During my economic 101 class at University of Toronto about 10 years ago, I was struggling to understand the actual interpretation of inflation. I always have doubts on the inflation number. Ever since the collapse of the financial market back in 2008, I am more convinced that the so called inflation is indeed unreal. Let's get back to basics. What is inflation? I am not going to explain it in an economic term. Let's look at it in a way where we can easily relate to. In short, inflation measures the impact of credit circulation in our financial system. Most developed countries have inflation target of around 2%-3% while developing countries have inflation target of around 5%-6%. Societies believe that most people behave sensibly when inflations fall within the ranges. When we have high inflation of 20%, people will start stealing and crime rate will go through the roof. When we have deflation of -5%, people will no longer be motivated to work hard and stop innovating. I am sure you could imagine what will happen to the world if either of these happens. Now, we all understand inflation is an extremely important figure that all the politicians, economists, investors, industrialists and many others pay close attention to.
OK, what is the big deal now? The big deal now is there is a flaw in the calculation of inflation. Many people have been wondering where all the QE monies have gone to. Many believe these monies have been used to inflate assets all around the world, but they were at the same time puzzled by the reasonable levels of inflation in many countries. Where is the missing link? Let's understand the calculation of inflation. Every country has constructed a unique CPI basket of goods. Each of these baskets of goods should reflect what an average consumer would consume in the country. What's wrong with that? Here is the flaw: Mr. Inflation will never know exactly what we consume, he only knows how much we spend on each of the category of items. Here is the missing link. This is where the missing QE monies have gone to. In places like Hong Kong, Singapore, Shanghai and many other big Asian cities, people have been moving to nicer looking homes, but much smaller homes in the recent past couple years. Mr. Inflation will never know people are downsizing their homes due to the rising of price per square feet (NYSE:PSF) driven by cheap credit. Mr. Inflation simply does not care about the shrinkage effect. If we were to adjust for the shrinkage effect, we would probably be running at 10%-20% hyperinflation in the past couple years, particularly in those places I have mentioned above. This is not just for the recent past, our real inflation has been understated for many decades!
Let's recall what we learnt from our economic class. Remember this formula: Real GDP = Nominal GDP - Inflation. I'm sure it looks familiar to some of you. We all know that the real economic success should always be measured in real GDP term. For a country to progress and achieve higher standard of living, the country must achieve positive real GDP growth. But, how real is the real GDP growth that most of us know of? If you refer back to the second paragraph, the inflation is totally unreal. That would also mean that the real GDP growth is totally unreal. The value of our every single hard earned dollar has been eroded multiple times faster than the so called inflation.
If your investment portfolio has not been producing double digit returns for you, you better think twice! I am not suggesting anyone to buy properties to hedge against inflation as this is not a buying property article. What I like my reader to do is to pay closer attention to what is happening around us. Dare to investigate and explore, the truth will never present itself to you until you discover what's underneath.