Among the list of the many challenges facing the economy is a growing concern over the return of inflation. The double-digit inflation of the late 1970’s is a faint memory, but in the last several months inflation rose at the highest annual rates in over 16 years (except for a brief post-Katrina increase).
For investors, higher inflation means that investment returns may be gobbled up by higher prices. Since Treasury bonds have no risk of default, the market’s collective expectation of inflation is reflected in the yields of long-term Treasury bonds. In other words, investors want to be paid enough to cover what they perceive to be the risk of higher prices in the future. Except for a few months in 2003, the 10-year Treasury bond yield is at its lowest levels in 40 years, an indication that the market does not believe rampant inflation will materialize in the coming years. Even this indicator is not perfect, however, and those Treasury yields have also been driven down by strong demand from investors who have abandoned more risky bonds and fled to the safety of Treasury bonds. Investors may be willing to trade safety now in exchange for less purchasing power later.
Inflation is best described as “too much money chasing too few goods”, or demand outpacing available supply. Without additional money in the system, higher prices for some goods would mean lower demand, and lower prices, for other goods; the market would have to decide how to allocate it available money. Despite the slowing economy, additional money comes from increases in wages and increased borrowing by consumers and from foreign governments to subsidize the large trade deficit. Wall Street has also developed new instruments to broaden investments in commodities of all types, adding more speculative money to demand than in years past.
Inflation is the increase in prices of goods and services across the economy, and does not necessarily reflect the price experience of any particular consumer. This makes it difficult for the public to grasp that inflation is, say, 4% when they are faced with steady increases in regular purchases like food, gasoline and health care. And it is human nature to focus on the most recent pain of higher prices and overlook some costs that may actually be going down.
Just how does inflation get measured? The most common yardstick is the Consumer Price Index – All Urban consumers (CPI-U). The Bureau of Labor Statistics monthly surveys prices around the country for a basket of products and services and publishes the combined results in comparison to prices in 1984, which is the “base year”. The survey includes over 80,000 prices collected in 87 urban areas and 30,000 family surveys on spending habits. The percentage change in the CPI-U, or its components, from one period to the next determines the rate of inflation.
Several aspects of the CPI-U contribute to the “disconnect” between the overall inflation rate and the individual. There can be significant regional differences in costs, and these are blended in the national rate. The weighting of the components of the CPI-U can differ from individual spending patterns; for example, housing, including utilities, is just over 42%, transportation, including fuel, is 17%, food is 15% and medical care is over 6%. The basket tries to measured prices on an “apples-to-apples” basis, so products which dramatically improve over time tend to go down in price. This is especially true for computers, communications and media and, to a lesser extent, motor vehicles. Low-cost imports have kept costs down in apparel and home furnishings.
The details of the CPI-U reveal some interesting changes. The biggest long-term increase has been in tobacco products, which are nearly 500% higher than in the 1984 base year, followed closely by hospital services and tuition and childcare. At the other end of the spectrum is information technology, which has become 90% cheaper over time.
Policy makers use a measure of inflation called the “core” inflation rate, which excludes the energy and food components because they can be affected by weather and other seasonal factors. This is particularly frustrating for the average consumer when these “volatile” areas account for a large part of everyday expenditures, and they also happen to be the areas which are currently rising the fastest. In the past year, energy is up 17% and some food categories are up 8% to 10% due to increased oil prices and the shifting of agricultural production to biofuels. Those seasonal factors do even out, however, and over the long term core inflation and overall inflation as measured by the CPI-U are nearly identical.
Overall inflation has been rising at a 4% annual rate, well above the Federal Reserve’s comfort level, and core inflation is at 2.4%, also above the Fed’s unofficial target of 2% or less. Normally, the Fed would be raising interest rates and reducing the money supply to fight inflation, but with the economy slowing and the financial system facing a dramatic credit crunch, the Fed has continued to cut interest rates and pump money into the system, drawing criticism for indirectly contributing to higher prices. At the same time, wage increases, which have outpaced inflation over the long term, are barely keeping up with prices, and the job market is tightening. The best defense for consumers is the tried-and-true path of living within their means and maintaining some financial flexibility to take unexpected price increases in stride.
May 2008