrote:

> The CPI is a staggeringly stable number. Is there any other number
> out there, other than the speed of light, which meets this test?
> We can only conclude, and verity from personal experience, that the
> government created CPI is a managed number and therefore unreliable
> as a measure of actual inflation.

Jan 09 01:10 PM

[briacal:]

I agree that treasure bonds are the best way to accumulate long term financial security.The process,however,requir... strict discipline;many people,like myself,have the tendency to accumulate up to a certain point and then find some excellent reasons to start spending some of it.With the precious metal,you buy it ,put it away and forget you have it until a serious emergency knock at your door.This strategy worked for me wery well .

Jan 09 01:46 PM

[wojmax:]

One statement I would take issue with is that when speaking of a lower CPI, 'A lower CPI means the government saves money'.
While it is not too important to this article, in general it is very important. It is that government does not EVER save money. It simply spends less.

Jan 09 05:35 PM

[wojmax:]

I neglected to add to my earlier comment, that for me, it is an excellent primer on the economy, Inflation, CPI, core CPI, PPI and gold.

Jan 09 06:06 PM

[Dr.Jackpot:]

These data figures don't mean 'Jack' to me. I define inflation/deflation as the spread between what you get and what you need to spend to live. Inflation can happen in two ways. Forget the data. If your cost of living stays the same but Greenspan takes your fixed income down from something to nothing, that's huge inflation. Also if your fixed income stays the same but your cost rise------that's inflation. The converse can be 'deflation'. By my definition, inflation is roaring thanks to Greenspan and Bernanke. My life savings don't bring Jack anymore. This theft makes Madoff look like a circus pick-pocket and nobody talks about it.

Jan 09 10:28 PM

[devassocx:]

the CPI is so cooked today that it is almost meaningless...thanks to the
trickery and deceit of our favorite politicians. Same thing goes for a lot of
previously important government statistics such as unemployment numbers
and GDP.

The American public are the unwilling victims of the biggest ponzi scheme
the world has ever known.

And certainly, if you are depending on savings interest for your income
as many retirees are you are being stolen from by your government.

Jan 10 12:35 AM

[Kunst:]

I'd as soon believe Bernie Madoff as our government's CPI numbers, or unemployment numbers for that matter.

Jan 10 01:48 AM

[BrucePile:]

Gold is the only unaffiliated arbiter, judge, jury, accountant, and poll taker for inflation numbers, policy soundness, and all things monetary. It's not the perfect inflation hedge like TIPS tries to be, and it suffers from overbuying and overselling. But it has to be considered more trustworthy than the bumbling meddling of transient governments and the unpredictable effects of wars and other surprises.

Jan 10 11:01 AM