This "Hidden" Inflation Could Wipe Out Small Returns

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Official measures of inflation tell a very different story from the reality facing consumers as they shop for groceries, gasoline, insurance, healthcare, and other everyday goods.

In the real world away from government statistics, product prices continue to rise at an inexorable rate. 

Asset prices also continue to rise, particularly the prices of financial assets such as stocks and bonds as well as high-end real estate and art.

While there remain pockets of weakness in the housing markets, the prices of homes have also resumed their upward trajectory after crashing during the financial crisis.

So the question remains: If the prices of just about everything are rising, why is the government telling us that inflation is so low?

How the Government Measures (and Grossly Understates) Inflation

Before answering that question, it is important to understand how the government measures inflation.

There are two standard measures of inflation: the Consumer Price Index (CPI) calculated by the U.S. Bureau of Labor Statistics and the Personal Consumption Expenditures price index (PCE) prepared by the U.S. Bureau of Economic Analysis.

Each index is constructed for different groups of goods and services, and the CPI tends to show more inflation than the PCE. 

From January 1995 to May 2013, the average rate of inflation was 2.4% according to the CPI and 2.0% according to the PCE. 

Of course, when you think about it, both measures are absurdly low compared to what occurred in the real world, but we will leave that aside for the moment.

The Federal Reserve's Open Market Committee, which is responsible for setting monetary policy, favors the PCE, while the government uses the CPI to make inflation adjustments to certain government benefits such as Social Security.

The Federal Reserve favors the PCE for three main reasons. 

  • First, the expenditure weights in the PCE can change as people substitute away from some goods and services to others;
  • Second, the PCE includes more comprehensive coverage of goods and services; and
  • Third, historical PCE data can be revised.

At the moment, the most significant difference between the two measures is probably the fact that the CPI consists of a 42.4% weighting for housing while the PCE (seasonally unadjusted) consists of a much smaller 26.5% weighting.

The CPI also gives a 23.4% weighting to what it calls "Owner's Equivalent Rent," while the PCE only gives a 12.9% weighting to that category.

In other words, the cost of housing plays a larger role in the CPI than in the PCE. The other big difference is that the CPI only weights medical care at 5.2%, while the PCE (unadjusted) weights it at a whopping 22.3%. 

Food and beverages, the other large category in both indices, is roughly equally weighted in both at 15.1% in the CPI and 13.8% in the PCE (unadjusted).

While the differences between the CPI and PCE are not insignificant and would add up to large numbers over long periods of time, both measures grossly understate real-world inflation. One reason for this is because inflation is a complex phenomenon. For example, the government makes so-called "hedonic" adjustments to its price measurements to account for quality improvements in goods and services.

To take a crude example, obviously an average automobile costs a great deal more today than it did in the age of Henry Ford. But the average automobile today is light years more advanced technologically than earlier models. In order to try to account for this, the government hedonically adjusts the prices of automobiles to try to account for the change in quality.

The Real Reasons the Government Suppresses Inflation Rates

Regardless of the complexities of calculating inflation accurately, it is clear that it is in the government's interest to show inflation to be low. The most obvious reasons are that increases in government benefits are geared to the inflation rate and interest rate policy is heavily influenced by the rate of inflation. In the case of the former, the government is required by law to increase government benefits by the rate of inflation as measured by the CPI (not the PCE). 

These cost of living increases (COLA) amount to tens of billions of dollars a year. With a burgeoning government deficit, it is in the government's interest to keep these increases as low as possible.

In the case of monetary policy, the government has an interest in convincing the bond market that inflation is low and will not eat away at the value of its investments. The inflation-sensitive TIPS market closely monitors the rate of inflation.

Just because the government produces statistics stating that inflation is low does not mean that the markets will believe these statistics.

Investors are constantly on the hunt for evidence that inflation is about to rear its ugly head and eat into the value of their fixed-income investments.

It's already happening.

The year-over-year change in headline CPI was 1.58% in January and rose to 1.95% in April, while the year-over-year change in core CPI was 1.62% in January and 1.83% in April (these figures are not seasonally adjusted).

While these are still very low numbers and below the Federal Reserve's 2% target, they are clearly moving higher.

If the trend continues, the bond market may react negatively. We have already seen the yield on the benchmark 10-year Treasury bond rise by 8.3% in the last two weeks from a low of 2.44% on May 28 to 2.64% on June 11.

With interest rates so low, it won't take a large move to inflict big losses on bondholders.

So, keep an eye on what you own... and the impact the "real" inflation is going to have on it.