Bogleheads

[mvm]

There is an interesting article in the Wall Street Journal:

http://online.wsj.com/article/....mmentaries

So...if inflation is likely to be higher than 4%...what is the investment strategy that works?

TIPS?

[Sheepdog]

Thanks for the story. Inflation is rising, over 4% at present. The story shows how just this inflation rate cuts buying power.

The accompanying graph shows how rapidly the purchasing power of income declines from an ongoing inflation of 4%. After nine years, an income of $100,000 is worth only $70,000. After 17 years its purchasing power has been cut in half, and after 30 years by about 70%.

The cumulative loss of purchasing power if inflation persists above 4% is an awesome prospect that is surely going to be unacceptable. When the Fed gets its eye back on the inflation ball, a return to higher interest rates will not be far behind.

We can see what has happened in the last year looking at grocery and energy prices. This story about precious metal price correlation with commodities is not something that I appreciated before.

But worse may be yet to come. While commodities like energy and food are leading indicators of the CPI, precious metals like gold are, in turn, leading indicators of energy and food. It's sobering to note that precious-metals prices this year are running more than 30% ahead of where they were a year ago.
Historically, CPI inflation is more closely related to prior changes in the price of gold than most people realize. The correlation is obscured by great differences in short-term behavior -- the price of gold is notoriously volatile, while the CPI is very slow-moving. It's therefore necessary to take account of gold-price changes over a multi-year time frame.
There is a remarkable parallel between annual CPI inflation and the cumulative change in the price of gold measured from eight years before. A similar graph could be plotted for silver, and the parallel can also be seen in cross-section by comparing countries over time with varying degrees of currency instability.
_________________
Happiness is not having what you want.
It's wanting what you have.

[nisiprius]

[biasion]

[removed]

[Rose21]

It is ludicrous to think that we can continue to deny the real rate of inflation (as properly defined as a monetary phenomenon) by relying upon offsetting productivity gains and--more importantly--the masking effect of cheap overseas labor. As the developing world catches on to how the game is played, we can expect to see a decade's worth of inflation come roaring back to us in terms of vastly higher prices.

[nisiprius]

[Rose21]

Just for the sake of clarification, Nisiprius, my reference to a "ludicrous" idea was meant in the abstract--and not directed to your post.

[market timer]

[kellyfj]

The government should stop using the word "Inflation" in terms of I-Bonds and TIPS. What your average person means by inflation is COLA (Cost of Living Adjustment) - CPI is an economist's measure based on utility.

For example
- Say the cost of the average TV goes up 50%
- But the quality of the TV goes up 30%
- Economists see the 20% (50-30) as the inflation (CPI) component
- Your average person in the street (me included) cares most about the 50%

-Frank

[bolt]

Unless Im mistaken the inflation projection numbers do not include nessessities like food and energy, draw your own conclusions. Good Luck!

[tacitus7]

Make an allocation into gold, as I did over 2 years ago. 5% or better to be serious about it. That is how I am coping with inflation.

Joe E.

[nisiprius]

[roymeo]

i bet if we stopped using up all the capital letters, inflation would back off. or at least not seem so threatening.

[ note from admin alex - this was a reference to the OP's title being in ALL CAPS. I routinely change these titles to Title Case when I notice them.]
_________________
The sewer system is a form of welfare state.
-- "Libra", Don DeLillo

[stratton]

The 8.x% price drop in housing is a negative drag on the economy so we may actually be deflating despite high commodity prices.

Paul

[plake15]

[jh]

...

[drjdpowell]

[Fantumzone]

[nisiprius]

[jh]

...

[TheEternalVortex]

[alec]

Question: Say the CPI-U does understate inflation. Since the method(s) the BLS uses to calculate the CPI is fairly transparent, wouldn't the market already take this into account and this would be reflected in TIPS prices and yields?

Wouldn't the market penalize the gov't by forcing them to pay higher real TIPS coupons/yields?

