A million buck note.….okay it’s from Zaire but it is still a big number, and that’s the problem. People do tend to focus on the number rather than the value. What could you buy with this note? Well in Zaire probably not very much and outside of Zaire it’s probably worth a few US dollars but mainly for its novelty value. Like the oscar wilde quote…people understand the price of everything but the value of nothing. Now this might seem like an extreme example but really, how different is this from your own paper currency?
Consumer price index
That brings us to the topic of the consumer price index (CPI) which measures the average change in price of goods and services and is used as an indicator of inflation. There are actually lots of types of CPI. Fxample core CPI excludes things like food and energy costs. CPI-U is for wage earners and only accounts for 28% of the population whereas CPI-U is for urban consumers and that accounts for 88% of the population. You must be clear about what type of CPI someone is quoting to you.
Shown above are the eight components of the headline CPI. At first glance it seems to cover most of the expenses that most of us incur. However, it does not cover all important expenses. Firstly, taxation is a big expense but most people don’t realize it because it is usually extracted from wages before workers are paid. The percentage that people pay in tax does vary over the time with changes in tax policy. Another thing that most people don’t perceive is that as wages rise the tax threshold levels don’t budge and therefore more and more people fall into the higher tax bands. Therefore these tax expenses continue to rise over time. Also extra taxes keep getting added here and there. These expenses usually rise as well. Another expense is the cost of administration and bureaucracy and the fees are associated with paper shuffling. None of these things are included in the CPI calculation and yet these are substantial expenses that are not accounted for.
Different ways CPI is measured
An issue with measuring CPI is bias, by things like substitution, quality, new products, or a change in the outlets. In 1980 the CPI was measured as a fixed basket of goods where the quantity and quality of goods were fixed. In effect it was measuring a constant standard of living. However in 1990 the way the CPI was measured was changed and was so-called bias-adjusted to reflect the cost of living. For example a steak in the 1980 CPI was substituted for a hamburger in 1990, and that’s a huge difference. This has the effect of reducing the CPI but it also means that the standard of living is assumed to be reduced as well.
Why is CPI an important number?
One reason that CPI is important is because it is used to guide economic policy. If the CPI is quoted as low, that probably gives a greenlight to print money. We have been hearing lots of central banks saying how low inflation is, and that they are trying to stimulate inflation. However, real life tells a different story. Have your own expenses increased by one and a half percent a year?
CPI is also used to guide escalation agreements including benefits such as social security payments and the yield on inflation-adjusted treasury bonds. Wages and leases are also increased based on CPI and it is also a factor that is used in financial planning. CPI is clearly a very important number and let’s just say that certain parties benefit from CPI being quoted as low.
The true inflation rate?
John Williams from shadow stats has looked at this issue in great detail and in the above chart the red line shows the official CPI while the blue line shows the CPI based on the 1980 method. This suggests that current rates of inflation are closer to eight percent! Remember that this is all data from USA. This kind of data isn’t easily available for other countries so all we have is a the official data to rely on and we don’t have figures like shadow stats provide, to guide us about what’s really going on.
The role of inflation in investment
Let’s look at how this affects the everyday person in terms of their wealth. In the above chart, all values have been indexed to 100 in 1971 which was the start of the full fiat era. The official CPI is the red line and the blue line is the nominal hourly wage. We can see that wages have risen seven times, which sounds great…fantastic. It is that nominal value that most people take notice of. However the CPI has increased roughly together with wages. That means that in real terms wages are actually about the same as they were in 1971. However remember that this chart uses the official CPI figures. If we could use the shadow stats figures then the situation is actually worse. The red line would be higher than the blue line, meaning that in real terms the wage income isn’t keeping up with expenses and people are worse off than they were in 1971. Due to the steady decrease in purchasing power of the dollar, if someone worked hard, minimized their expenses and save their money as cash, their wealth would actually be shrinking.
Investment is therefore required to try and escape the inflation trap. Because people are so fixated on the nominal prices of things there are some misconceptions about investment outcomes.
This chart shows how different investments have fared. All values are indexed to 100 in 1971 and the reason for doing this is because that was the start of the full fiat era. This chart will look different depending on the index date. The red and blue lines are the wages and CPI respectively. In nominal terms gold has beaten CPI hugely. Those who invested their savings in gold back in 1971 have done exceedingly well in nominal terms. The green line shows the average house price in the USA, and again that has beaten CPI but not nearly as much as gold. That may sound surprising since the general perception is that house prices have outperformed most asset classes but the reason for this perception is because leverage is usually in play when buying property whereas it is uncommon for people to use leverage to buy physical gold and so the actual gains are greater with leverage.
Inflation steals wealth and most people don’t realize it because they are fixated on nominal values. The first most important step in increasing your wealth is to stay well ahead of inflation.