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What is Inflation, Consumer Price Index (CPI), And What Does it Mean to My Portfolio-Investments?

First I want to define these topics and in the end give you my personal opinion on what will happen (and why) in the near term:

Inflation: The rise of prices of goods and services in an economy over a period of time. In other words, think of any merchandise you purchase (iPod, books, camera, movie tickets) and places or people you pay such as a mechanic, an attorney, an accountant, and/or a Doctor. In time the prices always go up. Now when this happens, the currency (US Dollar, Euro, Peso, etc.) buys fewer of these goods which in short LOWERS your purchasing power (The ability to buy...anything). This is a loss of real value, which happens over time. To make this even simpler, for those that have been around in the 80's and earlier, what can a dollar USED to buy you? There was a time when the.99 cents store sold things that were actually.99cents. Now it is not the case.

This is part of the economic cycle. Yes, we have to go through a cycle in order for economics to perform correctly (in order not to side track, we will remain on this topic). Inflation is not positive or negative for the economy, it's both. Negative that your purchasing power goes down, which in turn makes people more reluctant to purchase goods, investments, and savings. In turn, it is positive in which the economy can recover from a recession and debt relief by reducing the level of debt. There is also Hyperinflation but I will speak of this later in the blog.

Now, after reading this, you should be thinking of the recent events and reports (if you know them) regarding how the national debt has been recently reduced and savings have gone up (more people are paying off debt and saving money). This is signs of beginning inflation. But what else are signs of inflation? Consumer Price Index that's what!

Consumer Price Index (CPI): Also known as the "True Cost of Living Index". This is simply a measurement of the average consumer (buyer) goods and services by household. Usually the goods are based on urban products that most households will need/want. Without getting too technical, it is also measured in weight (as in kilograms, LBS, etc). So weight+price=CPI. Now some countries report the CPI annually while some quarterly. As I mentioned before, the other name pretty much speaks for itself (True Cost of Living Index), in which CPI measures the rise and fall of cost of living. Why? CPI not only helps measure inflation but also wages, salaries, and pensions. In a nutshell, this index lets you know how much INCREASE you need to have PER YEAR in order to maintain the lifestyle you are currently living. For example: If CPI rose 2.4% for 2009, if you do not have an annual increase of that amount, you will (in a couple of years) not be able to maintain your current lifestyle because that dollar/peso/euro will not be able to buy you that same product that you normally purchase (because that price WILL go up eventually and yet you make the same leaving you with less money). *To see the numbers for yourself, I have included a link (located at the bottom of this article) from the Department of Labor that has a simple calculator.*

So this is a very important index! But how important is it to YOUR portfolio? If you only measure your investments and portfolio on the current stock market such as the Dow Jones, S&P, and/or Nasdaq, you are doing it wrong. As we have seen from the recent crash last year (Fall of 2008) the market drop to levels that set your portfolio back nearly, if not, 10 years (or more, depending on how NOT diversified you were) however CPI was at ZERO of 2008. So if you made 1% return AFTER TAXES then you did EXCELLENT for 2008. Please note that I said "after taxes" because a CD @ 2% for +12 months after taxes long term will not beat CPI, I will explain this on another blog in the near future. If you interview an adviser who wants to manage your money and says he measures your portfolio based on the markets and fails to mention CPI and YOUR expectations, run away!

What may happen in the near term (prediction for the USA): With talks of health reform, what we have already spent on companies not to fail, the stimulus packages, tax cuts that happened during the years of Bush, unemployment extensions, and everything else in between (such as the cash for clunkers), we have no choice but to make cuts and raise/add taxes. For example, congress may pass a law to tax EACH trader's transaction. Now I won't comment on this however you understand the idea. Tax increases will occur (but stated "in the future" which means it WILL happen). In addition, the City of New York's Governor Paterson is planning on raising taxes on film/television/theaters performed here in the great city of New York. At the same time, he has cut education and health care funding. I mention NYC because NYC is supposed to be one of the major benchmark cities in the United States, so if they are doing it, most likely your city might do the same! (with the exception of a few smaller cities)

This leads to what I believe will be a "Hyperinflation". This is, as the words "hyper" means, an out of control inflation which everything I have mentioned above but with extreme higher numbers of price increases and massive drop on currency value. In addition, history of "hyperinflation" is usually caused by the following: Aftermath of wars (We are withdrawing from Iraq by end of 2011), economic depressions (The major recession we are currently in that I feel will end by the end of 2009 or early 2010 THE LATEST), and political/social upheavals (Healthcare reform? Changes in Wall Street?).

