Inflation and the Billion Prices Project

John Osbon - May 24, 2011

Inflation really isn’t much of a factor these days, unless you drive a car, eat food, buy health insurance, fly for business, or send your kids to college. According to the Fed in late April, “indicators are subdued and somewhat below the levels” of the Fed’s price stability mandate.

Current indicators may seem subdued to Mr. Bernanke, but even modest inflation can strain household budgets and derail investment portfolios held for the long term. So what is really going on with inflation? Here are several different places to look for the answer.

The first place to look is your own wallet. Your opinion about inflation probably depends on where you are spending your money.  If you standing at the gas pump, you may think it is way up.  If you are hiring employees from a large supply of eager, qualified labor, you may feel relief that wage inflation has disappeared.  If you are thinking of buying a house, you probably know that the “affordability index” is at its highest level in 20 years.  No inflation there.

The Billion Prices Project

If you prefer something more scientific than your own perception, look to the price indexes. BPP, started in 2008 by MIT professors, uses real time online prices to record current inflation.  According to the site, they scan 5 million items sold by 300 online retailers in 70 countries.  Its current US prices page looks like this, with BPP tracking a higher rate of price increases than the better known and broader Consumer Price Index, especially in recent months:

(click image to enlarge)

The market price of inflation

Since 1997 we have had a real-time multi-hundred billion US government securities market that prices inflation.  The securities are called TIPS (Treasury Inflation Protected Securities) and chances are good that you own some by now.  TIPS adjust upward in price according to the CPI, thus affording bondholders true inflation protection.

It is possible to calculate how the markets are pricing inflation expectation by subtracting the TIPS coupon from the 10 year treasury coupon.  Here’s a recent look at the spread:

(click image to enlarge)

Inflation expectations in the TIPS market are falling, the opposite of BPP. CPI is somewhere in between.

So which measure is right?

All of the above, and none of the above. While we all like a single neat and tidy government-approved measure of inflation, real life is not so simple. Your own inflation rate depends on how you spend your money today and what you plan to buy in the future.

Who cares?

Does the inflation rate really matter?  Very much so. Inflation is why you must take some risk in your portfolio. While investors in the ‘70s and ‘80s saw firsthand how inflation devastated bond prices overtly and portfolio values covertly, even low levels of inflation can silently destroy huge amounts of wealth.

Even with the Fed’s long-term goal of 2% inflation (rarely, if ever, achieved) money buried in the backyard would fall in purchasing power by half over a generation.  (Remember the 15 cent Hershey bar?  The $8,000 Ford pickup?  The $12,000 tuition at Dartmouth?)

As we have said on many other investing topics, it is impossible to predict what happens next. Making bets on future inflation is speculation, not investing. Fortunately, you do have weapons to combat inflation, starting with diversification.  Over the historical long run, rising stock prices and dividends have provided excellent inflation protection, as well as real estate investment property (REITs) and gold.  TIPS are the only bonds with guaranteed inflation protection.  In my view, using this “Big Four” over the long term – stocks, TIPS, REITs, and gold – you should be able to stay ahead of the elusive inflation ghost haunting the investment markets right now.

 

 

Print Friendly, PDF & Email

Disclaimer

  • This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”
  • “Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.
  • Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
  • Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.
  • This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.
  • While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
  • Adviser does not endorse the statements, services or performance of any third-party vendor.
  • Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.