Wednesday, June 12, 2013

So Where's the Inflation?

The title of this post is one of the biggest questions facing our clients.  Inflation wreaks havoc on people saving for retirement and more so on people in retirement.  With interest rates as low as they have ever been, the risk of future inflation is magnified, because it is almost impossible that money currently in cash or bonds will be able to earn a rate of return even equal to inflation, should we see an uptick in the CPI.  

Ever since early 2009, when the Fed began it's massive effort to save the economy from the "financial crisis" by essentially "printing" massive amounts of money, we have been warning our clients that there is an increased risk of high inflation in the future.  We discussed it length in this post and this one.

Well, we are now more than four years beyond the beginning of the Fed's unprecedented actions, and there is still almost no inflation.  What's the deal?  Have things changed so much that we need new models to explain the economy?  Are we just measuring inflation incorrectly?  

Last week, this article appeared on the Economist website, discussing some of the issues surrounding the measurement of inflation:

"The datasphere is bursting with inflation indexes (inflation inflation?). The Bureau of Labour Statistics provides consumer and producer prices while the Bureau of Economic Analysis gives us all manner of deflators. There are headline and core series (the latter stripping out especially volatile prices). One can look at price indexes for personal consumption expenditures (PCE), core PCE, "market-based" PCE, and core market-based PCE. There are chained indexes. The Cleveland Fed computes up median and "16% trimmed-mean" CPI.
These different indexes provide a check on each other, and are often good at highlighting particular sorts of trends in the data. And new research by economists at the New York Fed suggests another way of chopping up inflation figures that looks especially informative. As it turns out, goods prices and services prices tend to behave very differently, with important implications for macroeconomic policy."

As an economics geek, I find this discussion of the difference between goods and services inflation very interesting.  Here's a graph from the article:

If you read the article, you'll find a detailed explanation of why goods and services inflation appear to be so different.  My take away is that this highlights one of the biggest problems in economics.  The global economy is so incredibly complex, that it is extremely difficult to accurately measure what's going on.  This graph provides one piece of a large puzzle that will never be complete. That said, it is interesting and important to look at these puzzle pieces to get as good an understanding as possible of the condition of the economy.  Unfortunately, there is no one explanation or analysis that will show us how to make the exact right decision at any given time.

I have said to many clients over the past few years that we would rather prepare for high inflation and not have it occur than to experience it unprepared.  I still believe that is the most prudent policy.