- Alec

[craigr]

[dougpnca]

That's an interesting piece as far as it goes. To the original question of "what investment strategy works?", there is no good answer, sorry to say. Having lived thru inflation / stagflation / etc. during the Nixon / Ford / Carter years, theory is interesting but the reality is everything gets screwed up. Perhaps the Big Dogs who deal in billions internationally have a way to make out on this, but for those of us on this forum it's batten down the hatches & try to ride out the storm. Fixed income is a serious loser (TIPS may lose less than 30 yr bonds but you'll lose something). You can sort of talk yourself into treading water with equities & some people get lucky with commodities (luck in picking the right one). But the biggest killer is the loss of purchasing power, plain & simple.

Ever had passbook savings account that paid 13%? I have, but inflation was 12%-16% (depending on which gov't agency was figuring). Trust me, there is no safe harbor when serious inflation kicks in. The 4% is worrisome & the gov't will do everything in their power to mess around with the numbers to keep us in the dark. Heck, the exclusion of food & energy is ridiculous. Too volatile? Welcome to the real world!

One HUGE factor the article misses is the ultimate cost of our huge spending deficits, with billions of dollars going into the economy both on & off budget. Those dollars will come back to haunt us. The inflation of the 70s / 80s had its roots in the Vietnam War expenditures. It's deja vu all over again.

The gov't is in a tough spot. The response control should be interest rate hikes & tax increases to slow the growth of the money supply. But that has no political traction & the idea will never even be proposed, it's such a non-starter. A more likely possibility is to reduce gov't spending but even that has very little chance of going anywhere. So get ready for a dose of serious inflation. Once it becomes a crisis, the Wizards in Washington will deal with it in their usual deft, sensitive manner.

dougP
_________________
every dollar not spent is a buck & a half you don't have to make.

[Fantumzone]

[TheEternalVortex]

[market timer]

[Jack]

[market timer]

[Jack]

Yes, inflation has increased by 4+ percent from a year ago. That is not the same thing as saying we have had a 4+ percent rate of inflation for over a year. The rate for most of the last year was much less than that. It is only the increasing rate in the last few months that has brought the average up. Annual inflation and rate of inflation are two different things.

The important point is that for most of the last year inflation has not been a problem, but the last few months the rate has increased sharply causing a lot of concern.

[craigr]

[Fantumzone]

[alec]

[nisiprius]

[altreg]

I recently received the annual report of the Julius Baer International Equity Fund and the manager, Rudolph Riad- Younes had a damning indictment of US fiscal policy as it involves inflation. I am enclosing it below and would appreciate any comments.

The Cardinal Sin: Believing in Santa Claus
If there were one cardinal sin to point to as the main enabler of the Age of
Decadence, it would be the overhauling of the inflation index. The high inflation
environment from the late 1970s to early 1980s created a vicious cycle for the
Federal government because entitlement benefits were indexed to the inflation rate.
High inflation led to higher entitlement costs and bigger government deficits.
One way to lower the entitlements was to bring inflation rates down, translating
into lower cost of living adjustments (COLA). Instead of inflicting the pain to bring
down the inflation rate, the government chose to alter the way it measured inflation,
bringing the index artificially down. It replaced house prices with owners’
equivalent rent (OER), introduced the concept of product substitution; and
reduced prices of goods for quality improvements. Under these rules, the new inflation
index was consistently below the old one. For example, under the old method,
inflation during the past ten years would have ranged between 8% and 10% while
under the new method it ranged between 2% and 4%.
While the artificially low inflation reading aided our fiscal situation, it inflicted fatal
blows to our economic policies.With the new index understating inflation by
approximately 4%-6% during the past decade, the Fed set interest rates too low and
helped create the mirage of high real growth and low inflation which led credence
to the theories of “the productivity miracle” and “paradigm shift”.
However, history has taught us that the only miracle that comes from easy monetary
policies is a bubble in asset prices. Had the inflation methodology been kept
intact, inflation readings would have been 4%-6% higher and interest rates would
have been correspondingly higher. In such an environment, we would have grown
slower during the boom but we would have avoided the bubbles and the ensuing
bust. Like the tortoise, we would have beaten the hare through the full economic
(boom/bust) cycle.
12 Julius Baer Funds 2007 Annual Report
Directly targeting asset prices has always been political suicide for the Fed.The old
inflation index—since it included asset prices—would have allowed the Fed to fight
asset bubbles while only targeting inflation.
In short, the government (the parents) invented Santa Claus in order to cheer up
pensioners and laborers (the children) who were worried about their parent’s ability
to pay for their entitlements (gifts).The whole family was happy with Santa Claus.
The children were happy with the yearly gifts and parents were satisfied that their
children were buying the fairly tale and able to rein in spending. But as in real life,
it is a blessing only when children believe in Santa Claus and a tragedy when parents
do!
The Fed now conducts its policies based on the new method, ignoring many obvious
signs: the 8%-10% reading from the old method, the tech bubble, record trade
deficits, record budget deficits, free falling US dollars, skyrocketing commodities,
subprime bubble, housing bubble, etc… What a tragedy indeed!

