Monday, December 17, 2007

A Few Words About Inflation

Inflation is a fact of life in any economic system. In the U.S., we think (well, the Federal Reserve thinks) that if inflation is ~3% or lower that it is “acceptable” and “under control”. But even at “just” 3%, prices will double in 24 years (Rule of 72). People now in their 50’s will live long enough to see prices double. But inflation is not linear and every person’s inflation experience is different because we aren’t all buying the same goods and services.

Another problem with inflation is that the government cooks the numbers. Imagine that!

· You may have noticed over the past few years that when inflation figures are reported that you typically hear two figures: "headline inflation" which is the overall inflation figure and “core inflation, excluding volatile energy and food”. This is such a crock. Can you think of anyone you know who does not purchase energy and food? Energy and food are certainly part of my core basket of goods and services. It's like a shell game in that the government and media try to divert your attention from the total inflation figure by getting you to focus on the core inflation figure - "See how much lower the number is when we take out volatile energy and food?"

· The application of so-called “hedonic adjustments” was initiated during the Clinton years. Hedonic adjustments are concerned with the effect that the march of technological innovation has on prices. As an example, personal computers have gotten cheaper and cheaper over the years. The government decided that this improvement should be reflected in the calculations for inflation, thus the price of personal computers have essentially a negative impact on the official numbers.

If you are curious about how the figures are manipulated, check out http://www.shadowstats.com/

And finally, probably the least-understood impact of inflation is the purchase of goods and services that do not yet exist! Think back 10 years – how many people had cell phones? How many people had MP3 players? How many people had a broadband internet connection at home? Did you ever imagine that you would want to – let alone need to - purchase a personal paper shredding device? We could go on for several pages with examples. The point is that we don’t know what we don’t know. What will all these unknown items cost us? All of these unknown goods and services will be things that we will want to buy or for which a need will be created (e.g., identity theft = personal shredders).

Questions? kimm@sweetwaterinv.com

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