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Originally posted at Portfolioist.com.

The front page of Wednesday's Wall St. Journal features an article on rising commodity prices entitled Commodity Prices Surge. Prices on a wide range of commodities have risen in double digit percentages so far in 2010. Companies such as Dean Foods (NYSE:DF) and Sara Lee (SLE) have seen their earnings hit hard by the rising costs of commodities they use in their products.

Meanwhile, it was announced in mid October that there would be no Cost of Living Adjustment (COLA) for social security recipients for 2011. The COLA is calculated based on government-compiled inflation data, so the zero COLA means, apparently, that inflation is low.

Meanwhile, health care costs are expected to rise about 10% from 2010 to 2011. Tuition at public colleges and universities has gone up by almost 8% in the last year.

So, while the CPI is low, the costs of many of the things that we buy have soared. This is not hard to explain. The CPI is a fairly complex calculation of cost increases of a basket of goods and services, skewed to what is considered representative for urban consumers. The CPI is supposed to track the costs of the following eight major classes of items:

  • FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
  • HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
  • APPAREL (men's shirts and sweaters, women's dresses, jewelry)
  • TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
  • MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)
  • RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
  • EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
  • OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Source: Bureau of Labor Statistics

When we look at the official government numbers, the CPI is increasing very slowly, implying very low inflation.

A substantial issue with the CPI as a measure, however, is that it is simply based on an algorithm that weights together a wide range of factors--and this algorithm changes in time. Shadowstats.com, an economics website, compares the current CPI calculation to older calculations and the current inflation rate would be much higher--on the order of 6% or more--if CPI was calculated using the same method used in 1980. According to Shadowstats.com, the inflation rate would be about 4.2% if CPI was calculated using the methods used in 1990. The current official inflation rate is less than 2%.

Even aside from the issue of changing algorithms, CPI does not measure any individual's actual cost of living--as the Bureau of Labor Statistics points out. Different people will be exposed to cost increases of varying items and services in different ways.

There is no easy answer to this question, and peoples' perception of what they spend is not a meaningful measure either. If you have just been to the grocery store and noticed that the cost of milk or coffee is high, you are likely to think that costs have risen. But what about the fact that you refinanced your home to a markedly lower rate a few months ago and now pay less for housing than you did then?

Inflation determines how the purchasing power of our paper money changes through time. Aggregate inflation is a major reason that we must save fairly aggressively and invest in assets that are likely to at least maintain purchasing power. Inflation protected bonds are indexed to the CPI, but CPI may or may not be a good measure of our own experience.

Is inflation actually high or low? This is not the question that we need to ask. The real question is what your personal rate of inflation is and how we save and invest appropriately, given that exposure to rising costs.

Disclosure: No positions

Source: Inflation Is Low? The Answer Is Personal