Who's Wrong About Inflation?

Includes: DIA, IEF, QQQ, SPY, TIP
by: Toro

In a recent Bloomberg article, consumers' inflation expectations appear to differ quite markedly compared to investors' inflation expectations.

Consumers expect prices to rise 5.2 percent in the next 12 months, according to a monthly survey by the University of Michigan in Ann Arbor, the most pessimistic they've been since 1982. Treasury Inflation Protected Securities, or TIPS, show traders anticipate inflation of about 2.95 percent by January, in line with its average of 3.1 percent the last 20 years.

The question then is, who is wrong? Is it:

a.) consumers

b.) investors

Or maybe they are both right. But, how can this be?

Consider what TIPS are.

Treasury Inflation-Protected Securities, or TIPS, provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.

The key to this paragraph is "Consumer Price Index."

The consumer price index is a basket of goods measured by the Bureau of Labor Statistics [BLS]. Each month, the BLS surveys businesses on the prices in that basket of goods and compiles the data to calculate the CPI.

However, calculation of the CPI includes hedonic adjustments, which are adjustments to the data to account for changes in quality. For example, a computer that costs $500 today is of far higher quality than a computer that cost $500 two years ago. If the computer today is twice as good as it was two years ago, the government adjusts the price down today by half to account for the change in quality.

This is logically consistent. If a consumer is getting better value for a specific good at the same price, the cost per unit of value has fallen, as a result, inflation for that good has fallen.

However, concern has risen about the hedonic adjustments to the CPI. Critics have argued that hedonic adjustments are underestimating inflation, and that by making too many adjustments, the BLS is mis-calculating true inflation. The critics also contend that the construction of the CPI does not accurately represent the components of the economy.

Thus, both consumers and investors may accurately be forecasting inflation as they specify it.

Consumers experience inflation on a daily basis. Investors in TIPS are compensated based on the CPI. If the construction of the CPI is wrong, then there can be a wide disparity between inflation expectations of investors and what consumers are seeing on the store shelves.

Let us then add another option to who is wrong about inflation:

c.) the government

Choosing between (a), (b) and (c), my guess is (c). Based on my own personal experiences, I think the government is understating inflation.