[grayfox]

Here is something that has nothing to do with anything discussed.

Since there is always a lot of confusion over inflation rate whether it's year-over-year or whatever, I prefer to always look at the CPI-U level and think of it as dollars.

So for instance CPI-U was 168.8 in Jan00 and is 211.080 in Jan08 it means that if your monthly food bill was $168.80, now it is $211.08. Or if your rent was 1,688 per month back then it is 2,110 per month now.

I'm not as interested in whether it came in the first half or second half of 2007 or 2006, but what level it is at now and that is a 25.4% increase in the cost of living since Jan00. If you are retired and taking 4% withdrawal from your portfolio, did it grow by 25% since Jan00? Did your interest and dividends grown by 25%? If not you are not keeping up with inflation.

[Jack]

Market timer and Fantumzone are right. The monthly inflation rate published by the DOL is not the monthly annualized rate. Their monthly number is actually the annual change over the previous year. In a sense this method becomes a lagging indicator. I suppose they do it this way to smooth the monthly fluctuations and it is a useful number if you apply it to other year over year calculations. You have to look at the raw index to determine the annualized month to month rate.

[nisiprius]

[grayfox]

[craigr]

[nisiprius]

By the way, not that it matters but Social Security payments are adjusted by CPI-W, whatever that is, instead of CPI-U, whatever that is. CPI-W is a smidgen smaller, but really just a smidgen.
_________________
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

[MarcMyWord]

The debate about whether the CPI accurately reflects "inflation" has been handled articulately by various posters in this thread, and in many others on the forum, so I won't add to it.

But among the many things that bother me about TIPS, there is the following language in the Treasury's original description of the TIPS program: "If the CPI-U is discontinued during the period the inflation-protection security is outstanding, the Treasury will, in consultation with the Bureau of Labor Statistics (or successor agency), determine an appropriate substitute index and methodology for linking the discontinued series with the new price index series. Determinations of the Secretary of the Treasury in this regard are final."

As I read this language--which, to the best of my knowledge, remains in effect--it provides a giant "escape clause," in which the government could simply decide that the current CPI is costing too much in COLAs, TIPS inflation payouts, etc., abolish it, and then substitute an entirely new definition of inflation, applied not only to future TIPS issues but also retroactively to all outstanding TIPS, with no recourse for any holders (institutional or individual) of TIPS, since the decision of the Secretary "is final." In high finance, I believe this is called Bait and Switch.

No, I don't mean to sound overly suspicious of the government. Yes, I am buying TIPS. But no, I don't feel entirely at ease about it. Language like the quote above is just another reason that predicting the future behavior and investment outcome of TIPS, even TIPS bought at original issue and held to maturity, may not be as straightforward as we would all like to think.

[MarcMyWord]

Nisiprius,

CPI-U is for "All Urban Consumers"

CPI-W is for "Urban Wage Earners and Clerical Workers"

Don't know why TIPS are based on the former but Social Security increases on the latter.

http://www.bls.gov/ro3/fax_9195.htm

[drjdpowell]

[market timer]

Craig,

What got you so interested in currency, and do you have any recommendations for books on the subject? I studied a bit of monetary theory, but don't have much of an historical perspective. From the little I know, I don't see compelling reasons to store wealth in any fiat currency.

[Fantumzone]

Google mystery of banking
You should get a pdf book by rothbard (an economist)

[tacitus7]

[drjdpowell]

[drjdpowell]

[Fantumzone]