Tuesday, May 02, 2006

Inflation - part 2

The first part of this article on inflation identified why financial planning requires an awareness of inflation and how it can affect the value of savings over time. The second part looks at the question of exactly what is inflation and how much inflation are we experiencing?

The two most widely used definitions of inflation are:

1. the rate of increase in the supply of money (M3 being the broadest measure of the money supply is commonly used for this purpose); and
2. the rate of increase of prices in an economy.

The Federal Reserve stopped publishing M3 data in march 2006 effectively making it impossible to accurately measure the rate of increase in the money supply in the US. In the 12 months prior to the last set of M3 data being published, the money supply grew by a little bit less than 8%. The official explanation for ceasing to publish M3 data was because it was no longer considered to be useful. Many commentators have suggested other reasons.

The rate of price increase is harder to measure. Consumer price indices (CPI) are the most commonly quoted measure of inflation in an economy. The problem with CPI figures is that they represent only a selection of the goods and services consumed in an economy. Unfortunately they do not reflect all goods and services in an economy - only selected goods and services. It follows that we need to consider whether CPI data is an accurate representation of the rate of inflation.

Last week Tocquville Asset Management L.P. published an report showing the effect of the numerous adjustments to the way in which the US CPI data is calculated during the current administrations of presidents Clinton and George W Bush. The report draws on work published by John Williams at www.shadowgovernment.com . (Unfortunately I have not been able to access the website yet.) As a snap shot, currently the CPI is increasing by a little more than 3%. If CPI were calculated on the same basis as it was at the start of the Clinton administration, the number would be closer to 6.5%. This is a massive difference and one that has huge, and scary, consequences for everybody. Williams gives a practical example that the effect of the succession of downward manipulations of the CPI data is the effect on Social Security payments which should be about 43% higher under the old methology.

A further question which merits consideration is how accurate (or not) the CPI figure was at the start of the period under review.

By coincidence, the Hong Kong government announced last week that it was reweighting the components of the Hong Kong CPI data to reflect changes in consumption patterns. The effect of the reweighting was to reduce the inflation rate by about 0.2%.

While inflation indices should change over time to reflect changing patterns in consumer spending, I am highly suspicious of changes that habitually work in one direction only - downwards and, further, do not include a number of significant expense items.

A couple of questions follow from my ramblings on inflation. The first is whether it is possible for an individual such as myself to know with any degree of accuracy exactly what the rate of inflation is. The second, and more important, question is this. If the true rate of inflation is materially higher than the 2-3% often quoted, what implications does this have for financial planning and investing?

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