The ONLY way to avoid this hyperinflation is if Bernanke (Chairman of the Board of Governors of the United States Federal Reserve), Geithner (US Secretary of the Treasury), and the President do not take pressure from the outside community and SLOWLY raise rates and taxes because face it, with the rates and taxes at these levels, we enjoyed are tax cuts and lowered credit card rates but it was bound to come to an end.

What to do with your money during inflation? Invest in HARD consumer products. What do I mean by "hard"? Products and goods that you can actually touch, that the price will rise such as precious metals (my favorite). Gold does exceptionally well when the dollar decreases. Now you know that inflation, value of the currency goes down, so precious metals like Gold will rise. Not to mention the prices on products that use gold, silver, bronze, etc. will rise due to inflation. So that's where I would put my money. Other places would be in is Blue-Chip stocks that pay a dividend (stock price may go up or stay the same but you receive an income from that dividend). Equities may very well outperform during the upcoming inflation (saving rates will stay the same but most likely drop due to many non-educated investors just putting everything in CD's and savings). But there is something for you non-equity traders/investors: TIPS (Treasury Inflation Protection Securities) which pays you a decent yield but also the price of the bond adjusts with inflation making sure you do not go under that CPI keeping you at par. Not to forget, it is backed by the full faith and credit (and taxing power) of the United States. Plus TIPS are exempt from Federal taxes (growth & income) but subject to state and local. Not a bad deal!

So instead of worrying about inflation, just prepare for it (what we in the industry call a "Hedging"). Best case scenario is we just have a regular inflation and I was overestimating...but isn't it better to be safe than sorry?

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What Does the "Chained CPI" Social Security Adjustment Really Mean to Seniors

Recently, President Obama submitted a budget to congress that would have clear and relatively quick impacts on the finances of retirees. He included proposals that would affect Social Security benefits. If you are a person in or nearing retirement, what does this mean to you?

In the budget proposal, annual inflation adjustments to Social Security benefits would be reduced. The mechanism is a move to the so-called "Chained CPI" method for calculating inflation. The logic is that the standard method for calculating inflation - the Consumer Price Index or CPI - over-estimates inflation. The rationale for this is that people adjust their purchasing to compensate for higher prices. To give you an example, if the price of beef rises, people will switch to cheaper alternatives (e.g. chicken). Hence, the real rate of inflation is actually less than the CPI estimates and the adjustment to Social Security should be less to reflect this.

Sounds reasonable, right? However, what are the implications? Current estimates say that moving to a chained CPI inflation adjustment for Social Security would shave about 0.25% off of the annual adjustment. If, for example, the CPI estimates inflation at 3%, the Chained CPI would drop it to 2.75%. Social Security checks would be adjusted upward by the 2.75%, not the 3%.

That doesn't sound like much. However let's do the math. At the end of a 30 year retirement, assuming an annual 3% inflation rate you would be receiving 6.8% less with the chained CPI. This assumes that you started with the average 2012 Social Security benefit of $1250/month. Over 30 years this would be a cumulative loss of over $28,000 in benefits using the Chained CPI adjustment. Some estimates put that difference as much as 9.4% less or over $38,000 in cumulative benefits lost to the average retiree. This number could be more or less depending on your starting benefit. So, what seems like a minor change can have significant ramifications when you look long-term.

From the government's perspective this is one way to reduce the deficit. They estimate that over 10 years, savings would be about $341 billion. Of that, $127 billion would come from reductions in Social Security benefits, about $89 billion from other programs (the social safety net), and $124 billion from tax bracket indexing.

