Real Rate of Inflation

126 What’s the Real Rate of Inflation?

We’ve talked about a lot of scary financial concepts on the Insurance Pro Blog in the past and it seems as though few economic topics strike more fear in the hearts of Americans than unrelenting ‘i’ word. We are, of course, talking about inflation.

But what is this seemingly cryptic topic all about and why is it so frightening? Further, is it really the harbinger of death for our economy—or at least your personal financial life—so many others have suggested?

Probably not.

Did the Price of something go up? Let’s call it Inflation!

One super annoying tendency among the media and other laypeople is the incessant labeling of every price increase as inflation. Unless you’ve not stepped foot in a grocery store in the last few years, you likely know that grocery prices have experienced a little rise. And because your grocery bill is now a tad more expensive, we must label this phenomenon food inflation. Makes sense, right? After all the price did go up.

And every time we see an increasing price level for a good or collection of goods, several people fancy referencing this rise in prices as (insert label here) inflation. And few things could demean and confuse the true concept of real economic inflation more.

Inflation, Defined

Inflation is the sustained increase in price levels over a period of time—note the emphasis.

What causes inflation has been a long debated subject, but most professionals agree that it’s driven by a disparity between the money supply and the real growth of the economy. An example should ensure understanding.

Most of us a pretty comfortable with the idea that given a finite resource, the price of said resource will be driven up if demand for that resource increases while supple remains the same. There is a very subtle point to this.

Keep in mind that demand represents both the willingness and the ability to consume a good. For example I may want to buy a Koenigsegg Agera, but until I’ve got nearly $2 million to drop on a car that gets somewhere around 8 miles per gallon and can’t be driven practically anywhere in hilly pothole-laden Vermont my affect on demand for cars produced by the second coolest car manufacturer from Sweden is nil.

So not only would it be the case that one would want the good, they also have to possess the ability to buy it in order to make influence price levels.

Inflation, therefore, is a process of lots of people having more money in their pockets (and when we have more money we tend to want to buy more stuff) while the economy itself doesn’t expand to meet the increase capacity for consumption.

But, keep in mind that there is a big difference between a temporary shift in prices as the economy adjusts to meet the new demands and a sustained change with no counter balance to bring the price back down is the key driver between a price shock and actual inflation. A lot of people in the financial services industry and financial media industry love to forget this important distinction.

Also note that there is a very big difference between inflation itself and the rise in interest rates. Rising interest rates are a “symptom” (so to speak) of rising inflation. A mechanism used to slow down consumption by changing the money supply and curb consumption. Rising interest rates are not inflation itself.

The “Real” Rate of InflationReal Rate of Inflation

If you peruse the subject of inflation, you’ve likely run into discussions about how the US government works hard to deflate the real rate of inflation for a multitude of reasons. This theory has been kicked around for decades and while some of the arguments may seem completely reasonable, this claim is utter nonsense.

People in the financial services industry love to jump on this bandwagon as a means of scaring people into stocks or equity strategy mutual funds. You see, telling people that inflation is really at least a few hundred basis points higher than the rate published by the Bureau of Labor Statistics makes for a convincing argument for why you need to own stocks as the only means to save money and not have your nest egg worn out by the evils of inflation—great for fear mongering story telling, but of very little use for anything else.

The truth is all the claims are held up by misused aspects of some of the adjusting that takes place for the Consumer Price Index. Claims made about how the Consumer Price Index excludes such every day staples as food and energy are false. While it is true that some iterations of the CPI ignore some goods like food and energy this is done to not lead fiscal and monetary policy completely astray by freaking out over a momentary blip in price levels for a certain good—remember inflation is the sustained increase in price levels.

Take for example the rising oil prices we saw leading into and during 2008. Should the BLS have reported double digit inflation numbers taking into account the meteoric rise of energy prices? Absolutely not. The move was temporary and prices normalized after a while. And while it may have been wildly inconvenient to buy gasoline for a while, prices did fall after a while. We could make several arguments for whether or not current gas prices are as low as they should be, but that’s subject for an entirely different day.

Lately, we’ve been hearing a lot about food prices and in truth your grocery bill has probably been rising a bit. But this is primarily a result of some really terrible weather and growing seasons that have hit a lot of the U.S. and cause crops to suffer. It’s most likely temporary and very unlikely to be the start of some cataclysmic hyper inflation.

Is Inflation a Problem for Savings?

The case can be made for just about every subject being a problem for something. And it’s certainly true that inflation will have an effect on buying power over really long periods of time. And this can affect some retirees who have a long retirement ahead of them and the challenge of having enough money to weather the entire period. Of course, this is a problem most easily solved by one of my most favorite solutions—work longer…or at least save more.

But in order for inflation to really become a problem, we need a large disconnect between the money people have in their pockets and the production capacity of our economy. Meaning we’d need a period of rapid expansion leading into a trailing off economy or an immediate and significant decline in production capacity. Two events that are currently unlikely.

So I wouldn’t worry terribly much about inflation eating your lunch at the moment. And if you want to be somewhat defensive about how best to hedge the same general rules apply. Save more money.

About the Author Brandon Roberts

Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.

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