Whoa, hold on for one minute. I understand the cuts to Social Security benefits, but what is this tax bracket indexing thing? Well, the CPI also is used to adjust the Federal Income tax brackets each year for inflation. This protects tax payers from being pushed into higher tax brackets because of inflation. If the Chained CPI adjustment is applied, you get less protection. So, as a senior you potentially could get a double whammy. First, you are collecting less from the Social Security benefit. Second, depending on your income, you could get pushed into a higher income tax bracket.

Now, I understand that the country is in a time of need. However, before you start getting too patriotic let's do a reality check: Are the assumptions behind the Chained CPI correct?

• First, as prices go up, people shift their purchasing to lower priced alternatives. Nothing wrong with that assumption. This is exactly how people react. So, here I am in 2013 and I stop buying expensive beef and shift to cheaper chicken. However, fast forward to 2014 and inflation is up. I have already shifted to the less expensive options, but my Social Security check is under-compensating for inflation. Where do I go now? You see, the Chained CPI logic is very time bound and unless you have options to trade down to cheaper alternatives each year, it is a flawed logic. As a Social Security recipient, you could get into a deeper financial hole each year.

• Second, some economists have argued that the CPI adjustment that is used now, based on costs for urban workers, underestimates the rise in costs for seniors. That is because seniors disproportionately purchase goods and services that have inflation rates higher than the costs estimated by the CPI. An example of this would be health care and health care-related products. So, if the current CPI adjustment is under-compensating seniors for inflation now, a Chained CPI adjustment would only worsen the situation.

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Consumer Price Index (CPI): Does It Measure Inflation?

What is Inflation?

How to calculate CPI, we much first fully understand the concept of inflation. Inflation, in the most general terms, is a RISE in price levels of goods and services measured over a period of time. When price levels rise, each unit of currency buys fewer goods and services. Inflation also measures the erosion in purchasing power of money, the loss of REAL value in the medium of exchange. Inflation impacts everyone in society, rich or poor, young or old, working or unemployed. Anyone that has to buy food, goods, and services, pay bills, or transact in the economy is directly affected by inflation.

The CPI - official measure of inflation.

The government's key measurement for inflation is known as the CPI (Consumer Price Index). It has been around since 1913 and traditionally measured a basket of goods, which consumers would purchase. Then the price the basket of goods was compared on a year-over-year basis.

For instance you price a steak, a loaf of bread, a gallon of milk, etc. The following year you price the same products, look at the price change, and you are able to determine the rate of inflation. How much have items increased in price. That is (was) the purpose of the CPI, the rate of change on a fixed basket of goods (with a modicum of replacements when a product is no longer serving its core use, such a computer for a typewriter).

The CPI is very important data point for a couple of key reasons:

Used to adjust Social Security benefits.

The Federal Reserve uses it as their key measure of inflation to adjust monetary policy.

Obviously a lower CPI would be beneficial for both those key reasons.

The Cost of Living?

When the CPI came about it was used to strictly measure INFLATION, as described above. It did so for 70 years without any major changes. More recently in the last few decades, the model used for calculating the CPI has changed drastically. In fact, it no longer measures inflation, but rather the "cost of living".

The Cost of Living measures the CHOICES a consumer has made based on price changes. In fact INFLATION directly impacts those choices. Many of the changes that have been made to the CPI over recent years have been argued based on the Cost of Living and the freedom of choice. It would seem a sound argument if we forget the purpose of the CPI to measure inflation.

The "Cost of Living" is not synonymous with inflation, yet politicians and the media frequently use the words "inflation" and "cost of living" interchangeably.

The philosophy behind the changes.

The first big change was made in the mid 1980s, it removed housing from the CPI and replaced it with a "rental equivalent". It was argued that not everyone buys a house and some that do buy also rent homes, thus we should measure the inflation of rent rather than the inflation of home prices. This made a significant and measurable change to the CPI and lowered the results.

However, it was the "Cost of Living" argument in the 1990s that brought forth the largest changes. A powerful argument based on measuring the "Cost of Living" and freedom of choice. The belief was the CPI was not reflective of consumer choices, that consumers would make changes in their purchasing to meet a Standard of Living. In order to measure this Cost of Living, we must make significant changes to the method and make some "adjustments".